Chapter 11. Market-Clearing Models of the Business Cycle. Copyright 2008 Pearson Addison-Wesley. All rights reserved.

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1 Chapter 11 Market-Clearing Models of the Business Cycle

2 Study Two Market-Clearing Business Cycle Models Real Business Cycle Model Keynesian Coordination Failure Model 11-2

3 Applying Bank Run Model to Financial Crisis The Diamond-Dybvig bank run model is not only suitable to explain bank runs of consumers on a bank Investment banks typically invest long in for example mortgage backed securities and finance this by issuing commercial paper and taking other short-run loans They make a prediction of the amount of liquidity needed in period 1. When issuers of short-term loans become suspicious, they all want their loans back in period 1 and a bank run emerges. 11-3

4 Business Cycle Models with Microfoundations Since the seventies macroeconomic models in mainstream economics are based fully on microeconomic principles There is a still a divide on whether markets always clear with prices/wages fully flexible or whether there are rigidities and sticky prices Today equilibrium models, next week sticky price models 11-4

5 Real Business Cycle Model Business cycles are caused by fluctuations in total factor productivity. There is no role for the government in smoothing business cycles cycles are just optimal responses to the technology shocks. Model fits the data well. Type of shock addressed is permanent shock to total factor productivity 11-5

6 Figure 11.1 Solow Residuals and GDP Total factor productivity moves like output, so could be a cause of business cycles 11-6

7 Figure 11.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model Labor demand curve shifts out Output supply curve shifts out Output demand curve also shifts out, because of a higher income in the next period The interest rate must decline, because we assume that the shock to tfp is larger in this period than in the following period. Therefore consumers want to increase savings for next period, going along with lower interest rates As a result of labor interest rate labor supply shifts in, but shift of labor demand is larger causing a higher real wage 11-7

8 Figure 11.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model To summarize: Output increases Employment increases Real wages increase Real interest rate declines Consumption increases Investment increases Money market: money demand increases because of higher income and lower interest rates As a result the price level falls 11-8

9 Figure 11.3 Average Labor Productivity with Total Factor Productivity Shocks Average labor productivity rises, because output rises more than employment 11-9

10 Table 11.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Shocks 11-10

11 Figure 11.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money Money can also be procyclical, assuming endogenous money: People take more credits in booms, hence M2 or M3 rises without changes in monetary base, M0 Central bank policy is procyclical, raising the monetary base in recessions 11-11

12 Critique to Real Business Cycle Model The Solow residual, measuring total factor productivity, is procyclically biased In a boom people work harder, machines are used above capacity, therefore it seems that the Solow residual has increased, whereas in reality the increase in capital and labor is not fully accounted for Y = zk L α 1 α Yˆ = zˆ + αkˆ + ( 1 α )Lˆ 11-12

13 Critique to Real Business Cycle Model Other problem is that empirically labor supply seems to be very inelastic. Hence, employment does not move much along the labor supply curve, when labor demand increases The lower interest rate causes labor supply curve to shift inwards, hence the increase in employment might be (too) small 11-13

14 Figure 11.7 Percentage Deviations from Trend in Money Supply and GDP 11-14

15 Figure 11.8 Real and Nominal Interest Rates 11-15

16 Figure 11.9 Relative Price of Energy 11-16

17 Keynesian Coordination Failure Model Strategic complementarities imply that the aggregate production function has increasing returns to scale, and the labor demand function can be upward sloping. Therefore, there can be multiple equilibria. GDP fluctuates in the model because of self-fulfilling waves of optimism and pessimism. In an example, the model fits the data as well as the real business cycle model

18 The Coordination Failure Model: The Basic Idea The economy can move between good and bad equilibria, see second panel This is possible because of increasing returns to scale in production. How we will explore below Different equilibria are called sunspot equilibria: if people see a sunspot everybody is optimistic and the economy will be in a good equilibrium 11-18

19 Figure A Production Function with Increasing Returns to Scale 11-19

20 Figure Aggregate Labor Demand with Sufficient Increasing Returns to Scale Labor demand is upward sloping! Reasoning: at a higher level of employment, the marginal product of labor is higher because of complementarities between labor. Therefore, the marginal product increases and hence also the wage 11-20

21 Figure The Labor Market in the Coordination Failure Model We impose that increasing returns are so strong that the labor demand curve is steeper than labor supply Remember critique to RBC: in reality labor supply is highly inelastic, the same applies to this model 11-21

22 Figure The Output Supply Curve in the Coordination Failure Model The output supply curve is downward sloping! Remember how to derive output supply curve: Consider the effect of a change in the interest rate on employment, which translates into a change in output Suppose the interest rate increases from r1 to r2. Labor supply shifts out But because of the shape of the labor demand curve, this leads to lower equilibrium employment As a result output decreases with a lower interest rate 11-22

23 Figure Multiple Equilibria in the Coordination Failure Model Suppose the economy is in the low output bad equilibrium There is a shock in the economy causing a deviation from the bad equilibrium If the shock is large enough, the economy might walk to the other, bad equilibrium Money market: with lower output and higher interest rate, money demand decreases and prices go up 11-23

24 Multiple Equilibria in the Coordination Failure Model: Summary of Effects In a boom: Output goes up Employment goes up Real wages go up Real interest rate goes down Consumption goes up Investment goes up Prices go down Money 11-24

25 Figure Procyclical Money Supply in the Coordination Failure Model Money can move procyclically, but such that prices are still countercyclical Money can even be a sunspot variable driving the movement between equilibria 11-25

26 Table 11.3 Data Versus Predictions of the Coordination Failure Model 11-26

27 Figure Average Labor Productivity in the Keynesian Coordination Failure Model Average labor productivity goes up in the good equilibrium 11-27

28 Figure Stabilizing Fiscal Policy in the Coordination Failure Model Removing multiple equilibria by reducing current government expenditures Lower output demand Lower output supply, because people work harder to compensate for higher taxes leading to lower employment in equilibrium 11-28

29 Critique of the Coordination Failure Model There have to be sufficient complementarities to cause increasing returns in production Labor demand must be steeper than labor supply Theory rests on shocks to expectations which are essentially unobservable 11-29