1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 11 Market-Clearing Models of the Business Cycle

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-2 Study Three Market-Clearing Business Cycle Models Real Business Cycle Model Segmented Markets Model Keynesian Coordination Failure Model

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-3 Real Business Cycle Model Business cycles are caused by fluctuations in total factor productivity. There is no role for the government in smoothing business cycles – cycles are just optimal responses to the technology shocks. Model fits the data well.

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-4 Figure 11.1 Solow Residuals and GDP

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-5 Figure 11.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-6 Figure 11.3 Average Labor Productivity with Total Factor Productivity Shocks

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-7 Table 11.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Shocks

8. Behavior of Money Supply RBC can not generate: –Procyclical money supply. –Money supply leading real GDP Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-8

9. Procyclical Money Supply Endogenous Money –Not determined by monetary authority, but by the responses to conditions in economy. Two ways: –Expansion of banking sector increases money supply. –Price stability monetary policy raises money supply. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-9

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-10 Figure 11.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-11 Equation 11.1 Cobb-Douglas production function, with labor share of output of 64%:

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-12 Segmented Markets Model Business cycles can be caused in this model by unanticipated shocks to the money supply. Model exhibits a liquidity effect – the interest rate falls in the short run when the money supply increases. Monetary policy can only improve the functioning of the economy if the central bank has an informational advantage over the private sector. Fit to the data is not as good as with the real business cycle model.

13. Model Modification Consumers and firms make decisions on C, I, M d before CB takes actions in bond market. The size of open market operation is unknown to consumers and firms. Consumers cannot trade in bond market (shut down connection with financial market) Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-13

14. Model Features M d = PL (Y, r e ) –At the time decisions on money demand is made, the current interest rate in bond market is unknown to consumers and firms yet. So decisions are based on expected rate. The size of open market operation affects the amount of money firms have available to pay workers, therefore, labor demand. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-14

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-15 Figure 11.5 Effects of an Unanticipated Increase in the Money Supply in the Segmented Markets Model

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-16 Table 11.2 Data Versus Predictions of the Segmented Markets Model with Monetary Shocks

17. Neutrality – Anticipated M s Rise Money is neutral if the increase in money supply is anticipated. In this case, firms would purchase more investment goods since they know they would have more money at the time they pay workers. This would push up price proportionately and lead to no effects on real variables. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-17

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-18 Figure 11.6 A Welfare-Improving Role for Active Monetary Policy

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-19 Keynesian Coordination Failure Model Strategic complementarities imply that the aggregate production function has increasing returns to scale, and the labor demand function can be upward sloping. There can be multiple equilibria. In an example, the model fits the data as well as the real business cycle model. GDP fluctuates in the model because of self-fulfilling waves of optimism and pessimism.

20. Strategic Complementarities It is hard for private sector workers and producers to coordinate their actions, which leads to strategic complementarities (SC). SC: the willingness for someone to engaged in some activity increases with the number of other people engaged in that activity. eg: restaurant Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-20

21. Generalization Generalize the example of restaurant into the aggregate economic activity. The willingness of one producer to produce may depend on what other producers are doing (complementary goods). Example: software producers and hardware producers. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-21

22. Multiple Equilibria Good equilibrium: high output and employment if coordinate with other private agents. Bad equilibrium: low output and employment otherwise. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-22

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-23 Figure 11.10 A Production Function with Increasing Returns to Scale Outputs more than doubles If all inputs double. MP N is increasing with N.

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-24 Figure 11.11 Aggregate Labor Demand with Sufficient Increasing Returns to Scale

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-25 Figure 11.12 The Labor Market in the Coordination Failure Model

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-26 Figure 11.13 The Output Supply Curve in the Coordination Failure Model

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-27 Figure 11.14 Multiple Equilibria in the Coordination Failure Model

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-28 Table 11.3 Data Versus Predictions of the Coordination Failure Model

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-29 Figure 11.15 Average Labor Productivity in the Keynesian Coordination Failure Model

30. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-30 Figure 11.16 Procyclical Money Supply in the Coordination Failure Model

31. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-31 Figure 11.17 Stabilizing Fiscal Policy in the Coordination Failure Model