chapter 19 advances in business cycle theory l.
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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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recent macroeconomic ideas
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
real business cycle theory
Real Business Cycle Theory
  • Interpretation of the labor market
  • Importance of technology shock
  • Neutrality of money
  • Wage and price flexibility
interpretation of labor market
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

importance of technology shock
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
the neutrality of money
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
wage and price flexibility
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
new keynesian macroeconomics
New Keynesian Macroeconomics
  • Menu costs
  • Imperfect labor markets
  • Aggregate Demand externalities
  • Recession as coordination failure
  • Staggering of wages and prices
menu costs
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
imperfect labor markets
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
aggregate demand externalities
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
recessions as coordination failure
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
game theory example
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
game theory example15
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

coordination failure
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
staggering price variations
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
staggering wage variations
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