INTRODUCTION TO MACROECONOMICS FOR THE SHORT RUN (CHAPTER 1) WHY STUDY BUSINESS CYCLES? The intellectual challenge: Why is economic growth irregular?

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1 INTRODUCTION TO MACROECONOMICS FOR THE SHORT RUN (CHATER 1) WHY STUDY BUSINESS CYCLES? The ntellectual challenge: Why s economc groth rregular? The socal challenge: Recessons and depressons cause elfare losses due to unemployment busness falures captal losses uncertanty about the future The polcy challenge: A better understandng of busness cycles may help to mprove the qualty of macroeconomc stablzaton polcy

2 MACROECONOMIC THEORY FOR THE LONG RUN (GROWTH THEORY AND NATURAL RATE THEORY) seeks to explan the underlyng long run trends n macroeconomc aggregates and ho these trends may be nfluenced by structural economc polcy Key assumptons n long run theory: all prces are fully adjusted expectatons are correct there are no (recurrent) exogenous shocks Taken together, these as f assumptons mply that employment s at ts natural rate, that economc actvty s determned solely from the economy s supply sde, and that the economy evolves smoothly over tme. MACROECONOMIC THEORY FOR THE SHORT RUN (BUSINESS CYCLE THEORY) seeks to explan the short-run fluctuatons n macroeconomc aggregates around the long run trends and ho these fluctuatons may be dampened by macroeconomc stablzaton polcy Key assumptons n short run theory: Exogenous (stochastc) shocks to demand and supply nomnal rgdtes Expectatonal errors These assumptons mply that output and employment may (and generally do) devate from ther natural rates and that economc actvty s determned by aggregate demand as ell as by aggregate supply

3 QUESTIONS AND ANSWERS IN BUSINESS CYCLE THEORY 1) What are the mpulses ntatng busness cycles? Anser: Exogenous shocks to demand or supply Examples: Negatve shocks to the OECD economes Negatve supply shocks Rsng ol prces Rsng food prces Negatve demand shocks Crash n the stock market and n the ICT sector Increased uncertanty due to September 11, corporate scandals, unrest n the Mddle East, debt crss n Argentna, all of hch contrbuted to a further donturn n the stock market QUESTIONS AND ANSWERS IN BUSINESS CYCLE THEORY ) Why do shocks to nomnal demand generate changes n output and employment and not just changes n nomnal ages and prces? Anser: Because of nomnal rgdtes 3) Why are orkers llng to ork more durng a boom even f the real age falls (relatve to ts groth trend)? Anser: Because of expectatonal errors

4 EXLAINING NOMINAL RIGIDITIES AND LINKING LONG-RUN THEORY WITH SHORT-RUN THEORY The problem: Ho can nomnal age and prce rgdty be compatble th ratonal behavour, gven that the ( menu ) costs of age and prce adjustment are lkely to be very small? To explan nomnal age rgdty, e start by analyzng ho ages ould adjust to a change n unemployment n the absence of adjustment costs. We then ask ho large the adjustment costs ll have to be to make t optmal for age setters not to adjust nomnal age rates. If t only takes a very small adjustment cost to prevent adjustment, e have a potental explanaton for nomnal age rgdty. A SIMLE THEORY OF WAGE AND RICE SETTING Assumptons: The economy s dvded nto n sectors each producng a dfferentated product and facng a donard-slopng demand curve th a constant prce elastcty of demand In each sector one unt of labour produces one unt of output The age rate n each sector s set by a monopoly trade unon Each unon takes the general level of ages and prces as gven Notaton: W = nomnal age rate n sector W = general nomnal age level = output prce n sector = general prce level L = employment n sector L = aggregate employment Y = output n sector Y = aggregate output (GD) u = unemployment rate

5 RICE SETTING Demand for the output of sector σ Y Y Y = =, σ>1 n Y n 1 σ σ 1 1 σ Total revenue: σ TR Y = Y ( Y n) 1 1 TR σ 1 σ 1 MR = Y Y n σ = Y σ σ Margnal revenue: σ ( ) Margnal cost: MC = W RICE SETTING Maxmzaton of profts requres σ 1 MR = MC = W σ Mark-up prcng p p σ 1 = m W, m > 1 σ If m p s the same across all sectors, e have = p m W (1)

6 WAGE SETTING The trade unon for sector seeks to maxmze the total rent accrung to ts members. Ths total rent s gven by Ω = W v L here v s the representatve unon member s outsde opton, that s, the real ncome he could expect to earn outsde sector. The demand for labour n sector s L σ p L m W Y = Y = = n n from hch t follos that σ () (3) Ω = p W L m W v n σ (4) WAGE SETTING In the absence of any costs of age adjustment, the trade unon ll choose W so as to maxmze Ω hch s equvalent to maxmzng W p W Ω = + ( ) σ ( ) σ ln ln v ln L n ln m ln The frst-order condton for optmal age settng s d ln Ω = 0 W dw σ = v W Optmal age settng n the absence of adjustment costs W σ = m v, m (5) σ 1 (Note that n ths partcular model, e have m = m p. In a more general model, lke the one studed n Chapter 18, ths ll not be the case)

7 WAGE SETTING Denotng the real rate of unemployment beneft by b, e have ( 1 ) The outsde opton v = u + ub, W Wth a fxed replacement rato c, e have b = c so that ( ) ( ) v= v u = 1 1 c u, 0 < c< 1 Defnng W / and usng (5), e get The optmal sector real age n the absence of adjustment costs ( ) 1 ( 1 ) = = (6) m v u m c u THE COST OF NON-ADJUSTMENT Let us choose our unts such that the total labour force s normalzed at unty, mplyng L = 1-u. We may then rte (4) as 1 u p (,u ) v( u) ( m ) Ω = (7) n Suppose the unon has ntally set a real age = m v( u) to some ntal level of unemployment u. σ correspondng Suppose next that an exogenous shock drves unemployment to a ne and hgher level u. If the unon chooses not to change ts age rate, t ll suffer the follong utlty loss, UL, excludng the cost of age adjustment: ( ) ( ) UL =Ω,u Ω,u, (8) here s the ne optmal age rate (n the absence of adjustment costs).

8 THE COST OF NON-ADJUSTMENT No take a second-order Taylor approxmaton of Ω(,u ) around the ne optmum age rate : calculated ( ) ( ) (,u ) 1 Ω(,u) ( ) ( ) ( ) Ω Ω,u Ω,u + + (9) Snce (,u) 0 Ω = n the optmum, t follos from (8) and (9) that (,u ) ( ) ( ) Ω 1 UL (10) The second dervatve n (10) may be calculated from (7). Dong ths, usng (5), and expressng UL as a fracton of the total age bll, one fnds that THE COST OF NON-ADJUSTMENT UL L σ 1 (11) Before the shock, the unon had set ts age optmally, n accordance th (6). Snce s also gven by (6), t follos that = ( 1 c)( u u ) 1 ( 1 c) u (1) What s a realstc magntude of the cost of non-adjustment? To estmate ths, note that (6) mples = (symmetrc equlbrum). Insertng ths nto (6), solvng for u, and usng the defnton of m, e get the u Natural rate of unemployment m 1 1 = = m c c ( 1 ) σ( 1 ) (13)

9 THE COST OF NON-ADJUSTMENT Suppose that u = u = and c = 0. 5 Eq. (13) then mples σ = 40. Suppose further that u u = 00. Insertng these values nto (11) and (1), e obtan the estmate UL L In other ords, f the menu costs of age adjustment exceed 0.% of the age bll of the representatve trade unon, the unon ll prefer not to adjust ts real age through nomnal age adjustment. Thus even very small adjustment costs are suffcent to generate nomnal age rgdty. THE LINK BETWEEN REAL AND NOMINAL RIGIDITY Note that nomnal age rgdty arses because age setters do not ant to change the real age very much n response to a change n unemployment. Hence nomnal age rgdty s generated by real age rgdty. Emprcally, the real age s n fact rather nsenstve to fluctuatons n unemployment. EXLAINING NOMINAL RICE RIGIDITY Snce the proft-maxmzng prce s a mark-up over margnal cost, nomnal age rgdty can also explan nomnal prce rgdty. But even f nomnal ages ere fully flexble, one can sho that small menu costs of prce adjustment are suffcent to generate nomnal prce rgdty under monopolstc competton.

10 FINAL OBSERVATIONS ON NOMINAL RIGIDITIES Even though the prvate costs of nomnal rgdtes are small, the socal costs may be qute sgnfcant. In our numercal example, the prvate cost of nomnal rgdty as around 0.% of the age bll, and hence less than 0.% of GD, but at the aggregate level nomnal rgdty may cause GD to drop by several percentage ponts n response to a negatve shock. Nomnal rgdtes are a short run phenomenon. Over tme as shocks accumulate, nomnally fxed ages and prces become ever further removed from the levels that ould be optmal n the absence of adjustment costs. Eventually t therefore becomes optmal for age and prce setters to undertake nomnal age and prce adjustment. A LOOK AHEAD: THE MODERN AS-AD MODEL I fl t Inflaton rate Output O

11 OVERVIEW OF THE COURSE IN MACROECONOMICS FOR THE SHORT RUN Emprcal background Chapter 14: Some facts about busness cycles The theory of aggregate demand Chapter 15: Investment and asset prces Chapter 16: Consumpton, ncome and ealth Chapter 17: Monetary polcy and aggregate demand The theory of aggregate supply Chapter 18: Inflaton, unemployment and aggregate supply OVERVIEW OF THE COURSE IN MACROECONOMICS FOR THE SHORT RUN (CT ND) The short-run model for the closed economy Chapter 19: Explanng busness cycles The AS-AD model n acton Chapter 0: Stablzaton polcy Why and ho? The short-run model for the open economy Chapter 3: Aggregate demand and aggregate supply n the open economy Chapter 4: The open economy th fxed exchange rates Chapter 5: The open economy th flexble exchange rates