1. Chapter 13 Business Cycle Models with Flexible Prices and Wages Copyright © 2014 Pearson Education, Inc.

2. 1-2 © 2014 Pearson Education, Inc. Three Business Cycle Models Real Business Cycle Model: Business cycles are caused by fluctuations in total factor productivity (real shocks) => fits the data well in normal times. Keynesian Coordination Failure Model New Monetarist Model: goo to explain the facts related to the recent financial crisis.

3. 1-3 © 2014 Pearson Education, Inc. Figure 13.3 Average Labor Productivity with Total Factor Productivity ( TFP ) Shocks

4. 1-4 © 2014 Pearson Education, Inc. Figure 13.1 Solow Residuals (proxy for TFP) and GDP

5. 1-5 © 2014 Pearson Education, Inc. Figure 13.2 Effects of a Persistent (but temporary, not permanent) Increase in Total Factor Productivity in the Real Business Cycle Model a)↑ TFP=>Nd ↑: w ↑,N ↑ b)N ↑ =Ys ↑ r MUST ↓ because z is higher today than in the future, so Y is expected to ↓ in the future=> consumption smoothing=> save more today (this makes r ↓) and consume in the future Yd ↑ because of r ↓ and future Y ↑ (investment ↑, consumption ↑) c)Md ↑ because of r ↓ and Y ↑=>P ↓

6. 1-6 © 2014 Pearson Education, Inc. Table 13.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Stocks Model fits the data well

7. 1-7 © 2014 Pearson Education, Inc. Figure 13.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money

8. 1-8 © 2014 Pearson Education, Inc. A New Monetarist Model: Financial Crises and Deficient Liquidity Two classes of liquid assets in the economy: currency and financial liquid assets. Financial liquid assets include relatively safe assets that are widely-traded in the financial system – e.g. government debt, asset-backed securities, (bank reserves).

9. 1-9 © 2014 Pearson Education, Inc. Financial Liquid Assets Can be expressed as B = nominal government debt. k is a decreasing function of r, and k(r) denotes financial liquid assets that are “produced” in / “supplied” by the private financial system.

10. 1-10 © 2014 Pearson Education, Inc. Financial Liquid Assets Assume that, in the model, there can be two possible states of the world: adequate financial liquidity and deficient financial liqudity. Deficient financial liquidity occurs in a financial crisis due to factors that impair the ability of the financial sector to create financial liquid assets.

11. 1-11 © 2014 Pearson Education, Inc. Modifying the Basic Monetary Intertemporal Model In the New Monetarist model, financial liquid assets, a, have a positive effect on output demand if there is deficient financial liquidity. Given equilibrium in the money market,

12. 1-12 © 2014 Pearson Education, Inc. New Effect in the New Monetarist Model An open market purchase (M goes up, B goes down) shifts the output demand curve to the left, if there is deficient financial liquidity.

13. 1-13 © 2014 Pearson Education, Inc. Figure 13.13 A Reduction in Financial Liquid Assets, Producing Deficient Financial Liquidity

14. 1-14 © 2014 Pearson Education, Inc. Excess Reserves and the Liquidity Trap If reserves pay interest, as is the case currently in the United States, and there is a positive supply of reserves in the financial system, then the interest rate on reserves determines the market interest rate. Open market operations have no effect.

15. 1-15 © 2014 Pearson Education, Inc. Excess Reserves and the Liquidity Trap M r denotes reserve account balances, M c denotes currency. Now, re-define financial liquid assets as: Monetary Policy with Excess Reserves and a Liquidity Trap, an Increase in the Interest Rate on Reserves can be beneficial. Conventional Open market operations have no effect.