Transcript Chapter 11

Chapter 11
Market-Clearing
Models of the
Business Cycle
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Study Three Market-Clearing
Business Cycle Models
• Real Business Cycle Model
• Segmented Markets Model
• Keynesian Coordination Failure Model
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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.
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Figure 11.1 Solow Residuals
and GDP
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Figure 11.2 Effects of a Persistent
Increase in Total Factor Productivity in
the Real Business Cycle Model
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Figure 11.3 Average Labor Productivity
with Total Factor Productivity Shocks
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Table 11.1 Data Versus Predictions of
the Real Business Cycle Model with
Productivity Shocks
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Behavior of Money Supply
• RBC can not generate:
– Procyclical money supply.
– Money supply leading real GDP
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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.
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Figure 11.4 Procyclical Money Supply in
the Real Business Cycle Model with
Endogenous Money
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Equation 11.1
Cobb-Douglas production function, with labor
share of output of 64%:
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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.
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Model Modification
• Consumers and firms make decisions on C, I,
Md 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)
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Model Features
• Md = PL (Y , re)
– 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.
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Figure 11.5 Effects of an Unanticipated
Increase in the Money Supply in the
Segmented Markets Model
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Table 11.2 Data Versus Predictions of
the Segmented Markets Model with
Monetary Shocks
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Neutrality – Anticipated Ms 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.
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Figure 11.6 A Welfare-Improving
Role for Active Monetary Policy
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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.
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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
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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.
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Multiple Equilibria
• Good equilibrium: high output and employment
if coordinate with other private agents.
• Bad equilibrium: low output and employment
otherwise.
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Figure 11.10 A Production Function
with Increasing Returns to Scale
Outputs more than doubles
If all inputs double.
MPN is increasing with N.
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Figure 11.11 Aggregate Labor
Demand with Sufficient Increasing
Returns to Scale
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Figure 11.12 The Labor Market in
the Coordination Failure Model
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Figure 11.13 The Output Supply
Curve in the Coordination Failure
Model
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Figure 11.14 Multiple Equilibria in the
Coordination Failure Model
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Table 11.3 Data Versus Predictions of
the Coordination Failure Model
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Figure 11.15 Average Labor Productivity
in the Keynesian Coordination Failure
Model
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Figure 11.16 Procyclical Money
Supply in the Coordination Failure
Model
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Figure 11.17 Stabilizing Fiscal Policy
in the Coordination Failure Model
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