Business Cycle Theory - SLIDEBLAST.COM
Business Cycle Theory Summary • • • • •
Real business cycle model Keynesian sticky price model Imperfect information model Segmented markets (limited participation) model Coordination failure model
Real Business Cycle Model • Business cycle theories classified according to: ○ Impulses = The source of the shocks hitting the economy ○ Propagation mechanisms = The channels through which the shocks affect economic outcomes
Business cycles in the 2-period model ○ Must be careful about what amount of time each "period" represents Natural choice is frequency that GDP is measured i.e. 1 period = 1 quarter ○ First period: the current quarter ○ Second period: all future quarters Within planning horizon of current households and firms ○ ∴ a temporary has very small effect on C with consumption smoothing MPC is small
Real business cycle theory (RBC) ○ Argues that business cycles are the economy's response to exogenous shocks to TFP They represent the economy's efficient response to variations in its ability to produce goods and services ○ Impulse: TFP shocks (technology shocks) ○ Propagation mechanisms: Intertemporal substitution of leisure Consumption smooth Investment i.e. channels present in the dynamic model
Growth and business cycles ○ In Solow model, exogenous growth in TFP is source of long-run economic growth With convergence dynamics driven by capital accumulation Solow residual is measure of TFP Movements in Solow residual closely related to GDP fluctuations ∴ fluctuations in TFP could explain the business cycle ○ RBC theory makes: exogenous TFP fluctuations the impulse of business cycles Capital accumulation one of the propagation mechanisms
Technology shocks RBC theory requires TFP shocks to have the following properties in order to be Course Notes Page 38
○ RBC theory requires TFP shocks to have the following properties in order to be consistent with observed business cycles: They are exogenous They are relatively large and occur at business cycle frequencies They are neither entirely temporary nor permanent □ i.e. they are persistent (expected to dissipate gradually) ○ Technology shocks = uneven pace of technological progress Fluctuations in anything affecting the amount of Y that can be produced for given inputs of N and K ○ Sources of TFP shocks: Weather Energy prices Changes in regulations and institutions ○ Technological shocks affect output directly through the production function ○ Technological shocks also affect output through propagation mechanisms: Consumption smoothing Intertemporal substitution in both consumption and leisure Intratemporal substitution between consumption and leisure Capital accumulation What are the effects of a positive TFP shock? Current production function: □ □ Future production function: □ but not by as much as z Shock is persistent, but neither temporary nor permanent □ Labour demand curve shifts to the right □ Income rises in the current period and in the future □ Increases the PV of the household's lifetime income stream: □ Consumption increases by less than income Labour supply curve shifts to the left □ Leisure is a normal good along with consumption Demand for investment increases □ ↑ because z' is expected to be higher □ Demand for money increases (more transactions with higher output)
Course Notes Page 39
Real business cycle model Keynesian sticky price model Imperfect information model Segmented markets (limited participation) model Coordination failure model
Real Business Cycle Model • Business cycle theories classified according to: ○ Impulses = The source of the shocks hitting the economy ○ Propagation mechanisms = The channels through which the shocks affect economic outcomes
Business cycles in the 2-period model ○ Must be careful about what amount of time each "period" represents Natural choice is frequency that GDP is measured i.e. 1 period = 1 quarter ○ First period: the current quarter ○ Second period: all future quarters Within planning horizon of current households and firms ○ ∴ a temporary has very small effect on C with consumption smoothing MPC is small
Real business cycle theory (RBC) ○ Argues that business cycles are the economy's response to exogenous shocks to TFP They represent the economy's efficient response to variations in its ability to produce goods and services ○ Impulse: TFP shocks (technology shocks) ○ Propagation mechanisms: Intertemporal substitution of leisure Consumption smooth Investment i.e. channels present in the dynamic model
Growth and business cycles ○ In Solow model, exogenous growth in TFP is source of long-run economic growth With convergence dynamics driven by capital accumulation Solow residual is measure of TFP Movements in Solow residual closely related to GDP fluctuations ∴ fluctuations in TFP could explain the business cycle ○ RBC theory makes: exogenous TFP fluctuations the impulse of business cycles Capital accumulation one of the propagation mechanisms
Technology shocks RBC theory requires TFP shocks to have the following properties in order to be Course Notes Page 38
○ RBC theory requires TFP shocks to have the following properties in order to be consistent with observed business cycles: They are exogenous They are relatively large and occur at business cycle frequencies They are neither entirely temporary nor permanent □ i.e. they are persistent (expected to dissipate gradually) ○ Technology shocks = uneven pace of technological progress Fluctuations in anything affecting the amount of Y that can be produced for given inputs of N and K ○ Sources of TFP shocks: Weather Energy prices Changes in regulations and institutions ○ Technological shocks affect output directly through the production function ○ Technological shocks also affect output through propagation mechanisms: Consumption smoothing Intertemporal substitution in both consumption and leisure Intratemporal substitution between consumption and leisure Capital accumulation What are the effects of a positive TFP shock? Current production function: □ □ Future production function: □ but not by as much as z Shock is persistent, but neither temporary nor permanent □ Labour demand curve shifts to the right □ Income rises in the current period and in the future □ Increases the PV of the household's lifetime income stream: □ Consumption increases by less than income Labour supply curve shifts to the left □ Leisure is a normal good along with consumption Demand for investment increases □ ↑ because z' is expected to be higher □ Demand for money increases (more transactions with higher output)
Course Notes Page 39
