Macroeconomics II Lecture 7
Macroeconomics II Lecture 7 Krzysztof Makarski Fall 2010 Chapter 12. Market-Clearing Models of the Business Cycle:The Real Business Cycle Model
Intro •
Kydland and Prescott (1982) asked whether or not a standard model of economic growth subjected to random productivity shocks could replicate, qualitatively and quantitatively, observed business cycles.
•
Recall that many factors can lead to changes in TFP (good weather, technological innovations, the easing of government regulation, and decreases in the relative price of energy).
Persistence of the Solow Residual • •
The Solow residual is a persistent variable, see Figure 12.1 thus, when current period
zt
is high we can expect the next period
zt+1
to be high. Thus in analyzing
how the real business cycle model reacts to a TFP shock we need to combine the results of two dierent shocks from Chapter 9, shock to
z
and a shock to
z0.
Eects of a Persistent Change in Total Factor Productivity •
Now suppose that there is a persistent increase in TFP in the monetary intertemporal model.
See
Figure 12.2
First increase in current TFP increases the current marginal product of labor, thus the shifts right and thus the output supply schedule
Y
s
Nd
curve
shifts right.
Since also the future TFP increases there are additional eects. First marginal bene t of investment goes up thus investment go up. Also consumer anticipates that higher future TFP implies higher future income, so lifetime wealth increases and the demand for consumption goods goes up. Thus increase in investment and consumption leads to higher demand and the output demand curve shifts right.
•
In equilibrium, output goes up but eect on real interest rate is ambiguous, but it is more likely that it will fall (since the direct eect on the current supply is likely to be larger than the eects of the anticipated increase in future TFP). Thus real interest rate falls.
•
Thus we have:
Output increases - see above Consumption - increases (due to increase in wealth, and decrease in the real interest rate). Investment - increases (due to increase in future TFP and decrease in the real interest rate). Price level - falls, since increase in income and decrease in the real increases, increase demand for money, the nominal money demand curve shifts right and prices fall.
1
Money supply? Wage and employment increase - since it is more likely that the labor supply curve shifts less than the labor demand curve.
Average Labor Productivity •
See Figure 12.3, an increase in both output and employment can be accompanied by the growth of average labor productivity.
•
It is possible to generate a fall but this behavior is consistent with the results from Kydland and Prescott model.
Qualitative and Quantitative Replication of the Business Cycle Facts •
The behavior of the economy is summarized in Table 12.1 As can be shown with a more sophisticated model the model can replicate also quantitatively some important observations about business cycles. It can explain that:
consumption is less variable than output. investment is more variable than output.
Real Business Cycles and the Money Supply •
Since money is neutral and exogenous it seems that the model cannot replicate the following business cycle facts.
•
Cyclical Properties of the Money Supply:
(1) Nominal Money is Procyclical (2) Nominal Money Leads
Real GDP
•
Endogenous Money We can enrich our model so that these facts can be replicated. First we assume money is not exogenous, but it is endogenous. Monetary authority responds to changes in economic activity. Suppose that the monetary authority will stabilize the price level, then since price would fall without the central bank intervention (higher output and lower interest rate mean higher demand for money), the monetary authority will increase money supply in response to the positive TFP shock, see Figure 12.4.
This may explain the rst fact.
The second fact may lead people to conclusion
that nominal money supply uctuations cause uctuations in real GDP. But such a relation in the data tells us nothing about true causality, it is only statistical causality (for example every year we observe storks ying south before the onset of winter, so the ight patterns of storks statistically predict winter, however storks ying south do not cause winter, it is winter causing the storks to y south). If monetary authority is trying to stabilize prices and it can predict an increase in output that will cause prices to fall it will increase money supply even before increase in output takes place. Thus money can lead real GDP because of preemptive monetary policy actions.
2
Figure 12.1 Solow Residuals and GDP
12-4
© 2011 Pearson Addison-Wesley. All rights reserved.
return1 return2 return3
Figure 12.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model
12-5
© 2011 Pearson Addison-Wesley. All rights reserved.
return
3
Figure 12.3 Average Labor Productivity with Total Factor Productivity Shocks
12-6
© 2011 Pearson Addison-Wesley. All rights reserved.
return
Table 12.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Stocks
12-7
© 2011 Pearson Addison-Wesley. All rights reserved.
return
4
Implications of the Real Business Cycle Model for Government Policy •
Money is Neutral
•
Government Spending Based on Optimal Provision of Public Goods
•
Other Policy Goals
Monetary policy should satisfy the Friedman Rule (the nominal interest rates should be zero) The Smoothing of Tax Distortions Distortions should be distributed evenly over time. Thus tax revenue should rise in booms and fall in recessions.
Critique of the Real Business Cycle Model •
Price stickiness (?).
•
Measurement of Total Factor Productivity
Labor Hoarding Fully utilization of production factors during boom and not so full during recession. Labor hording may aect the Solow residual even without the change of TFP (see example in the book).
TCD: Monetary Shocks, Real Shocks, and US Experience During Some Pre-Financial Crisis Recessions •
Figure 12.1 makes a strong case for TFP as a main cause of business cycles in the USA. But, we should remember about a bias in the Solow residual.
•
Thus, we look at post 1970 recessions:
•
1974-75 recession conventionally attributed to an increase in the price of energy (oil crisis), consistent with Figure 12.7 (small changes of
M 0 relative to GDP), Figure 12.8 (decline in the real interest rate),
and Figure 12.9 (increase in the price of energy).
•
1981-82 recession, called Volcker recession, is conventionally believed to be instigated by the actions of the Fed, and there is certainly some evidence for it in Figure 12.7 (M 0 declines), and Figure 12.8 (interest rates rise), but there is also a big increase in the price of energy, Figure 12.9.
•
1990-91 recession is less clear.
There was a spike in energy prices Figure 12.9, money, Figure 12.7,
declined but way before and already in 1989 started to grow, and the real interest rate (nominal as well) was falling Figure 12.8.
•
As far as 2001 recession the immediate cause was drop in investment spending, the shock (dot-com bubble) that produced this drop is not in our models but it ts characteristics of bad news about future TFP. There is also an increase in the price of energy in 2000, see Figure 12.9. Monetary policy was rather loose, see Figure 12.7 (erratic) and Figure 12.8 .
5
Figure 12.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money
12-8
© 2011 Pearson Addison-Wesley. All rights reserved.
return
Figure 12.7 Percentage Deviations from Trend in the Monetary Base and Real GDP
12-14
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3
6
Figure 12.8 Real and Nominal Interest Rates
12-15
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3return4
Figure 12.9 Relative Price of Energy
12-16
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3
7
MiA: Business Cycle Models and the Great Depression •
Unique event. GDP between 1929 and 1933 drooped by 33%.
•
RBC gays, Cole and Ohanian (1999) show that the productivity shocks can explain decline but cannot explain slow recovery, in another paper they show that it the introduction the regulation that contributed to the slowed down recovery.
•
TFP drop still a puzzle.
•
There are also other explanations of the Great Depression.
PoFC: How Do the Equilibrium BC Theories Help Us Understand the 2008-2009 Recession? •
Between 2q2008 and 1q2009 GDP decreased by 3.19% and employment fell by 3.02% (normally it should be a little over 2%). What the RBC theory would tell us about 2008-09 recession?
•
First we would need to look at TFP, but problem no data on capital. Assuming that capital between 2008 and 2009 remained constant (not a bad assumption given a drop in investment) we obtain a decline in the Solow residual by 1.27%.
•
With this drop in the Solow residual we should not experience such a drop in GDP, thus we can conclude that the TFP contributed less to the recent shock than it normally does, Figure 12.1. Monetary factors have been rather mitigating, see Figure 12.8
•
Thus we can suspect that the nancial sector problems contributed to the 2008-2009 recession.
Summary •
RBC model and its predictions.
•
We looked at post-1970 recessions.
•
We looked at 2008-09 recession
Reading Williamson, Chapter 12 without Segmented Markets Model and Keynesian Coordination Failure Model.
8
Intro •
Kydland and Prescott (1982) asked whether or not a standard model of economic growth subjected to random productivity shocks could replicate, qualitatively and quantitatively, observed business cycles.
•
Recall that many factors can lead to changes in TFP (good weather, technological innovations, the easing of government regulation, and decreases in the relative price of energy).
Persistence of the Solow Residual • •
The Solow residual is a persistent variable, see Figure 12.1 thus, when current period
zt
is high we can expect the next period
zt+1
to be high. Thus in analyzing
how the real business cycle model reacts to a TFP shock we need to combine the results of two dierent shocks from Chapter 9, shock to
z
and a shock to
z0.
Eects of a Persistent Change in Total Factor Productivity •
Now suppose that there is a persistent increase in TFP in the monetary intertemporal model.
See
Figure 12.2
First increase in current TFP increases the current marginal product of labor, thus the shifts right and thus the output supply schedule
Y
s
Nd
curve
shifts right.
Since also the future TFP increases there are additional eects. First marginal bene t of investment goes up thus investment go up. Also consumer anticipates that higher future TFP implies higher future income, so lifetime wealth increases and the demand for consumption goods goes up. Thus increase in investment and consumption leads to higher demand and the output demand curve shifts right.
•
In equilibrium, output goes up but eect on real interest rate is ambiguous, but it is more likely that it will fall (since the direct eect on the current supply is likely to be larger than the eects of the anticipated increase in future TFP). Thus real interest rate falls.
•
Thus we have:
Output increases - see above Consumption - increases (due to increase in wealth, and decrease in the real interest rate). Investment - increases (due to increase in future TFP and decrease in the real interest rate). Price level - falls, since increase in income and decrease in the real increases, increase demand for money, the nominal money demand curve shifts right and prices fall.
1
Money supply? Wage and employment increase - since it is more likely that the labor supply curve shifts less than the labor demand curve.
Average Labor Productivity •
See Figure 12.3, an increase in both output and employment can be accompanied by the growth of average labor productivity.
•
It is possible to generate a fall but this behavior is consistent with the results from Kydland and Prescott model.
Qualitative and Quantitative Replication of the Business Cycle Facts •
The behavior of the economy is summarized in Table 12.1 As can be shown with a more sophisticated model the model can replicate also quantitatively some important observations about business cycles. It can explain that:
consumption is less variable than output. investment is more variable than output.
Real Business Cycles and the Money Supply •
Since money is neutral and exogenous it seems that the model cannot replicate the following business cycle facts.
•
Cyclical Properties of the Money Supply:
(1) Nominal Money is Procyclical (2) Nominal Money Leads
Real GDP
•
Endogenous Money We can enrich our model so that these facts can be replicated. First we assume money is not exogenous, but it is endogenous. Monetary authority responds to changes in economic activity. Suppose that the monetary authority will stabilize the price level, then since price would fall without the central bank intervention (higher output and lower interest rate mean higher demand for money), the monetary authority will increase money supply in response to the positive TFP shock, see Figure 12.4.
This may explain the rst fact.
The second fact may lead people to conclusion
that nominal money supply uctuations cause uctuations in real GDP. But such a relation in the data tells us nothing about true causality, it is only statistical causality (for example every year we observe storks ying south before the onset of winter, so the ight patterns of storks statistically predict winter, however storks ying south do not cause winter, it is winter causing the storks to y south). If monetary authority is trying to stabilize prices and it can predict an increase in output that will cause prices to fall it will increase money supply even before increase in output takes place. Thus money can lead real GDP because of preemptive monetary policy actions.
2
Figure 12.1 Solow Residuals and GDP
12-4
© 2011 Pearson Addison-Wesley. All rights reserved.
return1 return2 return3
Figure 12.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model
12-5
© 2011 Pearson Addison-Wesley. All rights reserved.
return
3
Figure 12.3 Average Labor Productivity with Total Factor Productivity Shocks
12-6
© 2011 Pearson Addison-Wesley. All rights reserved.
return
Table 12.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Stocks
12-7
© 2011 Pearson Addison-Wesley. All rights reserved.
return
4
Implications of the Real Business Cycle Model for Government Policy •
Money is Neutral
•
Government Spending Based on Optimal Provision of Public Goods
•
Other Policy Goals
Monetary policy should satisfy the Friedman Rule (the nominal interest rates should be zero) The Smoothing of Tax Distortions Distortions should be distributed evenly over time. Thus tax revenue should rise in booms and fall in recessions.
Critique of the Real Business Cycle Model •
Price stickiness (?).
•
Measurement of Total Factor Productivity
Labor Hoarding Fully utilization of production factors during boom and not so full during recession. Labor hording may aect the Solow residual even without the change of TFP (see example in the book).
TCD: Monetary Shocks, Real Shocks, and US Experience During Some Pre-Financial Crisis Recessions •
Figure 12.1 makes a strong case for TFP as a main cause of business cycles in the USA. But, we should remember about a bias in the Solow residual.
•
Thus, we look at post 1970 recessions:
•
1974-75 recession conventionally attributed to an increase in the price of energy (oil crisis), consistent with Figure 12.7 (small changes of
M 0 relative to GDP), Figure 12.8 (decline in the real interest rate),
and Figure 12.9 (increase in the price of energy).
•
1981-82 recession, called Volcker recession, is conventionally believed to be instigated by the actions of the Fed, and there is certainly some evidence for it in Figure 12.7 (M 0 declines), and Figure 12.8 (interest rates rise), but there is also a big increase in the price of energy, Figure 12.9.
•
1990-91 recession is less clear.
There was a spike in energy prices Figure 12.9, money, Figure 12.7,
declined but way before and already in 1989 started to grow, and the real interest rate (nominal as well) was falling Figure 12.8.
•
As far as 2001 recession the immediate cause was drop in investment spending, the shock (dot-com bubble) that produced this drop is not in our models but it ts characteristics of bad news about future TFP. There is also an increase in the price of energy in 2000, see Figure 12.9. Monetary policy was rather loose, see Figure 12.7 (erratic) and Figure 12.8 .
5
Figure 12.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money
12-8
© 2011 Pearson Addison-Wesley. All rights reserved.
return
Figure 12.7 Percentage Deviations from Trend in the Monetary Base and Real GDP
12-14
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3
6
Figure 12.8 Real and Nominal Interest Rates
12-15
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3return4
Figure 12.9 Relative Price of Energy
12-16
© 2011 Pearson Addison-Wesley. All rights reserved.
return1return2return3
7
MiA: Business Cycle Models and the Great Depression •
Unique event. GDP between 1929 and 1933 drooped by 33%.
•
RBC gays, Cole and Ohanian (1999) show that the productivity shocks can explain decline but cannot explain slow recovery, in another paper they show that it the introduction the regulation that contributed to the slowed down recovery.
•
TFP drop still a puzzle.
•
There are also other explanations of the Great Depression.
PoFC: How Do the Equilibrium BC Theories Help Us Understand the 2008-2009 Recession? •
Between 2q2008 and 1q2009 GDP decreased by 3.19% and employment fell by 3.02% (normally it should be a little over 2%). What the RBC theory would tell us about 2008-09 recession?
•
First we would need to look at TFP, but problem no data on capital. Assuming that capital between 2008 and 2009 remained constant (not a bad assumption given a drop in investment) we obtain a decline in the Solow residual by 1.27%.
•
With this drop in the Solow residual we should not experience such a drop in GDP, thus we can conclude that the TFP contributed less to the recent shock than it normally does, Figure 12.1. Monetary factors have been rather mitigating, see Figure 12.8
•
Thus we can suspect that the nancial sector problems contributed to the 2008-2009 recession.
Summary •
RBC model and its predictions.
•
We looked at post-1970 recessions.
•
We looked at 2008-09 recession
Reading Williamson, Chapter 12 without Segmented Markets Model and Keynesian Coordination Failure Model.
8
