Preliminaries
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Market-Clearing Models
of the Business Cycle
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Up to 1970’s Keynesian business cycle theory
dominated the macroeconomic policy and
research
Debate on the effectiveness of monetary policy
(mainly due to monetarists)
Early 1970’s: rational expectation revolution
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Copyright © 2002 Pearson Education, Inc. And Dr Yunus Aksoy
Slide 1
Figure 10-15 An Increase in the Money Supply in
the Sticky Wage Model
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Lucas, Sargent, Wallace, Prescott
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Slide 2
Table 10-1
Slide 3
rational expectation revolution
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microfoundations
Equilibrium models
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Slide 4
Two models to be studied
Two distinctive features
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1. macroeconomic models should be based on
microfoundations
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Friedman-Lucas money surprise model (as we
have seen in the derivation of the SRAS curve)
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Real Business Cycle model
2. equilibrium models, still room for policymaking
Copyright © 2002 Pearson Education, Inc. And Dr Yunus Aksoy
Slide 5
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Slide 6
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Figure 11-1 The Effects of an Unanticipated Increase in
the Money Supply in the Money Surprise Model
Imperfect Information Model
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Mechanism: Nominal wage rise is perceived as being
real wage riseÎ Labor supply increasesÎ Labor
market eq´m: higher employment and lower real
wages ÎLabor realizes that prices have also risenÎ
labor supply curve shifts back
Confusion between overall change in prices with
relative prices
Y = Y + α (P − P e)
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Slide 7
Table 11-1
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Real Business Cycle Model
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Slide 9
Kydland and Prescott (1982)
Question is: Can only real variables replicate
Business Cycle stylized facts?
Productivity shocks (Solow residuals)
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Slide 10
Figure 11-3 Effects of a Persistent Increase in Total
Factor Productivity in the Real Business Cycle Model
Figure 11-2 Solow Residuals and GDP
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Slide 8
Slide 11
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Slide 12
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Table 11-2
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In RBC money is neutral so it may seem that it cannot
account for
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Procyclical money supply
Money supply as a leading variable
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Copyright © 2002 Pearson Education, Inc. And Dr Yunus Aksoy
Slide 13
Figure 11-4 Procyclical Money Supply in the Real
Business Cycle Model with Endogenous Money
Endogenous money as a solution: money supply is
not determined by the monetary authority, but it
simply responds to market conditions!!
Causation versus correlation debate!
Copyright © 2002 Pearson Education, Inc. And Dr Yunus Aksoy
Policy Implications
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According to the basic form of this world view
there is no role for stabilization policy! (BC
smoothing!)
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Level changes in the money supply is neutral
All markets clear, no inefficiencies
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Role for G, consistent with LR
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Slide 15
Policy Implications
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Slide 16
RBC Critique
If however you recognize existence of
inefficiencies and distortions there is role for
the Policy
Mainly taxation (smooth taxes rates over time)
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Slide 14
Slide 17
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Is Solow residual a good proxy for productivity?
There may be labour hoarding that distorts the
measurement of productivity!
How to explain convincingly negative technology
shocks?
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Slide 18
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Figure 11.8 Relative Price of Energy
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Slide 19
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