1. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 0

2. C H A P T E R 20 Advanced Topics Learning objectives äUnderstand that in a rational expectations model, people form expectations that are consistent with the way the economy operates. Anticipated monetary policy has no real effects in the short run or the long run. äUnderstand that the random walk theory of GDP argues that most shifts in output are permanent, as opposed to transitory booms and recessions, and that changes in aggregate demand are much less important than changes in aggregate supply. äUnderstand that real business cycle theory argues that money is very important and that economic fluctuations are due largely to changes in technology. äUnderstand the New Keynesian models of price stickiness offer “microfoundations” explaining why the price levels does not always adjust quickly to changes in the money supply. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

3. Slide 2 Advanced Topics oFour New Theories in this Chapter oFour New Theories in this Chapter: 1)Rational Expectations 2)The Random Walk of GDP 3)Real Business Cycle Theory 4)New Keynesian Models of Price Stickiness. Chapter 20: Advanced Topics

4. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 3 Overview of the New Macroeconomics Chapter 20: Advanced Topics oRational Expectations Equilibrium oRational Expectations Equilibrium: A model in which expectations are formed rationally and markets are fully in equilibrium. oRational Expectations oRational Expectations: Theory of expectations formation in which expectations are based on all available information about the underlying economic variables; frequently associated with New Classical macroeconomics. oPolicy Irrelevance oPolicy Irrelevance: Refers to the inability of monetary or fiscal policy to affect output in rational expectations equilibrium models.

5. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 4 Overview of the New Macroeconomics Chapter 20: Advanced Topics oRandom Walk of GDP oRandom Walk of GDP: A variable in which changes over time are unpredictable. oReal Business Cycle Theory oReal Business Cycle Theory: Theory that recessions and booms are due primarily to shocks in real activity, such as supply shocks, rather than to changes in monetary factors. oPropagation mechanism oPropagation mechanism: Mechanism by which current economic shocks cause fluctuations in the future, for example, intertemporal substitution of leisure. oIntertemporal substitution of leisure oIntertemporal substitution of leisure: The extent to which temporarily high real wages cause workers to work harder today and enjoy more leisure tomorrow.

6. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 5 Overview of the New Macroeconomics Chapter 20: Advanced Topics oDisturbances oProductivity Shock oProductivity Shock: Changes in the level of technology that affect workers’ productivity. oNew Keynesian Models of Price Stickiness oNew Keynesians: oNew Keynesians: Those who develop models whose basis is rational behaviour and conclude that the economy is not inherently efficient and that, at times, the government ought to stabilize output and employment. oPrice Stickiness oPrice Stickiness: When prices do not move with the infinite speed assumed in the Classical model. oMenu cost oMenu cost: Small cost incurred when the nominal price of good is changed. oImperfect competition oImperfect competition: Forms of competition in which firms have market power.

7. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 6 Rational Expectations Revolution Chapter 20: Advanced Topics oAS oSimple Aggregate Supply-Aggregate Demand Model oAD (2)(2) (1)(1) (3)(3) (4)(4)

8. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 7 Rational Expectations Revolution Chapter 20: Advanced Topics oLucas critique oLucas critique: Points out that many macroeconomic models assume that expectations are given by a particular function, when that function can change. oPerfect foresight oPerfect foresight: Assumption that people know the future value of all relevant variables, or that their expectations are always correct. (5)(5) (6)(6) (7)(7)

9. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 8 Rational Expectations Revolution Chapter 20: Advanced Topics oA Rational Expectations Model (8)(8) (9)(9) (10)(10)

10. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 9 Rational Expectations Revolution oA Rational Expectations Model (cont’d) (11)(11) (12)(12) (10)(10) Chapter 20: Advanced Topics

11. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 10 Rational Expectations Forecast Errors Are Unpredictable BOXBOX 20-1

12. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 11 Rational Expectations Revolution Figure 20-1: Actual, Anticipated, And Unanticipated M2 Growth, 1973-2003

13. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 12 Rational Expectations Revolution Chapter 20: Advanced Topics Recap oRational expectations models predict that unanticipated changes to the money supply change the overall price level proportionately, leaving output unchanged. oWith respect to anticipated money growth, rational expectations models operate as if the long run aggregate supply curve is applied instantaneously, not just in the long run. oWhile the intellectual appeal of rational expectations models is very strong, the empirical evidence is less supportive.

14. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 13 Rational Expectations Revolution Figure 20-2: Expected Money Growth and Growth of Output, 1973-2002

15. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 14 The Imperfect Information AS Curve Chapter 20: Advanced Topics oImperfect Information Model oImperfect Information Model: Forecasts based on imperfect information will be less than fully accurate, although not necessarily biased.(13)(13) (14)(14) oSupply of output produced on the i th island i: (15)(15)

16. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 15 The Imperfect Information AS Curve Chapter 20: Advanced Topics(16)(16) (17)(17) (18)(18) oDemand for product i: oEquilibrium price:

17. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 16 The Imperfect Information AS Curve Chapter 20: Advanced Topics (19)(19) (20)(20) oIn the aggregate:

18. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 17 The Imperfect Information AS Curve Chapter 20: Advanced Topics Recap oAgents forecast the overall price level on the basis of imperfect information. As a result, increases in market-specific prices are attributed partially to increases in the overall price level and increases in real demand. oUnanticipated increases in the overall price level generate partial increases in the anticipated price level and partial increases in output. The positive associations between increases in p and y become the Phillips curve that we see in the data.

19. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 18 A Visual Example of Forming an Expectations BOXBOX 20-2

20. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 19 The Random Walk of GDP… Chapter 20: Advanced Topics oOutput is composed of a … oTrend (secular) component oTrend (secular) component: Potential output. oCyclical component oCyclical component: Fluctuations of output around its trend; the output gap.

21. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 20 The Random Walk of GDP… Output Time Figure 20-3: A Stylized Business Cycle Peak Trough RecoveryTrendRecession Peak

22. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 21 The Random Walk of GDP… Chapter 20: Advanced Topics oRepresentations of Trend and Shock… (21)(21) (22)(22) OROR(23)(23)Trend

23. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 22 The Random Walk of GDP… Chapter 20: Advanced Topics oIs the effects of shocks permanent or transitory? By adding a shock to eq. 21… (24)(24)OROR (25)(25)OROR By adding a shock to eq. 23…

24. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 23 The Random Walk of GDP… Chapter 20: Advanced Topics oTrend Stationary: oTrend Stationary: A variable is trend stationary when temporary shocks do not permanently affects its level. Changes in AD, for example, can only temporarily affect output. If changes in output were driven primarily by demand shocks, output would be trend stationary. oDifference Stationary: oDifference Stationary: Temporary shocks to a variable permanently affect its level. A random- walk is an example of a difference-stationary process. oTrend stationary with Breaks: oTrend stationary with Breaks: Trend stationary, but with a trend that sometimes changes.

25. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 24 The Random Walk of GDP… Figure 20-4: Actual and Potential GDP, 1960-2002

26. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 25 The Random Walk of GDP… Figure 20-5: Actual and Two Estimates of Potential GDP, 1960-2002

27. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 26 The Random Walk of GDP… Chapter 20: Advanced Topics Recap oThere is significant empirical evidence that macroeconomic fluctuations are dominated by shocks with permanent effects. Since aggregate demand shocks do not have permanent effects, this evidence argues that aggregate demand fluctuations are less important than aggregate supply fluctuations. Changes due to aggregate supply shocks, in particular shocks to technology, could well be permanent. oAn alternative view of the evidence is that there are occasional episodes of large, permanent aggregate supply shocks, but that between these episodes, aggregate demand shocks predominate.

28. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 27 Real Business Cycle Theory Chapter 20: Advanced Topics oReal Business Cycle Theory oReal Business Cycle Theory: The theory asserts that fluctuations in output and employment are the result of a variety of real shocks that hit the economy, with markets adjusting rapidly an d remaining always in equilibrium.(27)(27) oThe single parameter model: The intertemporal elasticity of substitution of labour. (26)(26) (28)(28)

29. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 28 Real Business Cycle Theory Chapter 20: Advanced Topics (29)(29) (30)(30) (31)(31)

30. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 29 Real Business Cycle Theory Chapter 20: Advanced Topics(33)(33) (32)(32)OROR (34)(34) Deep parameters: Deep parameters: Parameters that describe the preferences of individuals and the production of firms, and that can be identified from macroeconomic studies.

31. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 30 Real Business Cycle Theory Chapter 20: Advanced Topics Recap oReal business cycle theory models the macroeconomy through the optimizing decisions about work and consumption made by individuals and the optimizing decisions about production made by firms. The model presented above is a simple version of the non-linear, dynamic models deployed by RBC theorists. oReal business cycle theory minimizes the role of nominal fluctuations and money. oRBC theorists try to identify deep parameters that can be measured in microeconomic studies. The elasticity of the intertemporal substitution of leisure is a key example. The conclusion from the measurement of such parameters are not always favourable to the RBC models.

32. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 31 New Keynesian Model of Sticky Nominal Prices Chapter 20: Advanced Topics oNew Keynesian Models oNew Keynesian Models: Generally rely on an assumption of imperfect competition. New Keynesian models explain how individually rational decisions under imperfect competition lead to a socially undesirable booms and busts. oMankiw’s Model oMankiw’s Model: Explains why individual, imperfectly competitive firms might leave nominal prices unchanged (“sticky”) in the face of a change in nominal money supply. oMankiw shows that the private benefits of changing a price can be much smaller than the social benefits of changing a price… o…if there is substantial monopoly power in the economy.

33. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 32 New Keynesian Model of Sticky Nominal Prices Chapter 20: Advanced Topics (35)(35) The demand facing firm i as The price charged by the firm is The firm’s nominal profit will be (36)(36) (37)(37)

34. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 33 New Keynesian Model of Sticky Nominal Prices Chapter 20: Advanced Topics oNew Keynesian Models oNew Keynesian Models: Generally rely on an assumption of imperfect competition. New Keynesian models explain how individually rational decisions under imperfect competition lead to a socially undesirable booms and busts. oMankiw’s Model oMankiw’s Model: Explains why individual, imperfectly competitive firms might leave nominal prices unchanged (“sticky”) in the face of a change in nominal money supply. oMankiw shows that the private benefits of changing a price can be much smaller than the social benefits of changing a price… o…if there is substantial monopoly power in the economy.

35. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 34 New Keynesian Model of Sticky Nominal Prices Chapter 20: Advanced Topics menu cost oIf the firm raises its price, there is a menu cost Mankiw showed that the potential profit can be very small when two conditions hold: 1)If the deviation between optimal price and existing price is small, the profit opportunity is very small. 2)If the elasticity of firm demand is low, profit is relatively less sensitive to getting the price exactly right.

36. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 35 New Keynesian Model of Sticky Nominal Prices Figure 20-6: Profit Loss and Deviation From Optimal Price

37. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 36 New Keynesian Model of Sticky Nominal Prices Chapter 20: Advanced Topics Recap oThe New Keynesians try to build models based on maximizing behaviour that result in aggregate supply-aggregate demand-like behaviour. oMost New Keynesian models rely on imperfect competition. oPrices can be sticky, even though the menu costs of adjustment are quite small, because the increased profit from resetting prices is even smaller.

38. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 37 Chapter Summary Modern theories emphasize the consistency of macroeconomic and microeconomic theories. The rational expectations approach emphasizes the consistency of public expectations about the behaviour of the economy. Rational forecasts make errors, but not predictable ones. The rational expectations approach suggests that anticipated monetary policy is neutral even in the short run. Chapter 20: Advanced Topics

39. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 38 Chapter Summary (cont’d) An imperfect-information approach will explain a short run upward-sloping aggregate supply curve, but one in which the trade-off between output and inflation cannot be exploited through anticipated monetary policy. The random walk model of output suggests that economic fluctuations are highly persistent-and therefore not dud to changes in aggregate demand. The real business cycle approach builds models of a dynamic economy in which real shocks are propagated. These models minimize the role of the monetary sector. Chapter 20: Advanced Topics

40. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 39 Chapter Summary (cont’d) New Keynesian models attempt to reintegrate aggregate demand, especially sticky prices, with solid microeconomic foundations. Chapter 20: Advanced Topics

41. Copyright 2005 © McGraw-Hill Ryerson Ltd.Slide 40 The End Chapter 20: Advanced Topics