Chapter 11: Classical Business Cycle Analysis Focus: Real Business Cycle Theory Reverse Causation Hypothesis Misperception Theory

Real Business Cycle Theory Business cycle is caused by real shocks – shocks which directly affect IS and FE curves – and not by nominal shocks – shocks which directly affect LM curve. Most important shock causing business cycle is supply shocks/ productivity shocks/ technology shocks. Predictions of the RBC are consistent with many business cycle facts. Basic shortcoming of RBC is that it predicts inflation to be anticyclical.

Solow Residual = A = Y/F(K,N) Productivity shock is normally measured by Solow Residual or Total Factor Productivity. Solow Residual = A = Y/F(K,N) Solow residual is imperfect measure of technology shock because it is influenced by changes in capacity utilization. If we incorporate capacity utilization in the production function then the true measure of A = Y/F(ukK, unN), where uk and un are capacity utilizations of capital and labor respectively.

Labor hoarding occurs when due to the cost of hiring and firing workers firms keep excess workers during recession. The policy prediction of the RBC model is that the government should not use fiscal policies to dampen business cycles. Unemployment during recession rises due to increase in the mismatch between workers and firms.

Two approaches to make money supply procyclical and leading variable in classical models: Assume that the central bank objective is to maintain price stability and in order to achieve this, it responds to expected changes in money demand by changing money supply (reverse causation). Agents have imperfect information about changes in prices and there might be confusion between changes in relative prices and changes in the general price level (misperceptions theory).

According to Reverse Causation hypothesis the central bank increase the money supply in advance when they anticipate higher demand for money due to boom in order to maintain price stability and vice versa. Money remains neutral in the short run. Misperceptions Theory - When firms have imperfect information about changes in general price level then they may change their output in response to changes money supply. Money is no longer neutral in the short run. SRAS curve slopes upward.

b>0, Yf = Full Employment Output, Pe = expected price. The SRAS curve is given by Y = Yf + b(P – Pe), where b>0, Yf = Full Employment Output, Pe = expected price. Only Unanticipated (surprise) changes in money supply affects the real output. Rational Expectation Hypothesis - The public’s forecasts of various economic variables are based on sound and intelligent examination of economic data. They behave like statisticians. They are smart.