CHAPTER NINETEEN Advances in Business Cycle Theory

1. CHAPTER NINETEEN Advances in Business Cycle Theory

2. Learning objectives This chapter presents an overview of recent work in two areas: • Real Business Cycle theory • New Keynesian economics

3. The Theory of Real Business Cycles • all prices flexible, even in short run • implies money is neutral, even in short run • classical dichotomy holds at all times • fluctuations in output, employment, and other variables are the optimal responses to exogenous changes in the economic environment • productivity shocks the primary cause of economic fluctuations

4. The economics of Robinson Crusoe • Economy consists of a single producer-consumer, like Robinson Crusoe on a desert island. • Assume Crusoe divides his time between • leisure • working • catching fish (production) • making fishing nets (investment) • Assume Crusoe optimizes given the constraints he faces.

5. Shocks in the Crusoe island economy • Big school of fish swims by island. Then, GDP rises because • Crusoe’s fishing productivity is higher • Crusoe’s employment rises: he decides to shift some time from leisure to fishing to take advantage of the high productivity

6. Shocks in the Crusoe island economy • Big storm hits the island. Then, GDP falls: • The storm reduces productivity, so Crusoe spends less time fishing for consumption. • More importantly, investment falls, because it’s easy to postpone making nets until storm passes • Employment falls: Since he’s not spending as much time fishing or making nets, Crusoe decides to enjoy more leisure time.

7. Economic fluctuations as optimal responses to shocks • In Real Business Cycle theory, fluctuations in our economy are similar to those in Crusoe’s economy. The shocks aren’t always desirable. But once they occur, fluctuations in output, employment, and other variables are the optimal responses to them.

8. The debate over RBC theory …boils down to four issues: • Labor Market: Do changes in employment reflect voluntary changes in labor supply? • Technology: Does the economy experience large, exogenous productivity shocks in the short run? • Is money really neutral in the short run? • Are wages and prices flexible in the short run? Do they adjust quickly to keep supply and demand in balance in all markets?

9. The labor market • Intertemporal substitution of labor:

10. The labor market • Intertemporal substitution of labor:

11. Labor market • In RBC workers work more when wage is temporarily high of when interest rate is temporarily high • Labor supply and output fluctuate because of shocks that cause changes in rt or wt • Empirically, intertemporal substitution of labor is too small – changes in real wage lead to only small changes in hours worked

12. Technology Shock

13. Technology shocks • In RBC theory, economic fluctuations are caused by productivity shocks. • The Solow residual is a measure of productivity shocks: it shows the change in output that cannot be explained by changes in capital and labor. • RBC theory implies that the Solow residual should be highly correlated with output. Is it?

14. Solow Residual

15. The Solow residual and growth in output Percent per year 10 8 Output growth 6 4 2 0 Solow residual -2 -4 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Year

16. Technology shocks • Proponents of RBC theory argue that the strong correlation between output growth and Solow residuals is evidence that productivity shocks are an important source of economic fluctuations. • Critics note that the measured Solow residual is biased to appear more cyclical than the true, underlying technology. • Labor hoarding (firms keep labor that is underemployed during recessions) • Changes in the production process that are not part of technology (during recessions workers often do different tasks not directly related to production e.g. training, organizing the inventory etc.)

17. An econometric detour

18. Correlation does not imply causation! • Corr(X,Y)>0 or Corr(X,Y)<0 does not mean that X causes Y • during rainy days people carry umbrellas • rain is correlated with umbrellas • Some alien may wrongly infer that umbrellas cause rain • Moreover, Corr(X,Y)>0 or Corr(X,Y)<0 does not necessarily imply that either X causes Y or Y causes X: • There can be the third factor Z that causes both X and Y • i.e sleeping with one's shoes on is strongly correlated with waking up with a headache. • Therefore, sleeping with one's shoes on causes headache.

19. One more example • An episode of The Simpsons (Season 7, "Much Apu About Nothing") • Springfield had just spent millions of dollars creating a highly sophisticated "Bear Patrol" in response to the sighting of a single bear the week before. • Homer:Not a bear in sight. The "Bear Patrol" is working like a charm! • Lisa:That's specious* reasoning, Dad. • Homer:[uncomprehendingly] Thanks, honey. • Lisa:By your logic, I could claim that this rock keeps tigers away. • Homer:Hmm. How does it work? • Lisa:But I don't see any tigers around, do you? • Homer:(pause) Lisa, I want to buy your rock. Source: Wikipedia, click here *specious - plausible but false; "a specious claim"; "spurious inferences"

20. The neutrality of money • RBC critics note that reductions in money growth and inflation are almost always associated with periods of high unemployment and low output. • Lower money supply growth and/or lower inflation is correlated with higher unemployment in the short run • RBC proponents respond by claiming that the money supply is endogenous: • Suppose output is expected to fall.Central bank reduces money supply in response to an expected fall in money demand.

21. Reverse causality or “money illusion” • It could be the case that • This argument is called “money illusion” • Even though we observe that episodes of low unemployment are correlated with episodes of high growth of money supply, the causality goes from output to money

22. Empirical strategies to check the direction of causation • Ideally: controlled experiment • Every January, the chairman of the Fed flips the coin • If Heads: increase money supply • If Tails: reduce money supply • Therefore, money supply is exogenous random process • If output and labor are still positively correlated with changes in money supply then money are not neutral in the short run!

23. Event Studies • Alternative: study how some exogenous historical changes in monetary policy influence real variables • “A Monetary History of the US” M. Friedman and A. Schwartz • Death of B. Strong – the chairman of the New York Federal Reserve Bank in 1928 was one of the causes of the Great Depression • C. and D. Romer (1989) studied how the Fed’s Open Market Committee announcements about the shift in the monetary policy influenced the output and employment

24. The flexibility of wages and prices • RBC theory assumes that wages and prices are completely flexible, so markets always clear. • RBC proponents argue that the extent to which wages or prices may be sticky in the real world is not important for understanding economic fluctuations. • They also prefer to assume flexible prices to be consistent with microeconomic theory. • Critics believe that wage and price stickiness explains involuntary unemployment and the non-neutrality of money.

25. New Keynesian Economics • Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, and that these deviations occur because wages and prices are sticky. • New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment.

26. New Keynesian economics • Why exactly prices are sticky? • menu costs prevent firms to adjust prices which leads to high costs to society • coordination failure • Strategic motives in price setting • staggering of wages and prices • staggering makes the overall price level adjust gradually

27. How sticky the prices are? • “Economist” Sticky situations • Bils and Klenow (2004) • used data on 350 goods and services collected by the Bureau of Labour Statistics for calculating the consumer-price index. • in 1995-97 half of these prices changed at least every four or five months. • Nakamura and Steinsson“Five Facts About Prices: A Reevaluation of Menu Cost Models” • importance of sales and special promotions in the frequency of American price changes • In the US, median duration of retail prices lay between eight and 11 months in 1998-2005

28. Conclusion: the frontiers of research • This chapter has explored two distinct approaches to the study of business cycles: Real Business Cycle theory and New Keynesian Theory. • Not all economists fall entirely into one camp or the other. • An increasing amount of research incorporates insights from both schools of thought to advance our study of economic fluctuations.

29. Chapter summary 1. Real Business Cycle theory • assumes perfect flexibility of wages and prices • shows how fluctuations arise in response to productivity shocks • the fluctuations are optimal given the shocks 2. Points of controversy in RBC theory • intertemporal substitution of labor • the importance of technology shocks • the neutrality of money • the flexibility of prices and wages