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Chapter 19: Advances in Business Cycle Theory

Chapter 19: Advances in Business Cycle Theory. Recent Macroeconomic Ideas. Real business cycle theory Prices are fully flexible, even in the short-run Stabilizations policy must show “real” effects New Keynesian economics Wages and prices are sticky in the short-run

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Chapter 19: Advances in Business Cycle Theory

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  1. Chapter 19: Advances in Business Cycle Theory

  2. Recent Macroeconomic Ideas • Real business cycle theory • Prices are fully flexible, even in the short-run • Stabilizations policy must show “real” effects • New Keynesian economics • Wages and prices are sticky in the short-run • Managing the Aggregate Demand (IS-LM model) is the key to economic stability

  3. Real Business Cycle Theory • Interpretation of the labor market • Importance of technology shock • Neutrality of money • Wage and price flexibility

  4. Interpretation of Labor Market • Intertemporal substitution of labor: workers express preferences for the time periods they supply labor hours Time periods: 1 and 2 W = real wage rate r = real interest rate Intertemporal Relative Wage = (1 + r)W1 / W2

  5. Importance of Technology Shock • Technology refers the method of combining production factors (labor and capital) • Robert Solow using Y = AKα Lβ attributes output growth to the growth of production factors (L,K) and technology (A) which is a residual factor; where ΔA/A = α(ΔK/K) - β(ΔL/L) • Growth of technology causes the growth of output

  6. Output and Technology Growth in the U.S.

  7. The Neutrality of Money • Money plays a “neutral” role in economic activity even in the short-run • Monetary policy has no significant effect on output and employment growth; it only affects “nominal” values (e.g., nominal interest rate and price level change, leaving real interest rate unaffected) • Critics of this idea assert that monetary policy appear to have strong effects on economic stability

  8. Wage and Price Flexibility • Wages and prices are not sticky; they are flexible even in the short-run • The foundation of macroeconomics is microeconomics in which wages and prices respond to changes in market conditions

  9. New Keynesian Macroeconomics • Menu costs • Imperfect labor markets • Aggregate Demand externalities • Recession as coordination failure • Staggering of wages and prices

  10. Menu Costs • Prices are sticky in the short-run because of the costs associated with price adjustments • Printing and distributing new catalogs and menus • Distributing new price lists to sales staff • The “menu” costs lead firms to adjust prices intermittently rather than continuously

  11. Imperfect Labor Markets • Nominal wages are sticky in the short-run because markets are generally regulated by labor unions which • Keep wages sticky downward • Regulate employment of union members to keep union wage rate above the market wage rate

  12. Aggregate Demand Externalities • When a firm lowers the price it charges, it slightly lowers the general price level, raising the real money balances • The increase in real money balances expands aggregate income, hence increasing the demand for all products • Increased demand for products requires price adjustments for all other firms in the market

  13. Recessions as Coordination Failure • Each firm must decide whether to cut prices after a decline in the money supply • Firms make this decision without knowing the strategy other firms choose • Inferior outcomes due to coordination failure would cause a recession

  14. Game Theory Example • Two firms: 1 and 2 • Two strategies: Cut Price, Keep High price • Firm 1’s best strategy is Cut Price to make highest possible profit • Firm 2’s best strategy is Cut Price to make highest possible profit

  15. Game Theory Example Firm 2 Keep High Price Cut Price Firm 1 makes $30 Firm 2 makes $30 Firm 1 makes $5 Firm 2 makes $15 Cut Price Firm 1 Firm 1 makes $15 Firm 2 makes $5 Firm 1 makes $15 Firm 2 makes $15 Keep High Price

  16. Coordination Failure • If both firms cut prices, the gain the highest level of profit ($30 each) • If one firm cuts the price, the other firm would keep its price high, a recession would follow hurting the price cutting firm the most ($5 vs. $15 of profit) • If both firms keep their prices high, a recession would also follow, lowering profits for both firms to $15 each. This outcome is highly probable if firms fail to coordinate pricing decisions

  17. Staggering Price Variations • Staggering makes the overall level of prices adjust gradually, even when individual prices change frequently. • Firms change prices intermittently in response to a demand shift and change in profit . Prices change in the • beginning of a month • middle of the month • end of the month

  18. Frequency of Price Change

  19. Staggering Wage Variations • A decline in the money supply reduces the level of Aggregate Demand, output, and employment. Lower employment requires nominal wage rate to fall • But, workers and labor unions are reluctant to take the wage cut. The reluctance of a worker to be the first to take a pay cut makes the overall level of wages slow to respond to changes in the Aggregate Demand

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