Title: Classical Business Cycle Analysis
1Classical Business Cycle Analysis
2Overview
- Classical BC analysis
- RBC Theory, the Solow residual and Productivity
Shocks - Unemployment and Fiscal Policy
- Money Non-neutrality and Reverse Causation
3Business Cycle in a Classical Model
- We assume that prices and wages adjust rapidly.
So, the economy is in or near the general
equilibrium. - A challenge of the classical theory of business
cycle is a fact that the money stock leads the
cycle when money should be neutral.
4The Real Business Cycle Theory
- The real business cycle (RBC) theory argues that
real shocks to the economy are the primary cause
of business cycle.
5The Real Business Cycle Theory (continued)
- Real shocks are disturbances to the real side of
the economy - the production function
- the size of the labor force
- the real quantity of government purchases
- the spending and saving decisions of consumers.
6The Real Business Cycle Theory (continued)
- Nominal shocks are shocks to money supply and
money demand (affect LM curve in IS-LM model). - Productivity (supply) shocks play the largest
role in the real business cycle theory, they are
the dominant form of economic disturbance.
7The Adverse Productivity Shock
- An adverse productivity shock
- reduces MPN
- the demand for labour falls
- equilibrium employment level and real wage fall
- equilibrium level of output falls
- the interest rate rises
- consumption and investment rises
- the price level rises.
8The Real Business Cycle Theory (continued)
- In the RBC approach output declines in recessions
and rises in booms because - the general equilibrium level of output has
changed - rapid price adjustment ensures that actual output
always equal full-employment output.
9RBC Theory and the Business Cycle Facts
- The correct predictions of the RBC
- productivity shocks cause recurrent fluctuations
in aggregate output - the employment is procyclical
- the real wages are procyclical
- average labour productivity is procyclical
- saving and investment move closely in different
countries.
10The Business Cycle Facts (continued)
- A fact that is not explain by the RBC
- inflation tends to slow during or immediately
after a recession, contrary to the prediction of
inflation.
11Are Productivity Shocks the Only Source of
Recessions?
- The assumption by RBC theorists that productivity
shocks are the only source of economic recessions
is criticized by both classicals and Keynesians. - The RBC theorists response is that a series of
small shocks can cause large fluctuation.
12The Solow Residual and Technology Shocks
- The most common measure of productivity shocks is
Solow residual, an empirical measure of total
factor productivity, A. - The Solow residual is procyclical.
13The Solow Residual (continued)
- The interpretation of the Solow residual as a
measure of technology is questioned. - Some statistical studies reveal that it is
correlated with such factors as government
expenditures.
14The Solow Residual (continued)
- Capital and labour can be used with different
utilization rates uK and uN. - The evidence of utilization of both capital and
labour is procyclical.
15The Solow Residual (continued)
- Labour hoarding occurs when due to the cost of
hiring and firing workers, firms retain some
workers in a recession that they would otherwise
lay off. - Some economists find that technology shocks are
rather acyclical, it is due to lags.
16Price Stickiness
- Models of nominal price rigidity
- explain evidence of a procyclical movement of
real wages - while also explaining how aggregate demand shocks
can play an important role in explaining business
cycles.
17Price Stickiness
- Models of nominal price rigidity
- explain evidence of a procyclical movement of
real wages - while also explaining how aggregate demand shocks
can play an important role in explaining business
cycles.
18Price Stickiness (continued)
- Prices are sticky because firms, after
establishing a price for their output, find it is
in their best interest not to adjust that price
even though there has been a change in demand for
their output.
19Price Stickiness (continued)
- Flexible-price firms respond to increase in
aggregate demand by increasing price. - Fixed-price firms respond to increase in
aggregate demand by increasing output.
20Keynesian Business Cycle Theory
- Keynesians believe that a primary source of
business cycle fluctuations is unanticipated
shifts in the aggregate demand curve aggregate
demand shocks. - Keynesians attribute recessions to not enough
demand for goods.
21Keynesian Business Cycle Theory (continued)
- The Keynesian theory accounts for several
business cycle facts - recurrent fluctuations of Y in response to AD
shocks - employment fluctuates in the same direction as Y
- shocks to M are non-neutral, money is procyclical
and leading.
22Keynesian Business Cycle Theory (continued)
- Cyclical behaviour of durable and investment
goods can be explained if shocks to them are
themselves a main source of cycles.
23Keynesian Business Cycle Theory (continued)
- Inflation tends to slow during or just after
recessions because demand pressure is low during
recessions.
24Procyclical Labour Productivity
- This approach has a problem to explain the fact
that labour productivity is procyclical. - If the production function is stable, increases
in employment during booms should reduce average
labour productivity, so it should be
countercyclical.
25Procyclical Labour Productivity (continued)
- Firms may hoard labour during recessions and use
it less intensively. So, labour productivity
falls during a recession. - Labour hoarding is found to be reduced in the
last two recessions in Canada.
26Macroeconomic Stabilization
- According to Keynesians recessions are
undesirable, employment can be below the amount
of labour that workers want to supply.
27Macroeconomic Stabilization (continued)
- Average economic well-being would be increased if
governments tried to reduce cyclical fluctuations.
28Macroeconomic Stabilization (continued)
- Under no AD policy wages and prices will be
eventually cut in the long run. - While the adjustment process takes place economic
well-being is reduced.
29Macroeconomic Stabilization (continued)
- If prices adjust slowly and the fiscal or
monetary policies can be implemented quickly, the
AD policy could move the economy back to
full-employment output more quickly than doing
nothing.
30Difficulties of the Policy of Macroeconomic
Stabilization
- Actual macroeconomic stabilization is less
successful than Keynesian theory suggests - monetary and fiscal policies should be
coordinated - depth of a recession is difficult to measure
- the size of effects of monetary and fiscal
policies is not known.
31Difficulties of the Policy (continued)
- Monetary and fiscal policies have lags.
- Policymakers should concentrate of fighting major
recessions. - Policymakers should be willing to take economic
advice.
32Supply Shocks in the Keynesian Model
- In 1970s Keynesian theory failed to account for
the stagflation. - The theory predicts that inflation movements are
procyclical.
33Supply Shocks (continued)
- Keynesians admit that there can be occasional
episodes when supply shocks play a primary role
in economic downturns. - An adverse supply shock reduces MPN and demand
for labor. The FE line and LRAS curve shift to
the left.
34Supply Shocks (continued)
- The adjustment takes place slowly.
- In the long run, full-employment output falls,
the price level and the real interest rate
increase.
35Supply Shocks (continued)
- In the situation of adverse supply shock fiscal
and monetary policies can offer little help. - An unanticipated contractionary AD policy can
reduce the size of increase in the price level,
but it can cause a fall in output below the new
full-employment level.