Lecture 12: The Equilibrium Business Cycle Model

1. Lecture 12: The Equilibrium Business Cycle Model L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.8 18 February 2010

2. Introduction • Last time: • Completed the macroeconomic model by analysing how consumption impacted investment • Today • Begin to apply the model by studying the fluctuations in output more closely • Test whether the model fits the data

3. ‘Equilibrium Business Cycle’ • The model we have constructed is known as an ‘Equilibrium Business Cycle Model’ • ‘Equilibrium’ because markets are continually in equilibrium • ‘Business Cycle’ because it seeks to explain the cycle of fluctuations known by this name • Aims to explain economic fluctuations

4. Fluctuations • There are clearly fluctuations, but how do we measure them? • GDP is trended upwards, but deviates around that trend • Can estimate trend and deviation using filtering techniques • Classify ‘recessions’ as periods of growth which are significantly lower than trend growth

5. Testing the Model • Fluctuations in technology: • Part one of the course established that growth in A is the best explanator of long-run economic growth • Idea here: fluctuations in A are best explanator of fluctuations in growth • So positive and negative shocks to technology drive short-term expansions and contractions

6. Testing the Model • Test this idea with the following questions • If fluctuations in output are caused by fluctuations in technology, what does that imply for fluctuations in wages, rents, consumption, investment, unemployment, capital utilisation? • Does the data conform with the predictions of the model?

7. Technology Shocks • Our production function is subject to shocks in A • Positive shock to A means that for a given K,L output increases (so MPL and MPK increase) • Negative shock to A means that for a given K,L output decreases (so MPL and MPK decrease)

8. Implications: • Increase in technology level • Raises demand for labour, with inelastic supply this causes increase in real wage w/P • Raises demand for capital, with inelastic supply this causes increase in rental cost R/P • Increase in rental cost means i also increases

9. Implications for Consumption • Interest rate i increases • Intertemporal substitution effect encourages households to save, consumption should fall • But if A is permanent, large positive income effect encourages consumption to increase • So net effect is increase in consumption when technology shock hits

10. Predictions • So, if technology is driving output fluctuations • Wages should rise when output rises and fall when output falls • Interest rates should rise when output rises and fall when output falls • Consumption and Investment should both rise when output rises and fall when output falls • That is, all of these variables should be procyclical (instead of counter-cyclical)

11. Outcome • Is the data consistent with a model in which permanent changes to A drive output • Wages a procyclical (as predicted) • Rental cost is procyclical (as predicted) • Consumption is procyclical (as predicted) and less variable than GDP • Investment is procyclical (as predicted) and more variable than GDP • How to explain the last two patterns?

12. Summary • Began testing model of fluctuations on data • Permanent changes in A imply a particular pattern for key variables • This pattern appears evident in the data: supports the model • Next time: no longer assume L and K are fixed • Wages are procyclical – but so is employment (i.e. L is not fixed!) how do we explain this?