W7B Outline

1. W7B Outline • Recap Classical vs Keynesian Model • Expectations • Rational/Behavioral/Adaptive • Incomplete Information and Policy • Divergent Modeling Strategies • Text RBC Real Business Cycles • RBC vs Monetarism • Kydland + Prescott Results • Outside material on Real Business Cycles

2. LM r Classical 3 Parts First Ns=ND gives N* Take K as momentarily given and plug K, N* into AN0.7K0.3=YFE Second Spending behavior defines the IS curve. YFE and IS curve give r*. Third Which price level sets MD=MS at YFE and r*? IS Y w NS ND=MPN N

3. Classical 3 layer model: work up

4. Keynesian 3 pt. model

5. Keynesian 2 pt. model

6. Key Price Distinction • Classical model has the economy staying at or near full employment via changes in the price level. The flexibility of prices and the expectation mechanisms governing price movements become very important. • If price setters know how the economy works they can set market clearing prices. This is the case of “rational expectations” in a market clearing economy.

7. Lucas Short Run Production • Y=YFE+b(P-Pe) • When the price of any good goes up it encourages more production of the good. • But not if all input prices have risen proportionately! • Ch10 372-3

8. Figure 10.05 The aggregate supply curve in the misperceptions theory

9. unanticipated increase in the money supply Figure 10.06 An unanticipated increase in the money supply This is the Lucas, RBC model But this picture is characterist Of a Monetarist view.

10. anticipated increase in the money supply Figure 10.07 An anticipated increase in the money supply

11. Pool on Rational Expectations By "rational expectations" I mean that market outcomes have characteristics as if economic agents are acting on the basis of the correct model of how the world works and that they use all available information in deciding on their actions. That information includes probable future monetary policy actions and, more generally, how monetary policy actions are likely to depend on various possible states of the economy. Poole 2000

12. Pool on Rad X cont. The key idea of the rational expectations hypothesis is that the market forms expectations based on estimates of model parameters that match the true model parameters. Pool 2000 In the context of the Classical ISLM Mode this means that if the economy tends toward full employment then prices and price expectations will bring us there more quickly. This is made clearer in Chapter 12 and its key analytical problem.

13. No one should be surprised if economists have difficulty confirming the rationality of market expectations about inflation, for example, if economists cannot even characterize Fed policy with much accuracy. • Why should economists judge the market by standards they themselves, with all their knowledge of theory and econometrics, cannot meet? • Pool 2000

14. Non Rational Expectations Expectations may be nonrational in an infinity of ways… Keynes said that, "A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield.“ Popular commentary on bond, stock, commodity and foreign exchange markets often focuses on presumed patterns in the data such as resistance and support levels that make no theoretical sense and are completely unsupported by careful empirical investigation. Pool 2000

15. Adaptive Expectations In econometric models, economists have often used adaptive expectations, which are simple, and simple-minded, extrapo- lations of the past. Adaptive expectations are the antithesis of the emotional process Keynes emphasized. Adaptive expec- tations, as averages of recent observations, change relatively smoothly and continuously. They are unaffected by news items per se; if news moves the market, the adaptive expectation incorporates only a fraction of the unexpected price adjust- ment into expected future prices. Pool 2000

16. Incomplete Information Pool asks: Are bank runs irrational? e.g. Rode Island 1990, a state chartered credit union fails due to Fraud, CNN shoots a clip in front of Old Stone Bank-a federally insured bank, and it faces a run that peters out once better info is available. He notes that:Often information is costly to obtain, or mentally process and retain. Government may send mixed or unclear signals. So in practice it is hard to distinguish imperfect information from irrationality.

17. Pool on Expected Fed Funds 1994-onwards FRB announces changes in Fed Funds after Each FOMC meeting. And its bias (inflation risk vs. slow Growth risk—the “balance of risks”) for next meeting. 1994-2000 the Federal Funds Futures predict changes well in SR. Not at long intervals. My note: this raises the question of why fully expected policy should have an impact.

18. Continuing Divide Some economists model decisions with far seeing rational probabilistic models. Others emphasize fundamental uncertainty and rely on informal psychological views of market reaction.

19. Monetarism vs RBC Monetarism RBC with Rad X Shocks are monetary (AD) technology shocks (AS) People will learn that the Expected AD shocks have gov. is inflating, but no real impact. can’t call each shock. That’s why M policy is so counterproductive.

20. unanticipated increase in the money supply Figure 10.06 An unanticipated increase in the money supply This is the Lucas, RBC model But this picture is characterist Of a Monetarist view.

21. anticipated increase in the money supply Figure 10.07 An anticipated increase in the money supply This is the sort of behavior that Sargent and RBC emphasize.

22. Figure 10.01 Actual versus simulated volatilities of key macroeconomic variables Kydland+Prescott 1 Edward Prescott 1986 cited in Ch 10.

23. Figure 10.02 Actual versus simulated correlations of key macroeconomic variables with GNP Kydland+Prescott 2

24. Kydland+Prescott 3 Figure 10.03 Small shocks and large cycles

25. RBC Results Pro cyclical real wage Pro cyclical employment Pro cyclical A

26. Real Business Cycle Models • Hansen, Sargent, Prescott, Cooley all present work with a similar foundation and have worked on papers in various combinations. • Hansen’s 1985 paper is the basis for most introductory computer exercises. • Hansen, Greg (1985) ‘Indivisible Labor and the Business Cycle’ Journal of Monetary Economics, 16, 309-27.

27. Components of Hansen’s RBC • Forward looking consumers maximize lifetime utility from their work income. • At each moment they look forward and pick a “path” of work, consumption and savings. • Unexpected shocks may disrupt this path, when that happens consumers recalculate their best path looking forward.

28. Output per worker We can simply say: C=net income-savings Technology increases over time in an erratic way. There are constant technology shocks

29. Production Like Y/N=A*(K/N)^theta*(work per worker)^1-theta

30. When technology improves unexpectedly people work more. Part of the income is saved (increasing the future capital stock, labor productivity and wage) and part is consumed.

31. http://www2.wiwi.hu-berlin.de/institute/wpol/html/toolkit/DynaMo_vers2.htmlhttp://www2.wiwi.hu-berlin.de/institute/wpol/html/toolkit/DynaMo_vers2.html • This link takes you to Prof. Uhlig’s page which has two models on it. • The first is the Hansen model which shows you how technology shocks can produce business cycles. You must install the program on your computer. • Then you can run simulations: pictures of what the economy looks like over time when we experience shocks. • You can produce impulse response graphs: how the variables respond to a (technology) shock. • You can also see the moments, that is the distribution of the variables and how they relate to each other: how much do output, consumption and the capital stock vary as technology varies.

32. Simulations

33. Like Our Text on Kydland and Prescott Small productivity shocks Cause Large changes in other Variables

34. Impulse Response

35. Impulse response • A positive technology shock increases consumption over time and increases the capital stock.

36. “moments”

37. “moments”

38. Finance Minister Model • Uhrig’s Finance Minister Model comes in three flavors, let’s just focus on the • FinanceministerDynaMo.exe • Model available from the page I mentioned earlier: • http://www2.wiwi.hu-berlin.de/institute/wpol/html/toolkit/DynaMo_vers2.html

39. Finance Minister • This model adds government spending and taxation to the previous Hansen Real Business Cycle Model. • Gov spending and transfers give people utility. • Taxes can be raised in three ways: • On Wages, On Dividends (Capital income), On Consumption • MACRODATA part two asks you to experiment • With this model to determine how different taxes affect the economy.

40. Finance Minister • Loosely based on • Discussion Paper 38 (January 1991)Tax Distortions in a Neoclassical Monetary EconomyThomas F. Cooley and Gary D. Hansen [Paper available on-line as PDF (Adobe Acrobat) file or PostScript file] Published later in Journal of Economic Theory, but there is no web link for that.

41. Which tax? • Experiment in Finance Minister (this roughly follows the scenarios Uhlig sets out on his web site): • In each scenario you will lower one tax and replace it with another. You vary the replacement tax untill you get the Gov Debt to GDP ratio back to its original level by the end of the simulation.

42. Postwar British Economic Growth and the Legacy of Keynes • Thomas F. Cooley; Lee E. Ohanian • The Journal of Political Economy, Vol. 105, No. 3. (Jun., 1997), pp. 439-472. • Stable JSTOR URL: http://links.jstor.org/sici?sici=0022-3808%28199706%29105%3A3%3C439%3APBEGAT%3E2.0.CO%3B2-5

43. Abstract • The policies used by Britain to finance World War II represented a dramatic departure from the policies used to finance earlier wars and were very different from the policies used by the United States during the war. Following Keynes's recommendations, Britain taxed capital income at a much higher rate than the United States during the war and for much of the postwar period. We analyze quantitatively the policies designed by Keynes using an endogenous growth model and the neoclassical growth model. We also evaluate the implications of tax-smoothing policies. We find that the welfare costs of Keynes's policies were very high relative to a tax-smoothing policy and argue that Britain's poor macroeconomic performance in the early postwar period is a consequence of the high tax rates levied on capital income.

44. Figure 10.04 Effects of a temporary increase in government purchases Effects of a temporary increase in government