Chapter 13
Business
Cycle Models
with Flexible
Prices and
Wages
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Three Business Cycle Models
• Real Business Cycle Model: Business cycles are caused
by fluctuations in total factor productivity (real shocks)
=> fits the data well in normal times.
• Keynesian Coordination Failure Model
• New Monetarist Model: goo to explain the facts related to
the recent financial crisis.
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Figure 13.3
Average Labor Productivity with
Total Factor Productivity (TFP) Shocks
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Figure 13.1
Solow Residuals (proxy for TFP) and GDP
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Figure 13.2
Effects of a Persistent (but temporary, not
permanent) Increase in Total Factor Productivity in
the Real Business Cycle Model
a) ↑TFP=>Nd ↑: w ↑,N ↑
b) N ↑ =Ys ↑
• r MUST ↓ because z is higher today
than in the future, so Y is expected to ↓
in the future=> consumption
smoothing=> save more today (this
makes r ↓) and consume in the future
• Yd ↑ because of r ↓ and future Y ↑
(investment ↑, consumption ↑)
c) Md ↑ because of r ↓ and Y ↑=>P ↓
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Table 13.1
Data Versus Predictions of the Real Business
Cycle Model with Productivity Stocks
Model fits the data well
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Figure 13.4
Procyclical Money Supply in the Real Business Cycle
Model with Endogenous Money
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A New Monetarist Model: Financial Crises and
Deficient Liquidity
• Two classes of liquid assets in the economy: currency
and financial liquid assets.
• Financial liquid assets include relatively safe assets that
are widely-traded in the financial system – e.g.
government debt, asset-backed securities, (bank
reserves).
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Financial Liquid Assets
• Can be expressed as
a
B
 k (r )
P
• B = nominal government debt.
• k is a decreasing function of r, and k(r) denotes financial
liquid assets that are “produced” in / “supplied” by the
private financial system.
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Financial Liquid Assets
• Assume that, in the model, there can be two possible
states of the world: adequate financial liquidity and
deficient financial liqudity.
• Deficient financial liquidity occurs in a financial crisis
due to factors that impair the ability of the financial
sector to create financial liquid assets.
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Modifying the Basic Monetary Intertemporal
Model
• In the New Monetarist model, financial liquid assets, a,
have a positive effect on output demand if there is
deficient financial liquidity.
• Given equilibrium in the money market,
BL(Y , r )
a
 k (r )
M
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New Effect in the New Monetarist Model
• An open market purchase (M goes up, B goes down)
shifts the output demand curve to the left, if there is
deficient financial liquidity.
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Figure 13.13
A Reduction in Financial Liquid Assets,
Producing Deficient Financial Liquidity
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Excess Reserves and the Liquidity Trap
• If reserves pay interest, as is the case currently in the
United States, and there is a positive supply of reserves in
the financial system, then the interest rate on reserves
determines the market interest rate.
• Open market operations have no effect.
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Excess Reserves and the Liquidity Trap
• Mr denotes reserve account balances, Mc denotes
currency.
• Now, re-define financial liquid assets as:
( M r  B) L(Y , r )
a
 k (r )
Mc
Conventional Open market operations have no effect.
Monetary Policy with Excess Reserves and a Liquidity
Trap, an Increase in the Interest Rate on Reserves can
be beneficial.
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