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Classical Business Cycle Analysis

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Classical Business Cycle Analysis. Overview. Classical BC analysis ... RBC theorists' response is that a series of small shocks can cause large fluctuation. ... – PowerPoint PPT presentation

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Title: 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.
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