Chapter 13 The Real Business Cycle Model: Shocks and Transmission Mechanisms

1. Chapter 13 The Real Business Cycle Model: Shocks and Transmission Mechanisms

2. Introduction • Transmission mechanisms—are economic forces that can amplify the impact of shocks on the economy. • They work by transmitting these shocks across times and sectors of the economy. • In this chapter we learn what these shocks are and how they create problems for the U.S. economy.

3. Shocks • Shocks—are rapid changes in economic conditions that have large effects on the productivity of capital and labor. • We will examine the following shocks. • Weather shocks • Oil shocks • Other possible shocks

4. Shocks • Weather shocks • In many economies agriculture is the single largest contributor to real GDP. • Shocks to the weather are important. • As economies become less dependent on agriculture, weather shocks have less impact. • India is a good example • % of real GDP accounted for by agriculture has fallen from 40% in 1970 to 20% in 1990. • Since 1980, rainfall shocks have become less important. • The next figure shows this…

5. Shocks • Weather shocks (cont.)

6. Shocks • Oil Shocks • An economy with a large manufacturing sector is sensitive to reductions in oil supplies. • Let’s look at the first major oil shock to the U.S. economy. • 1973 OPEC oil embargo. • Price of oil more than tripled • Because oil is an important input in many sectors, sharp increases in its price can disrupt the economy as a whole. The following figure shows this. • The link with U.S. recessions is shown next…

7. Shocks • In each of these recessions, there was a large increase in the price of oil just prior to or coincident with the onset of recession. • This is especially true in the first three recessions where wars caused a decrease in the supply of oil.

8. Shocks • Oil Shocks (cont.) • It is easy to see the impact of a large increase in the price of oil. It is harder to eyeball the effect of smaller shocks. • Careful statistical analysis can disentangle the effect of oil shocks from other shocks. • The following figure shows the results of this analysis…

9. Shocks • Oil Shocks (cont.) • After the oil price increase, the economy slows for • 5 quarters—15 months. • After 10 quarters–2½ years, the economy has fully • adjusted and the growth rate has returned to normal.

10. Shocks • Oil Shocks (cont.) • Starting in 2002 the price of oil dramatically increased, and by 2009 in real terms it was as high as ever. • Did not immediately cause a recession. Let’s look at three reasons why. • The American economy has become less dependent on oil than it was in the 1970s. • American producers have learned to protect themselves. • Economy uses oil more efficiently. • The following figure shows this…

11. Shocks • Oil Shocks (cont.)

12. Shocks • Oil Shocks (cont.) • Oil shocks were offset by positive productivity shocks. • Advances in computers and information technology. • Some positive shocks outweighed other negative shocks. • The Federal Reserve responded more appropriately to recent oil shocks than in the past.

13. Shocks • Shocks, Shocks, Shocks • Other shocks: • Wars and terrorist attacks • Major new regulations → increase in costs. • Tax rate changes → spending and incentives. • Mass labor strikes → disrupts production. • New technologies → “creative destruction.” • Important points • Typical year: good shocks outweigh the bad → economy grows. • Bad year: big negative shock or small shocks, more negative than positive.

14. Consider the ubiquity of cell phones throughout the world. How can this ubiquity be considered a positive shock? (Hint: compare with 10 years ago.) • How would a large and sudden increase in taxes, for example a tax on energy, shift the Solow growth curve?

15. Transmission Mechanisms Amplify and Spread Shocks • We now focus on transmission mechanisms: indirect negative effects that amplify shocks and spread them throughout the economy. • Five transmission mechanisms: • Intertemporal substitution. • Uncertainty and irreversible investments. • Labor adjustment costs. • Time bunching. • Sticky wages and prices.

16. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution • Behavior that reflects how people choose to allocate spending, work, and leisure across time to maximize well being. • In other words… • A person or business works less hard when working hard brings the lowest return. • High unemployment and low wages → more people leave the workforce and enroll in college. • During a recession, people are more likely to retire or take early retirement.

17. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) • Result: Intertemporal substitution magnifies economic shocks. • When things go a bit bad, the return to work and investing falls and people work and invest less. • On the upside, intertemporal substitution can feed an economic boom and make it more intense. • We can see this in the next diagram…

18. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) Point: When GDP is growing slower than the trend, the employment to population ratio is also growing slower than the trend. The reverse is also true.

19. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) • When we add intertemporal substitution to the RBC model, real shifts in AD can also change the growth rate of the economy. • Let’s illustrate this with two examples… • Large change in government spending, , can encourage workers to enter the workforce → temporary ↑ supply of labor. • →↑ Solow growth rate. • Solow growth curve shifts to the right.

20. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) • A large fall in household and business wealth will reduce and . • Intertemporal substitution will result in people leaving the workforce. • →↓Solow growth rate. • Solow growth curve shifts to the left. • The next diagram shows the effects on the Solow growth curve.

21. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) Shocks with Intertemporal substitution Solow growth curve Inflation rate (p) Shocks without Intertemporal substitution Conclusion: intertemporal substitution amplifies the shocks. Negative shock (2%) Average (3%) Positive shock (4%) Real GDP growth rate

22. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) • Let’s use the full RBC model to analyze the effect of our two examples… • A large increase in the growth rate of government spending, . • A large decrease in the growth rates of household spending, and business fixed investment, resulting from a decline in household and business wealth. • The next two diagrams use the RBC model to show the impact of these changes.

23. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) Inflation rate (p) Solow growth curve Example 1: 1. ↑government purchases → ↑ AD 2. Workers take advantage of higher aggregate demand by ↑work → Solow growth curve shifts right. 3. Economy moves from a → b. Both growth rate and inflation ↑. 4. In the long run both AD and and the Solow growth curve shift back and the economy returns to a. b 5% a 2% AD AD 3% 5% Real GDP growth rate Important point: the Solow growth curve shifts to the right because of intertemporal substitution.

24. Transmission Mechanisms Amplify and Spread Shocks • Intertemporal Substitution (cont.) Solow growth curve Inflation rate (p) Example 2: 1. ↓wealth → ↓ AD 2. Workers respond to the lower aggregate demand by ↓work → Solow growth curve shifts left. 3. Economy moves from a → b. Both growth rate and inflation ↓. 4. In the long run both AD and and the Solow growth curve shift back and the economy returns to a. a 5% b 2% AD AD 3% 5% Real GDP growth rate Important point: the Solow growth curve shifts to the left because of intertemporal substitution.

25. Transmission Mechanisms Amplify and Spread Shocks • Uncertainty and Irreversible Investments • Negative shocks increase uncertainty. • When investors are uncertain about the future, they often prefer to wait and sample more information before committing. • Because many investments are irreversible. • Example: Once construction on an office building is started, it is hard to tear down the building and redeploy the steel and glass to other economic uses. • The more uncertain the world appears, the harder it is for investors to determine where to invest their resources.

26. Transmission Mechanisms Amplify and Spread Shocks • Labor Adjustment Costs—the costs of shifting workers from declining sectors of the economy to growing sectors. • Labor adjustments to shocks are not always rational. • Example: A union worker in the auto industry making $100,000 a year without a high school degree will probably turn down a lot of available jobs before they finally accept reality and take a job at a lower wage. • Result: ↑unemployment and ↓real GDP growth.

27. Transmission Mechanisms Amplify and Spread Shocks • Labor Adjustment Costs (cont.). • The high cost of reversing job decisions. • Example: Closure of a Detroit automobile plant results in the following choices: • Wait and hope the plant reopens soon. • Seek another job in Detroit. • Move to find a job. • The choice involves a costly-to-reverse decision. • Many will simply bide their time until the future is clearer. • Result: ↑unemployment and ↓real GDP growth.

28. Transmission Mechanisms Amplify and Spread Shocks • Time Bunching—the tendency of economic activities to be coordinated at common points in time. • It pays to coordinate your economic activities with those of others. • Bunching also causes shocks to spread through the economy through time. • Example: Suppose a negative economic shock arrives and the economy slows down. • Many people will be less keen to work. • This will induce others to cut back on their work as well.

29. Transmission Mechanisms Amplify and Spread Shocks • Time Bunching—the tendency of economic activities to be coordinated at common points in time (cont.). • The “seasonal business cycle” is one form of economic clustering (bunching) in time. • The fourth quarter October-December brings more economic activity than any other time. • After Christmas, the party is over and economic activity is the lowest. • The next figure shows bunching.

30. Transmission Mechanisms Amplify and Spread Shocks • Time Bunching: “Seasonal Business Cycle”

31. Transmission Mechanisms Amplify and Spread Shocks • Time Bunching: “Seasonal Business Cycle” (cont.)

32. Transmission Mechanisms Amplify and Spread Shocks • Sticky Wages and Prices • The final transmission mechanism comes from the New Keynesian theory. • Sticky wages and prices can amplify real shocks. • The mechanism works like this: • A negative real shock reduces productivity and shifts the Solow growth curve to the left. • If wages are perfectly flexible, the SRAS will shift along with the Solow growth curve to the left.

33. Transmission Mechanisms Amplify and Spread Shocks • Sticky Wages and Prices (cont.) • The mechanism works like this: (cont.) • The economy is now in a recession and unemployment rises. • When the economy is in a recession, real growth is negative and wages must fall. • If wages are sticky, firms must cut output and hiring even further in order to remain profitable. • In addition firms will raise prices even faster.

34. Transmission Mechanisms Amplify and Spread Shocks • Sticky Wages and Prices (cont.) • The mechanism works like this: (cont.) • The SRAS shifts even further to the left than the Solow growth curve. • We will now use the New Keynesian model to illustrate how this mechanism works.

35. Transmission Mechanisms Amplify and Spread Shocks • Sticky Wages and Prices (cont.) Solow growth curve Inflation rate (p) SRAS with sticky wages SRAS with flexible wages • Negative shock: • Solow growth curve • shifts left. • SRAS shifts up and • left as p↑. • Economy… • goes from a to b • if wages are flexible. • goes from a to c • if wages are sticky. c SRAS (pe = 2%) 10% 6% b 2% a AD -5% -1% 3% Real GDP growth rate

36. Transmission Mechanisms Amplify and Spread Shocks • Transmission Mechanisms: Summary • There are five factors that magnify negative economic shocks. • Core lesson: a medium-sized negative economic shock is capable of causing a disproportionately large downturn in the economy. • Questions to be addressed in later chapters: • Could the government increase AD enough to offset some of these negative supply shocks? • If so, under what conditions?

37. Immediately after 9/11, most U.S. companies eliminated business travel temporarily. After a few weeks, business travel started to pick up again. Which transmission mechanism came in to play? Go through as many aspects of business travel as you can think of: air travel, transportation to and from airports, hotel stays, meals out, contact with people remaining back in the office. Explain how the unexpected almost-cessation in business travel amplified the original shock.

38. Takeaway • One reason why the economy fluctuates is because of productivity shocks. • We get a boom when we have a lucky series of positive shocks and a bust when we have an unlucky series of negative shocks. • Transmission mechanisms magnify shocks. • Intertemporal substitution: “make hay while the sun shines.”

39. Takeaway • Uncertainty and irreversible investments: cause investors to put off decisions to invest. • Labor adjustment: costs increase frictional unemployment. • Time bunching: Economic sectors follow each other as the economy fluctuates. • Sticky wages and prices: create a mismatch between AD and the Solow growth rate.

40. Chapter 13 Appendix: Business Fluctuations and the Solow Model

41. Business Fluctuations and the Solow Model • Some business fluctuations are just economic growth in the short run. • They can be analyzed using a version of the Solow growth model. • Main ideas of the modified Solow model… • Labor is added to the aggregate production function from Chapter 7:

42. Business Fluctuations and the Solow Model • In the Solow model we treated At as increasing smoothly over time as new ideas are created. • In this version of the model: • At jumps around in the short run as productivity shocks hit the economy. • L changes during booms and busts due to intertemporal substitution.

43. Business Fluctuations and the Solow Model • The effects of productivity shocks can be simulated using an Excel spreadsheet. • We use the random number generator to let At fluctuate randomly around 1. • If At is a little bigger than one → Positive productivity shock. • If At is a little smaller than one → Negative productivity shock. • Let’s see this in the following slide.

44. Business Fluctuations and the Solow Model Plotting output over time is shown next…

45. Business Fluctuations and the Solow Model