Business Cycle Theory
• Until the 1960s, macroeconomists believed that
money was not neutral in the short-run, arising
from the short-run inflexibility of wages and
prices
• Rational Expectations revolution in the early
1970s
– Macro models should be based on micro principles
– Models with flexible prices and wages can be useful
for studying macro phenomena
Business Cycle Models with
Flexible Prices and Wages
• Real Business Cycle Model
• Keynesian Coordination Failure Model
Key Questions
• How does each model fit the data? The first
two models are intended to fit the “average”
business cycle. The last one is intended to
capture particular features of the financial
crisis.
• What is the role for government policy in
each model?
Key Graphs
• Before getting into the specifics of the different
Market clearing Business Cycle models
• Let’s make sure we’re familiar with the
graphical analytical tools
– Labor Demand and Labor Supply
– Output and Labor (zF(K,N) as function in N)
– Output and interest rate (YS and YD)
• Recall that higher interest rates implies higher labor supply
– Price level and Money Supply (MS and PL(Y,r))
Graphs: Labor and Output
• In (a), the intersection of the
current labor supply and demand
curves determines the current real
wage and current employment
• In (b), the production function
determines aggregate output
Graphs: Output Curves
• An increase in real interest rate shifts
the labor supply curve to the right,
increasing employment and output
• Hence the output supply curve YS is
upward sloping
Graphs: Money Supply and
Demand
• Money Demand
increases with income,
price level and decreases
with interest rates
• Money Supply is given
exogenously
Real Business Cycle Model
• Business cycles are caused by fluctuations in
total factor productivity.
• There is no role for the government in
smoothing business cycles – cycles are just
optimal responses to the technology shocks.
• Model fits the data well.
Solow Residuals and GDP
• Kydland and Prescott
show that a standard
model of economic growth
with random productivity
shocks (real) match
observed business cycles
• They were perhaps
motivated by the fact that
detrended TFP closely
tracks detrended GDP
Persistent Increase in TFP
• With a persistent increase in TFP, firms’ labor
demand shifts to the right
• leading to a shift of the output supply curve to
the right
• lower interest rates lead to lower labor supply
• higher income leads to higher money demand
• leading to decrease in price levels
Average Labor Productivity
with TFP Shocks
• When output and
productivity are high,
average labor
productivity is also
high, as in the data
Data vs. Predictions of the
Real Business Cycle Model
Procyclical Money Supply
with Endogenous Money
A persistent increase in TFP
• increases aggregate real income
• reduces the real interest rate
money demand increases
If central bank attempts to stabilize
the price level, money supply
increases
As a result, money supply is
procyclical!
Implications of RBC Model
• Business Cycles are efficient – no role for government
stabilization policy
• If there are distortionary taxes (e.g. income tax, sales
tax), it is optimal to have smooth tax rates over time –
“built-in stabilizer” since tax revenue drops in
recessions and increases in booms
• Critique: Business Cycles are not “explained” – driven
by exogenous fluctuations in productivity
Keynesian Coordination
Failure Model
• Strategic complementarities (e.g. number of people at
party, computer software and hardware producers) give
rise to multiple equilibria – Business cycles can be
driven by waves of optimism and pessimism
• The model can fit the data as well as the real business
cycle model.
• GDP fluctuates in the model because of self-fulfilling
waves of optimism and pessimism.
A Production Function with
Increasing Returns to Scale
• Strategic complementarities
among firms imply that there
can be increasing returns to
scale at the aggregate level
• convex production function
• marginal product of labor
increases as the quantity of
labor input increases
Labor Demand with Sufficient
Increasing Returns to Scale
With sufficient increasing
returns to scale,
• aggregate marginal
product of labor increases
with aggregate
employment
• aggregate labor demand
curve slopes upward
The Labor Market in the
Coordination Failure Model
With sufficient increasing
returns to scale,
• labor demand curve is
steeper than the labor
supply curve
• required for the
coordination failure model
to work
Output Supply Curve in the
Coordination Failure Model
• An increase in real interest rate shifts the
labor supply curve to the right, reducing
employment and output
• Hence the output supply curve YS in the
coordination failure model is downward
sloping
Multiple Equilibria in the
Coordination Failure Model
• Because the output supply curve is
downward sloping, there can be two equilibria
• In one equilibrium, aggregate output is low
and real interest rate is high
• In the other, aggregate output is high and
the real interest rate is low
Data Versus Predictions of the
Coordination Failure Model
*
*: with extension
Average Labor Productivity in
the Coordination Failure Model
In the good (bad) equilibrium
• output is high (low),
• employment is high (low)
• average labor productivity
is high (low)
Procyclical Money Supply in the
Coordination Failure Model
• If the money supply is a sunspot
variable in the coordination failure
model,
• money may appear to be
nonneutral because people
believe it to be
• When money supply is high
(low), everyone is optimistic
(pessimistic), and output is high
(low)
Stabilizing Fiscal Policy in the
Coordination Failure Model
• Fiscal Policy can stabilize output
in the coordination failure model by
eliminating multiple equilibria
• With a decrease in govt spending,
the output demand curve shifts to
the left
• and the output supply curve shifts
to the right
• this can produce a unique
equilibrium where Y = Y* and r = r*
Implications of Coordination
Failure Model
• Policies that promote optimism are beneficial
(e.g. encouraging statements from the Fed
Chairman)
• Critique: this model requires increasing returns
to scale at the aggregate level – evidence is
mixed, at best
• Business Cycles are driven by expectations –
which are unobservable, making the model
difficult to test