Classical Business Cycle Analysis

1
Classical Business Cycle Analysis
2
Overview

• Classical BC analysis
• RBC Theory, the Solow residual and Productivity
  Shocks
• Unemployment and Fiscal Policy
• Money Non-neutrality and Reverse Causation

3
Business 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.

4
The Real Business Cycle Theory

• The real business cycle (RBC) theory argues that
  real shocks to the economy are the primary cause
  of business cycle.

5
The 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.

6
The 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.

7
The 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.

8
The 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.

9
RBC 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.

10
The 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.

11
Are 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.

12
The 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.

13
The 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.

14
The 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.

15
The 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.

16
Price 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.

17
Price 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.

18
Price 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.

19
Price 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.

20
Keynesian 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.

21
Keynesian 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.

22
Keynesian 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.

23
Keynesian Business Cycle Theory (continued)

• Inflation tends to slow during or just after
  recessions because demand pressure is low during
  recessions.

24
Procyclical 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.

25
Procyclical 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.

26
Macroeconomic Stabilization

• According to Keynesians recessions are
  undesirable, employment can be below the amount
  of labour that workers want to supply.

27
Macroeconomic Stabilization (continued)

• Average economic well-being would be increased if
  governments tried to reduce cyclical fluctuations.

28
Macroeconomic 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.

29
Macroeconomic 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.

30
Difficulties 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.

31
Difficulties 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.

32
Supply Shocks in the Keynesian Model

• In 1970s Keynesian theory failed to account for
  the stagflation.
• The theory predicts that inflation movements are
  procyclical.

33
Supply 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.

34
Supply Shocks (continued)

• The adjustment takes place slowly.
• In the long run, full-employment output falls,
  the price level and the real interest rate
  increase.

35
Supply 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.