Real Business Cycles: A New Keynesian Perspective

Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

N. Gregory Mankiw • Chairman of the Economics Dept. and Prof. at Harvard • Economic Advisor to the Bush Administration

Goal of Paper • “My goal of this essay is to appraise this newly revived approach to the business cycle” – Mankiw

Walrasian Equilibriums • Walrasian equilibrium • in equilibrium- prices adjust to equate supply and demand in every market simultaneously • The equilibrium determines the quantities of all goods and services and their relative prices • The level of output is already determined in the Walrasian System • Price Levels can adjust to equate supply and demand in the money market

Classical Theory • By introducing price levels this way. • The Walrasian System can determine real variables, output and relative prices • Classical theory ignores the money market because nominal variables do not affect real variables • the money market in the view of Classical Theory is irrelevant

Classical Theory Impact on Real Business Cycle Theory • Real Business Cycles embraces the Classical Theory that the money supply is irrelevant • Nominal variables, such as money supply and price level are assumed to have no role in explaining fluctuations in real variables

Real Business Cycle Views of Economic Fluctuation • According to RBC Theory economic fluctuations are only caused by the forces that change the Walrasian equilibrium • Many disturbances can generate fluctuations in the RBC model • But a disagreement between the RBC and Keynesian schools of thoughts regarding the mechanic of the disturbances exist

Different views of Disturbances Mechanics Consider a temporary increase in government purchases

RBC View of Mechanics • RBC’s emphasizes the inter-temporal substitution of goods and leisure • A increase in government purchases increase the demand of goods • To achieve equilibrium real interest rates must rise • A higher real interest rate causes labor supply to increase • Thus, causing equilibrium employment and output to rise

Keynesian View of Mechanics • Also predicts an increase in the real interest rate • Resulting in an increase in employment and output due to a reduction in the amount of labor unemployed because interest rates on labor supply does not play a crucial role • Problem: Walrasian approach of RBC’s does not allow for the possibility of involuntary unemployment

Technological Disturbances • typical business cycle consumption and leisure move in opposite directions. • In a recession consumption falls and leisure rises and in a boom it’s opposite • Business cycle theory must explain why individuals in a recession find it rational to increase the quantity of leisure they demand while decreasing the quantity of goods they demand.

Technological Disturbances cont. • With the production function unchanging, diminishing marginal returns would then produce a countercyclical real wage. • This is not the pro-cyclical real wage that is necessary to explain the fluctuations in consumption and leisure • Real business cycle theory describes the fluctuations as the Walrasian equilibrium changing. This is saying that the fluctuations are in fact efficient.

Technological Disturbances cont. • The levels of employment, output, and consumption cannot be improved. • Attempts by the government to alter the allocations of private market, such as policies that are made to stabilize employment are best ineffective but worst case can do harm by impeding the "invisible hand."

Technological Disturbances cont. • optimality of economic fluctuations is the most shocking because the level of welfare is actually lower in a recession than it is in the boom that follows it.

The Evidence on Technological Disturbances The Evidence on Technological Disturbance • The standard presumption increase in the economy's technological opportunities take place gradually over time but in fact there are substantial short-run fluctuations in the production function • Prescott states that there are substantial fluctuations in the Solow residual • Like Prescott, Mankiw found substantial fluctuations in measured total factor productivity • This shows that measured productivity is highly cyclical. Every year that output fell, total factor productivity also fell.

The Evidence on Technological Disturbances cont. • The standard explanation of cyclical productivity is that it reflects labor hoarding and other "off the production function" behavior. • when the economy experiences large real shocks, these shocks are easily identifiable and much discussed.

Real Business Cycles Theories with Multiple Sectors Now, let’s take a look at multiple sectors and their interactions.

Real Business Cycles Theories with Multiple Sectors • Even if shocks to sectors are independent, the outputs move closer together. A negative shock to a sector decreases the overall wealth of the individuals and thus they reduce their demand for all goods. • For example: An adverse shock to one sector reduces the wealth of the individuals in the economy; these individuals respond by reducing their demand for all goods. An observer would see an aggregate business cycle, even without a single aggregate shock.

Real Business Cycles Theories with Multiple Sectors • 1939-1944 total factor productivity grew an average of 7.6 percent. Demand or Supply shocks? • Solow Residual (empirical productivity growth), is not a good measure for short run and year to year comparison of production technology. • The existence of large fluctuations in the available technology is a crucial and but unjustified assumption of RBC theory.

Money and Prices over the Business Cycles • Before real business cycles theory was created both historical discussion and formal econometric work agreed on the conclusion that money matters. • Both discussions pointed to the Federal Reserve as an important source of macroeconomic disturbances causing a controversy as to weather systematic monetary policy could stabilize the economy, but universally accepting bad monetary policy could be destabilizing

Money and Prices over the Business Cycles • King and Plosser (1984): money supply endogenously responds to fluctuations of output. • M1 mostly inside money, or money created by the banking system. • K&P suggest transaction services of this inside money should be viewed as the “output” of the banking sector. • An increase in productivity in any sector will increase transaction services, and increase the output of more money by the Fed.

Money and Prices over the Business Cycles • Therefore, the pro-cyclical behavior of standard monetary aggregates cannot necessarily be interpreted as evidence that changes in outside money caused by the monetary authority have real effects.

The Tradeoff Between Internal and External Consistency • A good theory has two characteristics: internal consistency and external consistency. • An internally consistent theory is one that is has the least assumptions as possible, and invokes no peculiar axioms. • An externally consistent theory is one that fits the facts; it makes empirically refutable predictions that are not refuted.

The Tradeoff Between Internal and External Consistency • The choice between the RBC and NK theories of the business cycle is partly a choice between internal and external consistency.

The Tradeoff Between Internal and External Consistency • RBC theory extends the Walrasianparadigm, the most widely understood and taught model in economics, and provides a unified explanation for economic growth and economic fluctuations. • New Keynesian theory, in its attempt to mimic the world more accurately, relies on nominal rigidities that are observed but with only little understood. • NKT sometimes suggests to understand the business cycle one might have to reject the axiom rational and optimization of individuals, which jeopardizes the internal consistency.

The Tradeoff Between Internal and External Consistency Mankiw’s forecast for each model: RBC will fail to produce convincing evidence that there are substantial shocks to technology and that leisure is highly substitutable over time. NKT has made substantial progress in providing rigorous microeconomics (fatal flaw since 1960). Although RBC has served an important factor in provoking the scientific debate, it will ultimately be discarded.

The End

Real Business Cycles: A New Keynesian Perspective