Transcript Lecture 12
L11200 Introduction to Macroeconomics 2009/10 Lecture 12: The Equilibrium Business Cycle Model Reading: Barro Ch.8 18 February 2010 Introduction • Last time: – Completed the macroeconomic model by analysing how consumption impacted investment • Today – Begin to apply the model by studying the fluctuations in output more closely – Test whether the model fits the data ‘Equilibrium Business Cycle’ • The model we have constructed is known as an ‘Equilibrium Business Cycle Model’ – ‘Equilibrium’ because markets are continually in equilibrium – ‘Business Cycle’ because it seeks to explain the cycle of fluctuations known by this name • Aims to explain economic fluctuations Fluctuations • There are clearly fluctuations, but how do we measure them? – GDP is trended upwards, but deviates around that trend – Can estimate trend and deviation using filtering techniques – Classify ‘recessions’ as periods of growth which are significantly lower than trend growth Testing the Model • Fluctuations in technology: – Part one of the course established that growth in A is the best explanator of long-run economic growth – Idea here: fluctuations in A are best explanator of fluctuations in growth – So positive and negative shocks to technology drive short-term expansions and contractions Testing the Model • Test this idea with the following questions – If fluctuations in output are caused by fluctuations in technology, what does that imply for fluctuations in wages, rents, consumption, investment, unemployment, capital utilisation? – Does the data conform with the predictions of the model? Technology Shocks • Our production function is subject to shocks in A Y A F ( K , L) – Positive shock to A means that for a given K,L output increases (so MPL and MPK increase) – Negative shock to A means that for a given K,L output decreases (so MPL and MPK decrease) Implications: • Increase in technology level – Raises demand for labour, with inelastic supply this causes increase in real wage w/P – Raises demand for capital, with inelastic supply this causes increase in rental cost R/P – Increase in rental cost means i also increases i R / P Implications for Consumption • Interest rate i increases – Intertemporal substitution effect encourages households to save, consumption should fall – But if A is permanent, large positive income effect encourages consumption to increase – So net effect is increase in consumption when technology shock hits Predictions • So, if technology is driving output fluctuations – Wages should rise when output rises and fall when output falls – Interest rates should rise when output rises and fall when output falls – Consumption and Investment should both rise when output rises and fall when output falls – That is, all of these variables should be procyclical (instead of counter-cyclical) Outcome • Is the data consistent with a model in which permanent changes to A drive output – Wages a procyclical (as predicted) – Rental cost is procyclical (as predicted) – Consumption is procyclical (as predicted) and less variable than GDP – Investment is procyclical (as predicted) and more variable than GDP – How to explain the last two patterns? Summary • Began testing model of fluctuations on data – Permanent changes in A imply a particular pattern for key variables – This pattern appears evident in the data: supports the model • Next time: no longer assume L and K are fixed – Wages are procyclical – but so is employment (i.e. L is not fixed!) how do we explain this?