Real Business Cycles: A New
Keynesian Perspective
By N. Gregory Mankiw
Presented by: Scott Pecora, Sam Parent and Bruce Heytens
S
N. Gregory Mankiw
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Chairman of the Economics Dept. and Prof. at Harvard
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Economic Advisor to the Bush Administration
Goal of Paper
S “My goal of this essay is to
appraise this newly revived
approach to the business cycle” –
Mankiw
Walrasian Equilibriums
S Walrasian equilibrium
S in equilibrium- prices adjust to equate supply and demand in
every market simultaneously
S
The equilibrium determines the quantities of all goods and services
and their relative prices
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The level of output is already determined in the Walrasian System
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Price Levels can adjust to equate supply and demand in the money
market
Classical Theory
S By introducing price levels this way.
S The Walrasian System can determine real variables,
output and relative prices
S Classical theory ignores the money market because nominal
variables do not affect real variables
S the money market in the view of Classical Theory is
irrelevant
Classical Theory Impact on Real
Business Cycle Theory
S Real Business Cycles embraces the Classical Theory that the
money supply is irrelevant
S Nominal variables, such as money supply and price level are
assumed to have no role in explaining fluctuations in real
variables
Real Business Cycle Views of
Economic Fluctuation
S According to RBC Theory economic fluctuations are only caused
by the forces that change the Walrasian equilibrium
S Many disturbances can generate fluctuations in the RBC model
S But a disagreement between the RBC and Keynesian
schools of thoughts regarding the mechanic of the
disturbances exist
Different views of Disturbances
Mechanics
Consider a temporary increase in government purchases
RBC View of Mechanics
S RBC’s emphasizes the inter-temporal substitution of goods and
leisure
S A increase in government purchases increase the demand of
goods
S To achieve equilibrium real interest rates must rise
S A higher real interest rate causes labor supply to increase
S Thus, causing equilibrium employment and output to rise
Keynesian View of Mechanics
S Also predicts an increase in the real interest rate
S Resulting in an increase in employment and output due to a
reduction in the amount of labor unemployed because interest
rates on labor supply does not play a crucial role
S Problem: Walrasian approach of RBC’s does not allow for the
possibility of involuntary unemployment
Technological Disturbances
S typical business cycle consumption and leisure move in opposite
directions.
S In a recession consumption falls and leisure rises and in a boom
it’s opposite
S Business cycle theory must explain why individuals in a recession
find it rational to increase the quantity of leisure they demand
while decreasing the quantity of goods they demand.
Technological Disturbances cont.
S With the production function unchanging, diminishing marginal
returns would then produce a countercyclical real wage.
S This is not the pro-cyclical real wage that is necessary to explain
the fluctuations in consumption and leisure
S Real business cycle theory describes the fluctuations as the
Walrasian equilibrium changing. This is saying that the
fluctuations are in fact efficient.
Technological Disturbances cont.
S The levels of employment, output, and consumption cannot be
improved.
S Attempts by the government to alter the allocations of private
market, such as policies that are made to stabilize employment are
best ineffective but worst case can do harm by impeding the
"invisible hand."
Technological Disturbances cont.
S optimality of economic fluctuations is the most shocking because
the level of welfare is actually lower in a recession than it is in the
boom that follows it.
The Evidence on
Technological Disturbance
S The standard presumption increase in the economy's technological
opportunities take place gradually over time but in fact there are
substantial short-run fluctuations in the production function
S Prescott states that there are substantial fluctuations in the Solow
residual
S Like Prescott, Mankiw found substantial fluctuations in measured
total factor productivity
S This shows that measured productivity is highly cyclical. Every year
that output fell, total factor productivity also fell.
The Evidence on Technological
Disturbances
The Evidence on Technological
Disturbances cont.
S The standard explanation of cyclical productivity is that it reflects
labor hoarding and other "off the production function" behavior.
S when the economy experiences large real shocks, these shocks are
easily identifiable and much discussed.
Real Business Cycles Theories with
Multiple Sectors
Now, let’s take a look at multiple sectors and their interactions.
Real Business Cycles Theories with
Multiple Sectors
S Even if shocks to sectors are independent, the outputs move
closer together. A negative shock to a sector decreases the
overall wealth of the individuals and thus they reduce their
demand for all goods.
S For example: An adverse shock to one sector reduces the
wealth of the individuals in the economy; these individuals
respond by reducing their demand for all goods. An observer
would see an aggregate business cycle, even without a single
aggregate shock.
Real Business Cycles Theories with
Multiple Sectors
S 1939-1944 total factor productivity grew an average of 7.6
percent. Demand or Supply shocks?
S Solow Residual (empirical productivity growth), is not a
good measure for short run and year to year comparison of
production technology.
S The existence of large fluctuations in the available
technology is a crucial and but unjustified assumption of
RBC theory.
Money and Prices over the Business
Cycles
S Before real business cycles theory was created both historical
discussion and formal econometric work agreed on the conclusion
that money matters.
S Both discussions pointed to the Federal Reserve as an important
source of macroeconomic disturbances causing a controversy as
to weather systematic monetary policy could stabilize the
economy, but universally accepting bad monetary policy could be
destabilizing
Money and Prices over the Business
Cycles
S King and Plosser (1984): money supply endogenously responds to
fluctuations of output.
S M1 mostly inside money, or money created by the banking
system.
S K&P suggest transaction services of this inside money should be
viewed as the “output” of the banking sector.
S An increase in productivity in any sector will increase transaction
services, and increase the output of more money by the Fed.
Money and Prices over the Business
Cycles
S Therefore, the pro-cyclical behavior of standard monetary
aggregates cannot necessarily be interpreted as evidence that
changes in outside money caused by the monetary authority
have real effects.
The Tradeoff Between Internal and
External Consistency
S A good theory has two characteristics: internal consistency
and external consistency.
S An internally consistent theory is one that is has the least
assumptions as possible, and invokes no peculiar axioms.
S An externally consistent theory is one that fits the facts; it
makes empirically refutable predictions that are not
refuted.
The Tradeoff Between Internal and
External Consistency
S The choice between the RBC and NK theories
of the business cycle is partly a choice between
internal and external consistency.
The Tradeoff Between Internal and
External Consistency
S RBC theory extends the Walrasian paradigm, the most
widely understood and taught model in economics, and
provides a unified explanation for economic growth and
economic fluctuations.
S New Keynesian theory, in its attempt to mimic the world
more accurately, relies on nominal rigidities that are
observed but with only little understood.
S NKT sometimes suggests to understand the business cycle
one might have to reject the axiom rational and
optimization of individuals, which jeopardizes the internal
consistency.
The Tradeoff Between Internal and
External Consistency
Mankiw’s forecast for each model:
RBC will fail to produce convincing evidence that there are
substantial shocks to technology and that leisure is highly
substitutable over time.
NKT has made substantial progress in providing rigorous
microeconomics (fatal flaw since 1960).
Although RBC has served an important factor in provoking
the scientific debate, it will ultimately be discarded.
The End