Transcript Chapter 9 - Cengage Learning

Macroeconomics
Chamberlin and Yueh
Chapter 9
Lecture slides
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by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1
© 2006 Cengage Learning
Business Cycles and Stabilisation
Policy
• Economic Cycles
• Real Business Cycles
• New Keynesian Theories of
Fluctuations
Wage Rigidities
Price Rigidities
• Stabilisation Policy
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Learning Objectives
• Recognise the existence of business cycles
• Understand the two main theories of business
cycles: Real Business Cycles and new Keynesian
economics
• Analyse new Keynesian theories of short-run
fluctuations in output
• Identify sources of wage and price rigidities in the
Keynesian frameworks
• Consider the welfare effects of short-run
fluctuations
• Evaluate stabilisation policies
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Business Cycles
• Although output tends to rise over time, this
upward march is not smooth but punctuated by
alternating periods of high and low (including
negative) growth.
• These are known as booms and recessions.
• There are two main approaches to understanding
these cycles: real business cycle (RBC) theory
and New Keynesian approach to cycles.
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Real business cycle (RBC) theory
• This suggests that output movements are
driven by productivity shocks, which hit an
economy and lead to shifts in its production
function.
• Although these shocks are considered to be
both quick and temporary, they can lead to
persistent movements in output.
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New Keynesian approach to cycles
• Cyclical output movements here are predominately the
result of demand shocks which have a long lasting although
temporary effect on output. In this way, booms and
recessions are seen as periods of excess demand or supply.
• However, to generate cycles in output, it has to be the case
that these disequilibria are not quickly corrected by
movements in wages or prices. Therefore, persistent output
movements are explained by slow market clearing. New
Keynesian theory is then all about accounting for why
wages and prices move only sluggishly – meaning that in
the short run, demand shocks will have significant effects
on output.
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Stabilisation policy
• Whether or not we feel we should be worried about
business cycles, it is certainly true that governments and
policy makers over the years have made substantial efforts
to control them.
• The government can use monetary and fiscal policies in
order to offset the cycle; this is known as stabilisation
policy. Traditionally, it has also been referred to as demand
management. The reason for this is because fluctuations
were deemed to be caused by changes in aggregate demand.
• The use of stabilisation policy though is not uniformly
welcomed. Those against the use of active policy have
proposed a two pronged attack.
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Stabilisation policy
• The first questions the need for stabilisation policy, arguing
that economies will self-correct. This is really a market
clearing issue, booms and recessions are just the outcome
of excess demand or supply in an economy, so changes in
prices will ultimately correct the disequilibrium.
• The second forms the policy inadequacy debate. Although
the case for active stabilisation policy is recognised, in
essence it is very difficult to implement the correct policies.
Therefore, it is argued that active policy, if inappropriate,
may do more harm than good and is best not implemented.
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Economic Cycles
• A simple way of looking at the path of output is to
divide it up into a trend and cycle component.
Output = Trend + Cycle.
– The trend component represents the long run rate of
economic growth for an economy. However, the actual
path the economy takes fluctuates considerably around
this trend. These cyclical components are short run
temporary fluctuations in output, described as the
business cycle.
– The cycle is driven by short-term fluctuations in the rate
of economic growth. The goal of business cycle theory
is to account for these persistent fluctuations in growth.
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Actual and Trend GDP, U.S.
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Actual and Trend GDP, UK
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Annual growth rates, U.S.
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Annual growth rates, UK
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Real Business Cycle Theory
• Real business cycle theory (RBC) emphasises the
importance of ‘real’ factors in determining cycles. This is
simply because RBC theorists have a strong belief that
markets clear and that information is close to perfect. In this
case, the source of output fluctuations will come from ‘real’
factors which alter an economy’s production function –
these are predominately technology or productivity shocks.
• Nominal factors, which include price and money shocks,
have no impact on the real economy when information is
complete and prices are flexible. They are not considered to
play an important role in generating cycles.
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Real Business Cycle Theory
• A key part of explaining cycles is to account for how a
given shock can then generate a sustained movement in
output. If we look at the cycle dynamics in the UK and
U.S. GDP figures, we are certainly made aware that cycles
have a duration of at least several quarters, and typically
several years.
• Therefore, a key part of the theory must be to explain how
very short and temporary shocks generate these sustained
movements in output.
• The response of RBC theory is to consider cycles being
generated through the combination of two parts: impulse
and propagation.
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Real Business Cycle Theory
• The impulse is the initial productivity or technological
shock. This is a sudden and very short lived innovation.
• The propagation mechanism then describes how the shock
generates a persistent movement in output.
• Without the propagation mechanism, there would be no real
explanation of the business cycle. A temporary productivity
shock would lead to a change in the equilibrium level of
output and a shift in the long run aggregate supply curve,
but once the shock disappeared or was reversed, the
economy would jump back to where it started. As
productivity shocks are largely seen as very short lived
innovations, it would be hard to see how they can account
for cycles of several years in duration.
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Propagation mechanism
• The propagation mechanism is therefore central to the
understanding of real business cycles.
• One approach, following the seminal models of Ramsey
(1928) and Diamond (1965), argues that the persistence in
output movements results from a sustained increase in
capital investment following a productivity shock.
• The propagation mechanism at work here is consumption
smoothing. A positive productivity shock would increase
current income, but if households are permanent income
consumers, they will rationally attempt to spread this gain
over time so as to maximise their life-time utility.
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Real Business Cycle Theory
• The two period optimal consumption model aims to account
for the pattern of consumption undertaken by a household
to maximise its total lifetime utility.
• This is described by a utility function:
U  U  C1 , C2 
• From this, an indifference curve can be constructed, which
just gives the combinations of consumption that yields a
certain amount of utility. Accepting the law of diminishing
marginal utility of consumption, these indifference curves
will be convex in shape.
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Real Business Cycle Theory
• Naturally, the household consumption decision is constrained by
lifetime resources, which is defined by household income in each
period.
• The two period budget constraint ties the present discounted value of
lifetime consumption to be no greater than the present discounted value
of lifetime resources:
C2
Y2
C1 
1  r 
 Y1 
1  r 
• The optimal consumption decision sees the household choosing
consumption so that they can reach the highest level of utility given
their lifetime resources.
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Optimal Consumption Decision
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Real Business Cycle Theory
• A key feature of this model is that optimal consumption
decisions imply consumption smoothing behaviour. Faced
with fluctuations in income, households are generally better
off if they can use saving and borrowing in order to smooth
consumption.
• Ironing out fluctuations in income enables the household to
move on to a higher indifference curve which represents the
achievement of a higher level of lifetime utility, whilst still
being consistent with their lifetime budget constraint. This
result is due to the convexity of the indifference curves,
which in turn is a consequence of the law of diminishing
marginal utility. This always leads to a preference of
averages over extremes.
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Real Business Cycle Theory
• Due to the circular flow of income, total household
income should equal aggregate output.
• Output in turn is determined by two things, the
level of productivity and the level of capital stock.
This can be represented using a simple production
function: Yt  At  1  r K t
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Production Function
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Real Business Cycle Theory
• The production function describes the level of output an
economy can produce at each level of capital stock.
• Firstly, a higher level of capital stock enables a higher level
of output to be produced. The production function is linear
because there are constant returns to scale with respect to
the capital stock.
• Secondly, a change in the current level of productivity
would lead to a shift in the production function, implying
that the same level of capital can then produce a different
level of output. No attempt is made in this model to
account for the current level of productivity.
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Real Business Cycle Theory
• By writing the production function in this form – with
additive productivity and constant returns in production, the
marginal product of capital will always be constant
regardless of the current level of productivity or the size of
the capital stock. This form of production function is a
simplifying assumption but allows us to emphasize the role
that consumption smoothing may play as a propagation
mechanism.
• The capital stock is determined by the level of saving
undertaken by households. Any income that is not used for
consumption is saved. However, this will be deposited in
financial institutions, which will recycle the funds by
lending to firms who will invest.
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Real Business Cycle Theory
• Therefore, the link between saving and capital can be
established via a number of identities.
• Firstly, all income is either consumed or saved:
Ct  St  Yt
• From the circular flow of income, income and output must
be equal to expenditure:
Ct  I t  Yt
• Therefore, it can be instantly seen that:
St  I t
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Real Business Cycle Theory
• Current investment will then generate the size of the capital
stock in the following period:
Kt  1  I t
• Therefore, using these relationships in the production
function, future income will depend on the current level of
saving:
Yt 1  At 1  1  r St
• This accounts for how the household consumption and
saving decisions affect the level of output in an economy.
When a household saves, they are effectively trying to
postpone current consumption until the future. The way
that works here is through the capital stock – a higher level
of saving generates more future capital which increases
future income.
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Real Business Cycle Theory
• By using this mechanism in the two period optimal
consumption model, it is then possible to see how
temporary productivity shocks can generate
persistent movements in output.
• Suppose there was a one period temporary increase
in productivity: A  A  A
1
1
2
• The capital stock in period 1 is assumed to be predetermined. As a result, the production function
will shift upwards and income in period 1 will
increase with productivity:
Y1  A1  F K1   Y1  A1  F K1 
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Temporary increase in productivity
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Temporary increase in productivity
• Following the unexpected productivity shock, an increase in
period 1 income will lead to an increase in the household’s
lifetime resources and an outward shift in its two period
budget constraint:
C1 
C2
Y2
 Y1 
1  r 
1  r 
• However, utility maximising behaviour would require the
household to smooth their consumption, so although period
1 income has risen, the household would optimally prefer to
save more and enjoy higher period two consumption as
well. The new optimal consumption decision sees higher
consumption in both periods.
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Utility maximisation
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Increase in investment
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Temporary increase in productivity
• Postponing consumption requires the household to save
some of the current rise in their income for future use. This
is achieved through investment. By increasing the period 2
capital stock, they can increase future income which funds
higher future consumption. This consumption smoothing
behaviour acts as the propagation mechanism which can
turn temporary productivity shocks into fairly persistent
changes in output. For simplicity, we have just used a two
period model, but the results can be easily generalised to n
periods.
• Therefore, the initial increase in income would lead to a
higher level of saving, capital stock and output in all of the
proceeding periods.
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Output persistence and the Degree of
Consumption Smoothing
• The persistence of output movements entirely depends upon
the strength of the propagation mechanism, which in this
case is the consumption smoothing behaviour of
households.
• The desire to smooth consumption results from the
convexity of the indifference curve. As a result, an initial
shock can be propagated over a long period of time.
• The household indifference curve, though, will lose its
convexity the more that future utility is discounted. An
increase in current income will therefore not generate large
increases in saving, and hence the propagation mechanism
would be fairly weak.
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Weak propagation mechanism
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Output persistence and the Degree of
Consumption Smoothing
• It is fairly plausible to argue that households will place a higher value
on current rather than future utility. Households may be myopic or just
impatient. A more rational argument for discounting the future would
be a reflection of human mortality – there is less point in making
provision for the future when there is a probability that death will occur
before it is reached.
• Once the future is increasingly discounted, we begin to move away
from perfect consumption smoothing. Then, a current period
productivity shock will lead to less persistence in output, as saving and
investment taper off over time.
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Propagation mechanism
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Evaluating Real Business Cycle models
• Real business cycles are just the combination of impulses
and propagation. Therefore, an evaluation of the theory can
centre on each of these two parts.
• In terms of impulses, it can be asked if there are enough of
them, and are they sufficiently large in order to create the
type of cycles that have been experienced in developed
economies?
• Second, are the propagation mechanisms strong enough to
produce the necessary persistence in output movements?
Example: U.S. productivity growth and economic growth
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Global Applications 9.1
• Productivity and
Economic Growth in
the U.S.
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New Keynesian Theories of
Fluctuations
• Recall from the aggregate demand and supply (AD-AS)
model that in the long run, the economy cannot deviate
from the equilibrium level of output.
• However, this is not the case for the short run.
• Therefore, following a demand shock, the economy can
settle at a different level of output in both the short and the
long run.
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Disequilibrium following a demand
shock
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New Keynesian Theories of
Fluctuations
• Following a negative demand shock, output will fall below
the equilibrium level of output in the short run.
• Over time, wages and prices will fall and the economy will
move to its new long run equilibrium, but this may only
happen gradually, in which case the demand shock has a
persistent effect on output. This type of slow adjustment is
required to account for cycles of a reasonable duration.
• When output falls below its equilibrium level, it implies that
unemployment has risen above the non-accelerating
inflation rate of unemployment (NAIRU). The process by
which unemployment returns to the NAIRU and output to
the equilibrium level, is seen in the bargaining model.
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Unemployment after a negative
demand shock
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New Keynesian Theories of
Fluctuations
• Once it is accepted that wages and prices might adjust
slowly, it is then easily apparent why output can deviate
from the equilibrium level for sustained periods.
• The New Keynesian approach to business cycles argues that
this is the case – demand shocks will generate persistent
movements in output because wages and prices respond
very sluggishly.
• The New Keynesian contribution to the study of business
cycles is to account for rigidities in wages and prices.
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Wage Rigidities
• There are several factors which may account
for slow wage adjustments when the labour
market is in a position of excess demand or
supply.
• These fall into three camps:
– Contracting
– Efficiency wages
– Bargaining and institutional structures
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Price Rigidities
• Menu costs
• These are the real resources that are used up in changing
prices; for example, if a restaurant had to reprint it menus.
• It is often argued that these play a limited role in creating
price rigidities. However, if combined with other factors,
the small rigidities implied by menu costs may actually be
much more significant. If firms face little incentive to
change prices in the first place, then the additional menu
costs of doing so may be very significant at the margin.
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Price Rigidities
• Kinked Demand Curve
• The kinked demand curve is a concept of oligopolistic
markets. An oligopoly is a form of imperfect competition
where the market consists of a few large firms. The kink in
the demand curve arises because the price elasticity of
demand is different depending on whether the firm is
raising or cutting prices.
• With a kink in the demand curve, there will be a
discontinuity in the corresponding marginal revenue curve.
As a result, there are several different levels of marginal
cost that all have the same level of profit maximising prices.
In this case, prices will be rigid.
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Price Rigidities
• Recessions as the result of coordination failure
• If one firm were to reduce prices, it should have a small
effect on the overall price level, which then subsequently
affects the demand for the products made by other firms.
Blanchard and Kiyotaki (1987) refer to this as an aggregate
demand externality. An individual firm will not take these
externalities into consideration when setting prices, but in
the aggregate they are very important.
• This model has two equilibria: fix-fix and cut-cut. If the
economy enters the fix-fix equilibrium, the only way it can
escape to the preferable cut-cut equilibrium if there is
strong coordination between firms.
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Recessions as the result of
coordination failure
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Stabilisation Policies
• There are two main reasons why policy makers might wish
to intervene and iron out the business cycle.
• First, there are welfare losses associated with fluctuating
income. If households are permanent income consumers,
they are made better off in terms of lifetime utility if they
can smooth income.
• Secondly, short run cycles may actually lower the trend rate
of growth. Volatility could impede investment which drives
long run growth, and hysteresis mechanisms imply that
short run movements in output and unemployment can be
very persistent.
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Stabilisation Policies
• Despite this, there are several grounds against using an
active policy response to smooth the economic cycle.
• If markets clear quickly, then active policy will be
unnecessary, as prices will adjust and quickly reverse the
cycle. In addition, policy intervention may be harmful as it
can interfere with this automatic adjustment process.
• Secondly, policy makers may find it difficult to implement
the correct policies for two reasons.
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Stabilisation Policies
• Lags
– Recognition lags
– Implementation lags
– Effectiveness lags
• The presence of lags makes the timing of
policy difficult. Instead of correcting the
economic cycle, the policy maker may
actually make it worse.
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Stabilisation Policies
• Coefficient sizes and the multiplier
• To prescribe the right corrective policy, the government
must have complete knowledge of the structure of the
economy, including the interest sensitivity of investment,
the marginal propensity to consume, the size of the
multiplier, etc. Without all of this accurate information,
prescribing the right policy action becomes exceedingly
difficult.
• In addition, the Lucas critique argues that predicting the
effects of policy changes on the equilibrium level of
income/output is very difficult because major economic
relationships are unstable over different policy regimes.
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Stabilisation Policies
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Stabilisation Policies
• Following a fall in aggregate demand , the economy will
move from point a to point b and output will fall below the
equilibrium level. Eventually prices will fall and output
will be restored at the equilibrium level. In the long run, the
economy will move back to point c.
• If policy makers believe that the economy will only make
this adjustment over a long period of time, they may choose
to use active policy to restore output. This would simply
act to shift the aggregate demand curve back to whence it
came.
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Stabilisation Policies
• However, those against active policy would make the two
arguments above, and suggest that active policy will
enhance rather than neutralise the cycle.
• If the policy maker cannot calculate the exact policy
requirement, then there is a risk that policy may be overactive and move the economy from . Output will now rise
too far and require further policy in order to control prices.
If the economy follows path A, then the aim of stabilisation
policy is to move it onto a path B. However, incorrectly
administered policy could move it on to a path, such as C.
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Summary
• We have evaluated the existence of business cycles in the
macroeconomy.
• Real business cycles and fluctuations around long-run trend
output were analysed.
• We then turned to new Keynesian economics to gain a
perspective on sources of short-run fluctuations
• We identified and modelled wage and price rigidities,
including efficiency wage theories.
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Summary
• The welfare effects of cycles were considered.
• Whether or not we feel we should be worried about
business cycles, governments have and use monetary and
fiscal policies in order to offset the cycle, which is known
as stabilisation policy or demand management.
• The use of stabilisation policy, however, is not uniformly
welcomed, and the protests fall into two camps which we
covered. First, there is no need for stabilisation policy as
the economy self-corrects. Second, the policy inadequacy
debate argues that active policy, if inappropriate, may do
more harm than good and is best not implemented.
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