Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 13
The Real Business Cycle
Model: Shocks and
Transmission Mechanisms
Slide 1 of 44
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok
Introduction
• Transmission mechanisms—are
economic forces that can amplify the
impact of shocks on the economy.
 They work by transmitting these shocks
across times and sectors of the economy.
• In this chapter we learn what these
shocks are and how they create
problems for the U.S. economy.
Slide 2 of 45
Shocks
• Shocks—are rapid changes in economic
•
conditions that have large effects on the
productivity of capital and labor.
We will examine the following shocks.
 Weather shocks
 Oil shocks
 Other possible shocks
Slide 3 of 45
Shocks
• Weather shocks
 In many economies agriculture is the single
largest contributor to real GDP.
• Shocks to the weather are important.
• As economies become less dependent on
agriculture, weather shocks have less impact.
• India is a good example
 % of real GDP accounted for by agriculture
has fallen from 40% in 1970 to 20% in 1990.
 Since 1980, rainfall shocks have become
less important.
 The next figure shows this…
Slide 4 of 45
Shocks
• Weather shocks (cont.)
Slide 5 of 45
Shocks
• Oil Shocks
 An economy with a large manufacturing sector
is sensitive to reductions in oil supplies.
 Let’s look at the first major oil shock to the
U.S. economy.
• 1973 OPEC oil embargo.
 Price of oil more than tripled
• Because oil is an important input in many
sectors, sharp increases in its price can
disrupt the economy as a whole. The
following figure shows this.
 The link with U.S. recessions is shown next…
Slide 6 of 45
Shocks
•In each of these recessions, there was a large increase in the price of oil just
prior to or coincident with the onset of recession.
•This is especially true in the first three recessions where wars caused a
decrease in the supply of oil.
Slide 7 of 45
Shocks
• Oil Shocks (cont.)
 It is easy to see the impact of a large
increase in the price of oil. It is harder to
eyeball the effect of smaller shocks.
• Careful statistical analysis can disentangle
the effect of oil shocks from other shocks.
• The following figure shows the results of
this analysis…
Slide 8 of 45
Shocks
• Oil Shocks (cont.)
• After the oil price increase, the economy slows for
5 quarters—15 months.
• After 10 quarters–2½ years, the economy has fully
adjusted and the growth rate has returned to normal.
Slide 9 of 45
Shocks
• Oil Shocks (cont.)
 Starting in 2002 the price of oil dramatically
increased, and by 2009 in real terms it was as
high as ever.
• Did not immediately cause a recession. Let’s
look at three reasons why.
1. The American economy has become less
dependent on oil than it was in the 1970s.
• American producers have learned to
protect themselves.
• Economy uses oil more efficiently.
• The following figure shows this…
Slide 10 of 45
Shocks
•
Oil Shocks (cont.)
Slide 11 of 45
Shocks
• Oil Shocks (cont.)
2. Oil shocks were offset by positive
productivity shocks.
• Advances in computers and information
technology.
• Some positive shocks outweighed other
negative shocks.
3. The Federal Reserve responded more
appropriately to recent oil shocks than in
the past.
Slide 12 of 45
Shocks
• Shocks, Shocks, Shocks
 Other shocks:
• Wars and terrorist attacks
• Major new regulations → increase in costs.
• Tax rate changes → spending and incentives.
• Mass labor strikes → disrupts production.
• New technologies → “creative destruction.”
 Important points
1.Typical year: good shocks outweigh the bad →
economy grows.
2.Bad year: big negative shock or small shocks,
more negative than positive.
Slide 13 of 45
CHECK YOURSELF
Consider the ubiquity of cell phones
throughout the world. How can this
ubiquity be considered a positive shock?
(Hint: compare with 10 years ago.)
How would a large and sudden increase
in taxes, for example a tax on energy,
shift the Solow growth curve?
Slide 14 of 44
Transmission Mechanisms Amplify and Spread Shocks
• We now focus on transmission
•
mechanisms: indirect negative effects that
amplify shocks and spread them
throughout the economy.
Five transmission mechanisms:
1.
2.
3.
4.
5.
Intertemporal substitution.
Uncertainty and irreversible investments.
Labor adjustment costs.
Time bunching.
Sticky wages and prices.
Slide 15 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution
 Behavior that reflects how people choose to
allocate spending, work, and leisure across time
to maximize well being.
• In other words…
 A person or business works less hard when
working hard brings the lowest return.
• High unemployment and low wages →
more people leave the workforce and
enroll in college.
• During a recession, people are more likely
to retire or take early retirement.
Slide 16 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
• Result: Intertemporal substitution magnifies
economic shocks.
 When things go a bit bad, the return to work
and investing falls and people work and
invest less.
 On the upside, intertemporal substitution
can feed an economic boom and make it
more intense.
• We can see this in the next diagram…
Slide 17 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
Point: When GDP is growing slower than the trend, the
employment to population ratio is also growing slower
than the trend. The reverse is also true.
Slide 18 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
 When we add intertemporal substitution to the
RBC model, real shifts in AD can also change
the growth rate of the economy.
• Let’s illustrate this with two examples…
 Large change in government spending, G ,
can encourage workers to enter the
workforce → temporary ↑ supply of labor.
• → ↑ Solow growth rate.
• Solow growth curve shifts to the right.
Slide 19 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
 A large fall in household and business wealth
will reduce I and G.
• Intertemporal substitution will result in people
leaving the workforce.
 → ↓Solow growth rate.
 Solow growth curve shifts to the left.
 The next diagram shows the effects on the
Solow growth curve.
Slide 20 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
Shocks with
Intertemporal
substitution
Solow
growth
curve
Inflation rate (p)
Shocks without
Intertemporal
substitution
Conclusion: intertemporal
substitution amplifies the
shocks.
Negative
shock
(2%)
Average
(3%)
Positive
shock
(4%)
Real GDP
growth rate
Slide 21 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
 Let’s use the full RBC model to analyze the
effect of our two examples…
• A large increase in the growth rate of
government spending, G .
• A large decrease in the growth rates of
household spending, C and business fixed
investment, I resulting from a decline in
household and business wealth.
 The next two diagrams use the RBC model to
show the impact of these changes.
Slide 22 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
Inflation rate (p)
Solow
growth
curve
b
5%
2%
Example 1:
1. ↑government purchases → ↑ AD
2. Workers take advantage of higher
aggregate demand by ↑work →
Solow growth curve shifts right.
a
3. Economy moves from a → b.
Both growth rate and inflation ↑.
4. In the long run both AD and
and the Solow growth curve
shift back and the economy
returns to a.
AD (M  v  10%)
AD (M  v  5%)
3% 5%
Important point: the Solow growth curve shifts to
the right because of intertemporal substitution.
Real GDP
growth rate
Slide 23 of 45
Transmission Mechanisms Amplify and Spread Shocks
1. Intertemporal Substitution (cont.)
Inflation rate (p)
Solow
growth
curve
a
5%
2%
b
Example 2:
1. ↓wealth → ↓ AD
2. Workers respond to the lower
aggregate demand by ↓work →
Solow growth curve shifts left.
3. Economy moves from a → b.
Both growth rate and inflation ↓.
4. In the long run both AD and
and the Solow growth curve
shift back and the economy
returns to a.
AD (M  v  10%)
AD (M  v  5%)
3%
5%
Important point: the Solow growth curve shifts to
the left because of intertemporal substitution.
Real GDP
growth rate
Slide 24 of 45
Transmission Mechanisms Amplify and Spread Shocks
2. Uncertainty and Irreversible Investments
 Negative shocks increase uncertainty.
• When investors are uncertain about the future,
they often prefer to wait and sample more
information before committing.
 Because many investments are irreversible.
• Example: Once construction on an office
building is started, it is hard to tear down
the building and redeploy the steel and
glass to other economic uses.
 The more uncertain the world appears, the
harder it is for investors to determine where to
invest their resources.
Slide 25 of 45
Transmission Mechanisms Amplify and Spread Shocks
3. Labor Adjustment Costs—the costs of
shifting workers from declining sectors of
the economy to growing sectors.
 Labor adjustments to shocks are not always
rational.
• Example: A union worker in the auto industry
making $100,000 a year without a high school
degree will probably turn down a lot of
available jobs before they finally accept reality
and take a job at a lower wage.
• Result: ↑unemployment and ↓real GDP
growth.
Slide 26 of 45
Transmission Mechanisms Amplify and Spread Shocks
3. Labor Adjustment Costs (cont.).
 The high cost of reversing job decisions.
• Example: Closure of a Detroit automobile
plant results in the following choices:
 Wait and hope the plant reopens soon.
 Seek another job in Detroit.
 Move to find a job.
• The choice involves a costly-to-reverse
decision.
• Many will simply bide their time until the future
is clearer.
 Result: ↑unemployment and ↓real GDP growth.
Slide 27 of 45
Transmission Mechanisms Amplify and Spread Shocks
4. Time Bunching—the tendency of
economic activities to be coordinated at
common points in time.
 It pays to coordinate your economic activities
with those of others.
 Bunching also causes shocks to spread
through the economy through time.
• Example: Suppose a negative economic
shock arrives and the economy slows down.
 Many people will be less keen to work.
• This will induce others to cut back on
their work as well.
Slide 28 of 45
Transmission Mechanisms Amplify and Spread Shocks
4. Time Bunching—the tendency of
economic activities to be coordinated at
common points in time (cont.).
 The “seasonal business cycle” is one form of
economic clustering (bunching) in time.
 The fourth quarter October-December brings
more economic activity than any other time.
 After Christmas, the party is over and
economic activity is the lowest.
 The next figure shows bunching.
Slide 29 of 45
Transmission Mechanisms Amplify and Spread Shocks
4. Time Bunching: “Seasonal Business Cycle”
Slide 30 of 45
Transmission Mechanisms Amplify and Spread Shocks
4. Time Bunching: “Seasonal Business Cycle” (cont.)
Slide 31 of 45
Transmission Mechanisms Amplify and Spread Shocks
5. Sticky Wages and Prices
 The final transmission mechanism comes from
the New Keynesian theory.
 Sticky wages and prices can amplify real
shocks.
 The mechanism works like this:
a) A negative real shock reduces productivity
and shifts the Solow growth curve to the
left.
b) If wages are perfectly flexible, the SRAS
will shift along with the Solow growth curve
to the left.
Slide 32 of 45
Transmission Mechanisms Amplify and Spread Shocks
5. Sticky Wages and Prices (cont.)
 The mechanism works like this: (cont.)
c) The economy is now in a recession and
unemployment rises.
d) When the economy is in a recession, real
growth is negative and wages must fall.
e) If wages are sticky, firms must cut output
and hiring even further in order to remain
profitable.
 In addition firms will raise prices even
faster.
Slide 33 of 45
Transmission Mechanisms Amplify and Spread Shocks
5. Sticky Wages and Prices (cont.)
 The mechanism works like this: (cont.)
f) The SRAS shifts even further to the
left than the Solow growth curve.
 We will now use the New Keynesian
model to illustrate how this mechanism
works.
Slide 34 of 45
Transmission Mechanisms Amplify and Spread Shocks
5. Sticky Wages and Prices (cont.)
Inflation
rate (p)
SRAS with
sticky wages
Solow
growth
curve SRAS with
flexible wages
10%
c
6%
b
2%
a
Negative shock:
1.Solow growth curve
shifts left.
SRAS
(pe = 2%) 2.SRAS shifts up and
left as p↑.
3.Economy…
• goes from a to b
if wages are flexible.
• goes from a to c
if wages are sticky.
AD(M  v  5%)
-5%
-1%
3%
Real GDP
growth rate
Slide 35 of 45
Transmission Mechanisms Amplify and Spread Shocks
• Transmission Mechanisms: Summary
 There are five factors that magnify negative
economic shocks.
 Core lesson: a medium-sized negative
economic shock is capable of causing a
disproportionately large downturn in the
economy.
 Questions to be addressed in later chapters:
• Could the government increase AD enough to
offset some of these negative supply shocks?
• If so, under what conditions?
Slide 36 of 45
CHECK YOURSELF
 Immediately after 9/11, most U.S. companies
eliminated business travel temporarily. After a
few weeks, business travel started to pick up
again. Which transmission mechanism came in
to play? Go through as many aspects of business
travel as you can think of: air travel,
transportation to and from airports, hotel stays,
meals out, contact with people remaining back in
the office. Explain how the unexpected almostcessation in business travel amplified the original
shock.
Slide 37 of 44
Takeaway
• One reason why the economy fluctuates
•
•
is because of productivity shocks.
We get a boom when we have a lucky
series of positive shocks and a bust when
we have an unlucky series of negative
shocks.
Transmission mechanisms magnify
shocks.
1. Intertemporal substitution: “make hay
while the sun shines.”
Slide 38 of 45
Takeaway
2. Uncertainty and irreversible
investments: cause investors to put off
decisions to invest.
3. Labor adjustment: costs increase
frictional unemployment.
4. Time bunching: Economic sectors
follow each other as the economy
fluctuates.
5. Sticky wages and prices: create a
mismatch between AD and the Solow
growth rate.
Slide 39 of 45
Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 13 Appendix:
Business Fluctuations and
the Solow Model
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok
Business Fluctuations and the Solow Model
• Some business fluctuations are just
economic growth in the short run.
• They can be analyzed using a version of
the Solow growth model.
• Main ideas of the modified Solow
model…
 Labor is added to the aggregate production
function from Chapter 7:
Y  At  F(K,L)
Slide 41 of 45
Business Fluctuations and the Solow Model
• In the Solow model we treated At as
increasing smoothly over time as new
ideas are created.
• In this version of the model:
 At jumps around in the short run as
productivity shocks hit the economy.
 L changes during booms and busts due to
intertemporal substitution.
Slide 42 of 45
Business Fluctuations and the Solow Model
• The effects of productivity shocks can be
simulated using an Excel spreadsheet.
 We use the random number generator to let At
fluctuate randomly around 1.
• If At is a little bigger than one → Positive
productivity shock.
• If At is a little smaller than one → Negative
productivity shock.
• Let’s see this in the following slide.
Slide 43 of 45
Business Fluctuations and the Solow Model
Plotting output over time is shown next…
Slide 44 of 45
Business Fluctuations and the Solow Model
Slide 45 of 45