Chapter 11
Market-Clearing Models
of the Business Cycle
Copyright © 2002 Pearson Education, Inc.
Slide 1
A Little History
1930’s: Keynes’s General Theory of
Employment, Interest and Money appears.
1960’s: More effective to stabilize economy
Keynesians: Fiscal policy
Monetarists: Monetary policy
agreed that effective in SR because of P and W
inflexibility (markets don’t clear)
1970’s: Rational Expectations Revolution
(Lucas,…)
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Slide 2
Rational Expectations Revolution
The RER had two key principles
1. Macroeconomic Models should be based on
Microeconomic Principles
2. Equilibrium Models most productive to study
macroeconomic phenomena
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Slide 3
Study Two/Three MarketClearing Business Cycle Models
Money Surprise Model (Friedman-Lucas)
Real Business Cycle Model
(Keynesian Coordination Failure Model)
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11-4
Friedman-Lucas Money Surprise
Model
Before: all short run non-neutrality of money
was thought to be caused by sticky prices and
wages preventing markets from clearing
1968 (Friedman) formalized in 1972 (Lucas):
Markets clear but workers have imperfect
information in the SR about macro variables
important for decision making
Mistake surprise increase in Ms for increase in z
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Slide 5
Figure 11-1 The Effects of an Unanticipated Increase in
the Money Supply in the Money Surprise Model
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Slide 6
Table 11-1
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Slide 7
Real Business Cycle Model
(Kydland and Prescott, 1982)
(Cooley and Hansen, 1989)
Solow residual (TFP) is a persistent variable
In Monetary Intertemporal Model (Chapter 10)
consider increase in both, z and z’
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Slide 8
Figure 11-2 Solow Residuals and GDP
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Slide 9
Real Business Cycle Model
(Kydland and Prescott, 1982)
(Cooley and Hansen, 1989)
Current TFP, z, increases:
Future TFP, z’, increases:
N d increases, hence Ys increases
Id increases, Cd increases (increase in lifetime wealth)
Yd increases
Y* increases, if shift Yd smaller Ys, r* decreases
C, I, Md increases, P* falls, Ns falls but less Nd
(intertemporal substitution effect rel. small)
N* increases, w* increases, Y* increases
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Slide 10
Figure 11-3 Effects of a Persistent Increase in Total
Factor Productivity in the Real Business Cycle Model
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Slide 11
Figure 11.3 Average Labor Productivity
with Total Factor Productivity Shocks
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11-12
Table 11.1 Data Versus Predictions of the Real
Business Cycle Model with Productivity Shocks
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11-13
Figure 11-4 Procyclical Money Supply in the Real
Business Cycle Model with Endogenous Money
Increase in money supply due to increased activity in banking sector.
This affects deposits etc. increasing the money supply endogenously.
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Slide 14
Figure Deviations from Trend in M2 and GDP
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Slide 15