Chapter 10- Classical Business Cycle Analysis

What is a business cycle?

A business cycle is aggregate economic activity represented by GDP, they are made up by two components: economic disturbances and how macroeconomic variables such as output, unemployment and prices respond to these variables.

What is the real business cycle theory [RBC]?

This is theory that argues that real shocks to the economy are the primary cause of business cycles.

What are “real shocks” ?

These are disturbances to the “real side” of the economy such as shocks that affect the production function, the size of the labor force, etc. (Affects that only apply to the IS curve or FE line)

What are “nominal shocks”?

These are shocks related to money supply or money demand and they only affect the LM curve.

What are “productivity shocks”?

These are what we consider to be supply side shocks

What happens to output in recessions according to RBC theory? (Classical Economists)

Output declines in recessions but rapid price adjustments will ensure that real output is equal to full employment output. (No price stickiness exists because we assume that the general economy is represented by perfect competition).

What happens to output in economic booms according to RBC theory?

Output rises during economic booms because the general equilibrium amount of output has changed and rapid price adjustment will ensure that real output is equal to full employment.

Is RBC consistent with all business cycle facts?

RBC is not consistent with all business cycle facts; however, it is consistent with the assumption that productivity shocks are the dominant form of economic disturbance.

What is the first RBC theory fact that is consistent with the Business cycle facts?

If we assume that the economy is continuously buffeted by productivity shocks, then the RBC approach will be to assume that there will be recurrent fluctuations in aggregate output.

What is the second RBC fact that is consistent with the business cycle facts?

RBC fact correctly predicts that employment is procyclical with output.

What is the third RBC fact that is consistent with the business cycle facts?

RBC correctly predicts that real wages will be higher during economic booms than recessions (that the real wage is procyclical as well)

What is the fourth business cycle fact that is consistent with the business cycle facts?

RBC theory correctly predicts that average labor productivity (Y/N) is procyclical as well (Output per worker is higher during booms and lower in recessions)- this is consistent with business cycle data because booms are times of beneficial productivity shocks which will raise Y/N and recessions are times of adverse supply shocks that lower Y/N.

What is true about labor productivity as it retains to RBC theory?

Average labor productivity is procyclical because of supply shocks but it would be acyclical without these shocks. (Because with no shocks the expansion of employment would eventually be diminishing because of diminishing returns on MPN).

What business cycle fact is RBC inconsistent with?

RBC is inconsistent with the fact that business cycle data would suggest that inflation is immediate or slow after recessions; RBC theory claims that an adverse productivity shock would cause inflationary periods during recessions which is incorrect.

What did Kyland and Prescott find when researching the cyclicality of inflation?

Inflation being procyclical is problematic to RBC economists because they found that using different statistical methods yielded aggregate output being above it’s long run trend while the price level tends to be below it’s long run trend- which is more consistent with RBC theory that prices are cyclical.

What is the Solow Residual?

This is the most common measure of productivity shocks, it’s an empirical measure of total factor productivity (contributions to output besides labor or capital).

What is the equation for Solow’s residual?

What is the measurement used to measure the intensity of capital being used?

The Utilization rate of capital

What is the measurement being used to measure the intensity of labor being used?

The utilization rate of labor

What are capital services?

This is another measurement for the intensity of the use of capital. It is equal to the utilization rate of capital times the amount of capital.

What are labor services?

Thus is another measurement for the intensity of the use of labor. It is equal to the utilization rate of labor times the amount of labor.

What is the equation for the production function rewritten with capital and labor contribution to output?

How can Solow’s residual be rewritten with Capital and Labor services?

What is the cyclicality of solow’s residual?

Solow’s residual cyclicality is reliant on the cyclicality of the utilization rates of capital and labor ( i.e.- if the utilization rate of capital and labor are both procyclical then Solow’s residual will be procyclical)

What is labor hoarding?

This is the concept of firms keeping workers on payroll to avoid the cost of having to rehire someone or the cost of laying someone off during a recession. They will often do tasks unrelated to output during this time.

Can shocks other than shocks in productivity affect the economy in general equilibrium?

Shocks other than productivity shocks can occur such as wars and the corresponding military build up.

How does fiscal policy impact the classical model when Government spending rises due to Wartime efforts? (Fiscal policy as a shock)

Fiscal policy would cause the IS curve to shift up and to the right, the short-run equilibrium will be the intersection of the new IS curve and the original LM curve. Workers will supply more labor since the rise in government spending implies current or future tax burdens- causing FE to shift outward. When the price level adjusts (that is that prices will rise because the fiscal policy has an expansionary impact)- LM will shift up and to the left to meet the new FE line and IS curve forming a new general equilibrium at a higher level of output.

What are some other effects of an expansionary fiscal policy shock?

A rise in G will increase output, the real interest rate and the price level. Since labor supply was increased, the real wages will falls due to diminishing marginal returns on labor-and because of that we can assume a decline in average labor productivity when G rises.

What is the cyclicality of average labor productivity with Government spending?

Average labor productivity is countercyclical with government spending.

Why do classical economists believe that fiscal policy shouldn’t be used to smooth cycles?

Because this would go against the idea that the free market adjusts quickly enough on it’s own without government interference. They believe fiscal policy should only be used if the benefits of government programs exceed the costs of fiscal policy to taxpayers.

What is a recognition lag?

This is a lag that occurs in policymakers realizing that fiscal policy should take place in order for the economy to be brough back to general equilibrium.

What is a legislative lag?

This is a lag in the time it takes to instill (or create) a policy.

What is an implementation lag?

This is a lag in the time it takes to implement a policy federally.

What is an impact lag?

This is lag in the time it takes for the economy to respond to a new policy.

Why do classicalists assume that unemployment could be zero?

This is because at the market clearing rate, they assume that anyone who wants a job will be able to find one. They justify this with the reasoning that all jobs and workers are the same.

What is the justification for unemployment being higher in recessions in the classical model?

This is justified by the fact that during recessions because shocks increase the degree of mismatch between workers and jobs in different industries. (i.e.- Oil prices rising will lead to less jobs in energy intensive fields and more jobs in clean energy fields)

What is the other justification (retaining to labor demand) for unemployment being higher in recessions.

Labor demand could fall in some fields which will lead to frictional unemployment and structural unemployment since it could be that workers don’t meet the skillset required. The combination of these effects will cause the natural rate of unemployment to rise.

What does the term “Jobless Recovery” refer to ?

This term refers to how after periods of Business cycle troughs, the economy will go through a phase called recovery in which employment starts to spike up again. However, 1991, 2001 and 2009 recoveries are considered “Jobless” because employment was still decreasing in the recovery.

TLDR; The tendence of unemployment to continue falling in recovery periods after troughs.

What the equation for an index of employment relative to employment in a trough?

The index is higher in the months leading up to the trough and lower in the months after the trough. If it is exactly 100 then the index is representing the trough month.

According to the Book, how does the Federal reserve decrease money supply?

The federal reserve will sell bonds to the public in order to decrease money supply.

According to the Book, how does the federal reserve increase money supply?

The federal reserve will buy bonds from the public in order to increase money supply.

In the classical model, what affect does money supply have on real variables in the long run?

Monetary policy in the classical model has no effect on real variables such as output, employment or the real interest rate. (Money is neutral in the long run).

In the classical model, what affect does money supply have real variables in the short run?

Money supply can affect real variables before prices adjust (money is nonneutral in the short run- but classicalists believe that it’s too short run for the nonneutrality of money to matter).

Why is money not nuetral in the short run for the classical model?

Money being neutral is a result of the classical model, however, business cycle facts argue that money is a leading procyclical variable which is inconsistent with money nuetrality.

What is reverse causation?

Classical economists argue that money can be both procyclical and neutral because changes in money supply will occur because of expected changes in output- rather than changes in output causing changes in money supply. This way money supply will still have no effects on output.

What do Friedman and Schwartz argue about the nonneutrality of money?

They argue that changes in money supply:

1. Are closely associated with changes in economic activity, nominal income and prices

2. The interrelation between monetary and economic changes has been highly stable

3. Monetary Changes have often had an independent origin, they are not just reflections of economic activity

(Money supply is having effects on macroeconomic factors and it is procyclical) The third conclusion is backed by the fact that gold discoveries led to procyclical changes in money supply- implying that money supply is procyclical and nonneutral.

TLDR; Money supply is correlated with changes in economic activity and has a stable positive relation with such changes, Monetary changes could also be nonneutral because they could stem from other places.- Classical model has to be modified for money to be neutral.

What is the misperceptions theory?

This theory claims that since producers can’t directly observe the general price level they misperceive the general price level as the relative price of their goods and the result is a supply curve that is not vertical (diagonal).

What happens in the classical model when expected prices match the actual price change (no misperceptions)?

Then the free market operates as it has been because producers will be able to adjust to the price change quickly enough if they anticipate the price change. (The new point will be on LRAS with no short runs)

What happens in the classical model when expected price changes don’t match the actual price change (with misperceptions)?

When the expected price change is different from the actual price change, then producers will either supply more (if general price level goes up) or supply less (if general price level goes down) (remember that this is a monopolistic market so firms will just change production by hiring more employees or laying off workers in order to profit maximize)- this will occur until prices fully adjust and we are back in equilibrium.

In the misperceptions theory- will wages follow in procyclicality if misperceptions occur?

Yes wages will always follow in procyclicality.

What is the relationship between price and output mathematically expressed in the misperceptions theory?

Output equals full employment plus a positive parameter, b, that represents the elasticity of output with respect to price, P is price level and P^e is expected price level. If P is less than P^e then output will be less than full employment and if P is greater than P^e then output will be greater than full employment.

What does aggregate supply look like with misperceptions?

What are rational expectations in the classical model?

This is the idea that the firm cannot systematically surprise the public with money supply increases or decreases because people have rational expectations about how the fed might operate in response to a supply side shock.

How does rational expectations extend misperceptions?

Rational expectations violates misperceptions in that market forecasters would forecast price changes so that way the fed can’t fool firms into supplying more or less output- this is a problem because the fed won’t be able to use monetary policy to stabilize output.

What is a propagation Mechanism?

This is an aspect of the economy that allows short-lived shocks to have relatively long term effects on the economy. This is a result of changes in money supply that can have real effects that last more than a few weeks (longer than the short term).

What is a good example of propagation mechanism?

When increases in money supply are unanticipated, firms will increase production but in doing so, firms might decrease their inventory stock below normal levels so the firm will have to rebuild inventories- which will affect the economy in the long run as firms might have to change their production in the long run.

What is the equation for errors made in forecasting rational expectations?