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® A PowerPointTutorial to Accompany macroeconomics, 5th ed. N. Gregory Mankiw CHAPTER NINETEEN Advances in Business Cycle Theory Mannig J. Simidian Chapter Nineteen 1 Chapter Nineteen 2 • The interpretation of the labor market: Do fluctuations in employment reflect voluntary changes in the quantity of labor supplied? • The importance of technology shocks: Does the economy’s production function experience large, exogenous shifts in the short run? • The neutrality of money: Do changes in the money supply have only nominal effects? • The flexibility of wages and prices: Do wages and prices adjust quickly and completely to balance supply and demand? Chapter Nineteen 3 • Real business cycle theory emphasizes the idea that the quantity of labor supplied at any given time depends on the incentives that workers face. • The willingness to reallocate hours of work over time is called the intertemporal substitution of labor. Consider this example: Let W1 be the real wage in the first period. Let W2 be the real wage in the second period. Let r be the real interest rate. If you work in the first period, and save your earnings, you will have (1 + r)W1 a year later. If you work in period 2, you will have W2. Chapter Nineteen 4 Intertemporal Relative Wage = (1 + r) W1 W2 Working the first period is more attractive if the interest rate is high or if the wage is high relative to the wage expected to prevail in the future. According to real business cycle theory, all workers perform this cost-benefit analysis when deciding whether to work or enjoy leisure. If the wage is high, or if the interest rate is high, it is a good time to work. If the wage or interest rate is low, then it is a good time to enjoy leisure. Chapter Nineteen 5 Critics of the real business cycle theory believe: • Fluctuations in employment do not reflect changes in the amount people want to work. • Desired employment is not sensitive to the real wage and the real interest rate– unemployment fluctuates over the business cycle. • The high unemployment in recessions implies that markets don’t clear and that wages do not equilibrate labor demand and labor supply. Criticisms of Real business cycle theorists reply: • Unemployment statistics are difficult to interpret. • Simply because unemployment rate is high does not mean that intertemporal substitution Chapter Nineteen of labor is unimportant. Real Business Cycle Theory 6 The Importance Of Technology Shocks Chapter Nineteen 7 Real Business Cycle Theory Real business cycle theory assumes that our economy experiences fluctuations in technology, which determine our ability to turn inputs (capital and labor) into output (goods and services), and that these fluctuations in technology cause fluctuations in output and employment. Chapter Nineteen 8 Critics of the real business cycle theory: • Are skeptical that the economy experiences large technology shocks, and propose that technological improvements happen more gradually. • Believe that technological regress is especially implausible. Real business cycle theorists reply: • Adopt a broader view of shocks to technology. • Events, although not technological, have a similar affect on the economy (i.e. weather, regulations, oil prices). Chapter Nineteen Criticisms of Real Business Cycle Theory 9 Real business cycle theory assumes that money is neutral, even in the short run. That is, it is assumed not to affect real variables such as output and employment. Critics argue that the evidence does not support short-run monetary neutrality. They point out that reductions in money growth and inflation are almost always associated with periods of high unemployment. Advocates of real business cycle argue that their critics confuse the direction of causation between money and output. They claim the money supply is endogenous: fluctuations in output might cause fluctuations in the money supply. For example, when Y rises, because of a tech shock, the quantity of money demanded rises. The Fed may then increase the money supply to accommodate greater demand. 10 Nineteen ThisChapter gives the illusion of non-money neutrality. Real business cycle theorists believe that the assumption of flexible prices is superior methodologically to the assumption of sticky prices. Critics point out that wages and prices are not flexible. They believe that this inflexibility explains both the existence of unemployment and the non-neutrality of money. Chapter Nineteen 11 Chapter Nineteen New Keynesian Economics 12 Most economists are skeptical of the theory of real business cycles and believe that short-run fluctuations in output and employment represent deviations from the economy’s natural rate. They think these deviations occur because wages and prices are slow to adjust to changing economic conditions. This stickiness makes the short-run aggregate supply curve upward sloping rather than vertical. As a result, fluctuations in aggregate demand cause short-run fluctuations in output and employment. But, why are prices sticky? New Keynesian research has attempted to answer this question by examining the microeconomics behind short-run price adjustment. Chapter Nineteen 13 One reason prices do not adjust immediately in the short run is that there are costs to price adjustment. To change its prices, a firm may need to send out new price lists to customers. The costs of this price adjustment are called menu costs. When a firm reduces its price, it marginally decreases the overall price level, thereby raising real balances. This macroeconomic impact of one firm’s price adjustment on the demand for other firm’s products is called an aggregate-demand externality. Chapter Nineteen 14 Some new Keynesian economists suggest that recessions result from a failure of coordination. Coordination problems can arise in the setting of wages and prices because those who set them must anticipate the actions of other wage and price setters. Not everyone in the economy sets new wages and prices at the same time. Instead, the adjustment of wages and prices throughout the economy is staggered. Staggering slows the process of coordination and price adjustment. Staggering makes the overall level of wages and prices adjust gradually, even when individual wages and prices change a lot. Chapter Nineteen 15 Real business cycle theory New Keynesian economics Intertemporal substitution of labor Solow residual Labor hoarding Menu costs Aggregate-demand externality Chapter Nineteen 16