Market Clearing Model of The Business Cycle | ECON 3020, Study notes of Macroeconomics

Download Market Clearing Model of The Business Cycle | ECON 3020 and more Study notes Macroeconomics in PDF only on Docsity! 1 1 Chapter 11: Market Clearing Models of the Business Cycle – Wages and prices adjust quickly enough so that ‘market-clearing’ models of the economy are good approximations to reality. – Market clearing business cycle models have strong theoretical foundations (the microfoundations). – Real Business Cycle Theory: business cycles are the optimal responses of consumers & firms to TFP shocks – Lucas Money Surprise (misperception): Take the RBC model as a starting point, but give the consumer only partial information about economic events – Keynesian Coordination Failure Model: A market-clearing model with a role for government intervention 2 The Real Business Cycle Model – Introduced in the early 1980s. Can random TFP shocks (we call these ‘real’ shocks) cause business cycles? Potential since detrended Solow residuals from the exogenous growth model tracks fluctuations in GDP closely – TFP changes: weather, technological innovations, government regulations. We know that the economy is repeatedly hit with TFP shocks. – The Solow residual plays a central role in the arguments of both the proponents and opponents of RBC theory 3 – The RBC model can be studied with or without money because money has no effect in the model – We add money to the model to attempt to explain how the price level changes over the business cycle • Proponents of RBC theory calculate Solow residuals (TFP, or ‘Z’ in the production function) on an annual or quarterly basis. They plot these against GDP and point out the close relationship. • Opponents of RBC theory argue that the Solow residual is mis-measured. As we saw earlier, there are measurement errors associated with estimating TFP shocks. 4 – Variable capacity utilization: during an expansion capital fully utilized (less breaks, more overtime), in recessions all capital stock is not used – The same is true labor, firms may keep workers even if using less labor (called labor hoarding) since training new workers is costly (and often firms must pay severance pay), firms can encourage workers to work harder in expansions – Both of these facts means that labor/capital inputs are measured as higher than ‘truth’ in recessions, and lower than ‘truth’ in expansions- hence we measure bigger changes in TFP than in reality 2 5 – Example (recall that Zt =Yt / KtαNt1-α in the Cobb-Douglass production function) – Now let Yt=Zt(UtKt)α(StNt)1-α so that Zt=Yt / [(UtKt)α(StNt)1-α] – An example: 0 5 10 15 20 25 30 35 1 2 3 0 0.5 1 1.5 2 6 – There is a lot of empirical evidence of procyclical utilization of both labor and capital – Care must be taken in interpreting Solow residuals calculated in the standard way – Is the fact that we observe variable rates of capacity utilization (labor and capital) an argument against TFP shocks as the main source of business cycle fluctuations? – We do not incorporate variable utilization directly in our model to keep the analysis tractable 7 • The RBC model: The complete intertemporal model with a temporary productivity shock (a temporary increase in TFP) – Which empirical facts of the business cycle does the RBC model match? – Which empirical facts of the business cycle does the RBC model miss? – A model with a persistent TFP shock • Fiscal Policy in the RBC Model – Shocks (changes in) government spending or taxes may an additional source of fluctuations (RBC theorists believe that roughly 70% of business cycle fluctuations are due to TFP shocks, so even the strictest adherents to RBC theory think other shocks are important) 8 – Taxes and government spending do change over time – An increase in Government spending in the RBC framework – Does the result fit empirical facts? – We would conclude that government spending is procyclical. We could argue that this is evidence in favor of fiscal shocks as another source of business cycles. – Optimal fiscal policy in the RBC model: What should the government do to counteract a recession caused by a fall in TFP?