Transcript Chapter 14 power point

Second Edition
Chapter 14
The Real Business Cycle
Model: Shocks and
Transmission
Mechanisms
Chapter Outline





Uncertainty and Irreversible Investments
Labor Adjustment Costs
Time Bunching
Collateral Damage
Appendix: Business Fluctuations and the
Solow Model
2
Introduction
 Transmission mechanisms – economic
forces that can amplify the impact of
shocks on the economy
 We focus on five transmission
mechanisms:
•
•
•
•
•
Intertemporal substitution
Uncertainty and irreversible investments
Labor adjustment costs
Time bunching
Shocks to collateral and net worth
3
Intertemporal Substitution
 Intertemporal substitution – the allocation
of consumption, work, and leisure across
time to maximize well-being. Examples:
• Lack of rainfall affects crops directly, but it also
affects the farmer’s willingness to work hard,
which may reduce output further.
• When unemployment is high, some productive
people fearing they may lose their job leave
the work force and go back to college reducing
output even further.
4
Intertemporal Substitution
 Intertemporal substitution magnifies
economic shocks.
• When things go a bit bad, the rate of return to
work and investing falls and people work and
invest less.
• On the upside, Intertemporal substitution can
feed an economic boom and make it more
intense.
We can see this in the next diagram.
5
Transmission Mechanisms
Amplify Shocks
Inflation rate (p)
Solow
growth
curve
Shocks with
Intertemporal
substitution
Shocks without
Intertemporal
substitution
Negative
shock
(2%)
Average
(3%)
Positive
shock
(2%)
Real GDP
growth rate
6
Intertemporal Substitution
Point: When GDP is growing slower than the trend, the employment to
population ratio is also growing slower than the trend. The reverse is also
true.
7
Uncertainty and Irreversible
Investments
 Irreversible investments – have high value
only under specific conditions—they
cannot be easily moved, adjusted, or
reversed if conditions change.
 Negative shocks increase uncertainty
especially for irreversible investments
 Uncertainty slows investment and keeps
resources in less productive uses.
8
Labor Adjustment Costs
 Labor adjustment costs – the costs of
shifting workers from declining sectors of
the economy to growing sectors.
• Adjustments to shocks are not always rational:
 A union worker in the auto industry making $100,000
a year without a high school degree will probably
turn down a lot of available jobs before he finally
accepts reality and takes a job at a lower wage.
 Result: even higher unemployment and lower real
GDP growth.
9
Time Bunching
 Time Bunching – the tendency of economic
activities to be coordinated at common
points in time.
• Bunching causes shocks to spread through
the economy and through time.
 Suppose a negative economic shock slows the
economy down.
• Many people will be less keen to work (because
of Intertemporal substitution).
• This will induce others to cut back on their work
as well.
10
Time Bunching
 The “seasonal business cycle” is one form
of economic clustering in time.
• The fourth quarter October-December brings
more economic activity than any other time.
• After Christmas the party is over and
economic activity is the lowest.
 Once some economic activity is moving in
given direction, other parts of economic
activity tend to follow that momentum.
11
Collateral Damage
 Collateral – a valuable asset that is
pledged to a lender to secure a loan. If the
borrower defaults, ownership of the
collateral transfers to the lender.
 Collateral shock – a reduction in the value
of collateral. Collateral shocks make
borrowing and lending more difficult.
12
Collateral Damage
 A negative shock slows the economy down
and asset prices fall causing the value of
collateral to fall.
• Loans are more difficult to obtain if the value of
collateral is low.
• Investment slows down and growth slows
even further.
 During an economic boom, asset prices
rise and it becomes easier to get loans and
makes the boom even bigger.
13
Collateral Damage
 Collateral damage also affects consumers:
• Falling asset prices like homes make it difficult
for people to move to better jobs.
 General lesson: If the nominal owner of a
property has no equity in it they don’t do a
good job of taking care of it.
• Banks
• Houses
14
Takeaway
 Transmission mechanisms magnify
shocks.
 We identified five of these mechanisms.
 A medium-sized negative economic shock
is capable of causing a disproportionately
large downturn in production and
employment
15
Appendix: Business
Fluctuations and the
Solow Model
Second Edition
16
Business Fluctuations and the
Solow Model
 Some business fluctuations can be
analyzed using the Solow growth model.
 Main ideas of a modified Solow model…
• Labor is added to the aggregate production
function so that: Y  A t  F(K,L)
• In this version of the model
 At jumps around in the short-run as productivity
shocks hit the economy.
 L changes during booms and busts due to
intertemporal substitution.
17
Business Fluctuations and the
Solow Model
 The effects of productivity shocks can be
simulated using an excel spreadsheet.
• We use the random number generator to
simulate changes in At.
• At can fluctuate randomly around 1.
 If At is a little bigger than one → Positive
productivity shock.
 If At is a little smaller than one → Negative
productivity growth.
The following spreadsheet will generate this result.
18
Business Fluctuations and the
Solow Model
B2 = RAND( )(1/0.95−0.95) + 0.95 and D2 so it reads = B2*C2^(1/2);
Plotting output over time is shown next.
19
Business Fluctuations and the
Solow Model
20
Second Edition
End of Chapter 14
21