Slides for Part III-A

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Slides for Part III-A
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The Great Divide in Business Cycle Theory

• The issues
• Are mature, market industrialized economies
  inherently stablethat is, are they
  self-equilibrating in nature and tend to the
  full employment of resources?
• Should the powers of governments and central
  banks be deployed for purposes of
  counter-cyclical stabilization?

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Development of Business Cycle Theory
Theory Key Figures
Classical J.B. Say, I. Fisher, A. Pigou
Keynesian J.M. Keynes, J. Hicks, A. Hansen, P. Samuelson, J. Tobin, P. Davidson, J. Stiglitz
Monetarism (NewClassical, phase I) M. Friedman, D. Meiselman, D. Laidler
Rational Expectations (New Classical, Phase II) R. Lucas, T. Seargent, N. Wallace
Real Business Cycle Theory C. Plosser, E. Prescott, F. Kydland
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The Classical system
You can look at the Classicalsystem as an
application, or generalization, of the laws of
supply and demand to the problems of total
output, totalemployment, and the generalprice
level
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Three pillars of the Classical model

• The Classical theory of employment
• Says law (time preference theory of interest)
• The quantity theory of money

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Definitions
Y ? Real GDP (Income) N ? Employment of labor NS
? Supply of labor services ND ? Demand for labor
services S ? Saving I ? Investment i ? Rate of
interest (or yield of bonds) p ? Price level w ?
Nominal (money) wage W ? Real wage w/p M0 ?
(Exogenously-determined) nominal money supply v ?
Income-velocity of money
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The short-run aggregate production function--again
Y
Y f(N) (1) Y(N) gt 0
(1.1) Y(N) lt 0
(1.2)
0
N
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The labor market
w/p
NS
ND f(w/p) (2) ND(w/p) lt 0 ?
(2.1) NS f(w/p) (3) NS(w/p) gt
0 (3.1)
W
ND
The labor market equilibrium condition is given
by
0
N
N
ND NS (4)
? Due the the diminishing marginal revenue
product of labor
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Says Law

• Supply creates its own demand.
• The production of a given flow of output will
  result in the distribution of a flow of income
  (via factor market transactions) that is
  sufficient to give spending units the wherewithal
  purchase the output at prices that would enable
  firms to cover their costs of production
  (including a normal profit).
• Says Law apparently rules out the possibility of
  a general commodity glut.

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Note Goods includes consumer services
Simple circular flow
Factor markets
Costs of production
National income
Productive factors
Land, labor, capital
Goods
Goods
Product markets
Sales revenue
Consumption
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Knocks on Says Law

• Since income is received in money, households can
  withhold spending power from the
  income-expenditure streamthat is, they can save.
  
• Even if leakages (savings) are made available to
  potential borrowers as loanable funds, a
  shortage of profitable investment opportunities
  may prevent an offset of leakages to injections
  (investment spending).

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The loanable funds market
Re-establishing the validity of Says law in a
money-using economy?
i ()
S f(i) (5) S(i) gt 0
(5.1) I f(i) (6) I(i) lt 0
(6.1)
S f(i)
i
The equilibrium condition is given by
I f(i)
0
I S (7)
S,I
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The quantity theory of money
The theory is formally articulated using Irving
Fishers equation of exchange
Mv pY
(8) let ? 1/v. Now rewrite (8) M
?pY
(9) Let Y denote the value of real GDP
corresponding to the equilibrium condition
described in equation (4). Taking into account
that M is presumed to be under the control of the
monetary authority, (9) can be rewritten M0
?pY
(9.1)
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Equation 9.1 expresses the Classical neutrality
ofmoney postulate--that is, the time path of
real variables Y, N, I, S, C, and I are
invariantwith respect to changes in the money
supply. Moneyis a veil over economic activity
which is capableof producing changes in the
general price level--but not relative prices and
quantities.
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The complete Classical system
Y
Y
i()
M2v
S f(i)
M1v
Y
Y
i
I f(i)
0
0
0
p1
p2
w/p
w
N
N
p
S,I
NS
W w/p
W2
W
W1
ND
0
p1
p2
N
0
N
p
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What can explain unemployment?
Answer Labor market disequilibrium
NS
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• Actual wage 12
• Equil. Wage 9
• U 89 65 24

Real wages
9
ND
80
65
89
0
Employment (millions)
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Sources of friction in the labor market

• Minimum wage legislation
• Labor union truculence