Real Business Cycle
Real business Cycle theory
New Keynesian theory
Real Business Cycle
Real business cycle theory is an outgrowth of the new classical theory, which built on the original classical economics.
Real business cycle models are sometimes referred to as the second generation of new classical models
Real business cycle theorists agree
microeconomic foundations—the individuals’ optimizing decisions
business cycle is an equilibrium phenomenon in the sense that all markets clear
all unemployment is voluntary
Real business cycle theorists - fluctuations - arising from variations in the real Supply side factors
Shocks to technology
Environmental conditions
Changes in the real (relative) prices of imported raw materials
Changes in individuals’ preferences—for example, a change in the preference for goods relative to leisure
Real Business Cycle
View Differ from classical: RBC believe the supply side factors can lead to short run fluctuations
However classical believe that it will lead to fluctuations only in long run
Differ from Keynesian: Keynes discus more about Demand side shock little attention to Supply
side shock
Real Business Cycle
A SIMPLE REAL BUSINESS CYCLE MODEL
Real Business Cycle
EFFECTS OF A POSITIVE TECHNOLOGY SHOCK
Real Business Cycle
MACROECONOMIC POLICY IN A REAL BUSINESS CYCLE MODEL
Monetary Policy
No role for activist monetary stabilization policy of a Keynesian type
A desirable monetary policy would result in slow, steady growth in the money supply and thus
stable prices, or at least a low rate of inflation
Real Business Cycle
Fiscal Policy
fiscal policy actions will affect output and employment in a real business cycle model
The effect will not be caused by an effect on aggregate demand, as in the Keynesian model, but by supply-side
effects
Policymakers can reduce the distortion due to taxation by financing a portion of government spending with
newly created money - seigniorage
Real Business Cycle
Robert Lucas and Real Business Cycle Theory : PERSPECTIVES 12-1
Lucas therefore argues that “Taking U.S. performance over the past 50 years as a benchmark, the
potential for welfare gains from better long-run, supply-side policies exceeds by far the potential
from further improvements in short-run demand management
fiscal policy changes that improved incentives to work and save
Real Business Cycle
Critics of RBC
critics point out that many technology shocks are likely to be specific to individual industries
Technology shocks are, of course, only one type of shock considered in the real business cycle
theory
Voluntary Employment Changes
Real Business Cycle
New Keynesian Economics
Additional explanations of involuntary unemployment: new Keynesian models
N. Gregory Mankiw and David Romer, both of whom have made important contributions to the new
Keynesian eco
New Keynesian : “dizzying diversity”
Imperfect competition is assumed for the product market
Focus on product price rigidity
Real rigidities—factors that make the real wage or firm’s relative price rigid
New Keynesian Economics
STICKY PRICE (MENU COST) MODELS
Firm must not be a perfect competitor
monopolistic competitor or oligopolistic firm
Monopolistic competitors and oligopolies have some control over the price of their products. In
fact, the incentive to lower prices may be fairly weak for these types of firms. If they hold to their
initial price when demand falls, they will lose sales, but the sales they retain will still be at the
relatively high initial price
New Keynesian Economics
Menu costs refer to any type of cost that a firm incurs if it changes its product price
The name stems from the fact that if restaurants change prices, they must print new menus.
More generally, when firms change prices, they incur direct and indirect costs of several types
managerial costs: These include the costs of gathering the information
set off competitive rounds of price cuts or even lead to a price war
loss of consumer goodwill
Declines in aggregate demand will result in falls in output and employment, not price reductions
New Keynesian Economics
New Keynesian Economics
EFFICIENCY WAGE MODELS
Modern efficiency wage models have the same premise: The efficiency of workers depends
positively on the real wage they are paid
New Keynesian Economics
New Keynesian Economics
Several rationales have been offered for the payment of efficiency wages:
1. The shirking model. By setting the real wage above going market levels (i.e., a
worker’s next best opportunity), a firm gives a worker an incentive not to shirk or
loaf on the job. If he does, he may be fired, and he knows it would be hard to get
another job at such a high wage. If firms can monitor job performance only
imperfectly and with some cost, such a high-wage strategy may be profitable.
2. Turnover cost models. By paying an above-market wage, firms can reduce quit
rates and, thus, recruiting and training costs. The high wage also allows them to
develop a more experienced, and therefore more productive, workforce.
3. Gift exchange models. Another explanation of why efficiency depends on
the real wage centers on the morale of a firm’s workers. According to this
argument, if the firm pays a real wage above the market-clearing wage, this
higher wage improves morale, and workers put forth more effort. The firm
pays the workers a gift of the above-market wage, and the workers reciprocate
with higher efficiency
New Keynesian Economics
INSIDER–OUTSIDER MODELS AND HYSTERESIS
The union members, whom we will call insiders, are assumed to have bargaining power with
employers because it is costly to replace them with outsiders (nonunion members).
The cost of replacing them is a recruiting and training cost for new workers.
Union members may also impose costs on outsiders who attempt to underbid them for jobs—for
example, by setting up picket lines
the insider–outsider model, unemployment results from a real wage set above the market-
clearing level (outsider unemployment) as well as from a cyclical response to changes in
aggregate demand
New Keynesian Economics
Past unemployment, then, causes current unemployment by turning insiders into outsiders; this
is the hysteresis phenomenon
Hysteresis- Leads to involuntary unemployment
