Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University

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Edward Prescott (Minnesota)
Finn Kydland (Carnegie-Mellon)
Charles Plosser (Rochester)
Robert Barro (Harvard)

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The late 1970s and early 1980s was a time of New Classical Dominance
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By the early 1980s, however, significant doubts had arisen
“signal-extraction” problem not robust enough to explain business cycles
Evidence supportive of monetary neutrality of announced policy weak
Tobin suggests a “way out” that he does not himself take seriously – random real shocks

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Kydland and Prescott take seriously this alternative and develop the foundations of Real Business Cycle Theory – a theory that accounts for cycles wholly by changes in real supply variables.
Kydland and Prescott, “Time to Build and
Aggregate Fluctuations,” Econometrica
(November 1982)
Originally viewed as augmenting the New
Classical approach

Large random fluctuations in technology produce supply-side shocks to the production function, generating fluctuations in aggregate output and employment as rational individuals respond to the altered structure of relative prices by changing labor
(resource) supply and consumption
(investment) decisions.

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th
Booms are not “good” and recessions are not “bad”
Recessions are not desired by agents in the economy but they are nonetheless unavoidable consequences of changes in constraints agents face

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th
Agents react optimally to changes in constraints and the resulting aggregate fluctuations are efficient
Supply, not demand shocks, are key to understanding economic fluctuations

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RBC replaces the impulse mechanism of
New Classical economics
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“Technology shocks” instead of “monetary surprise”
RBC retains the propagation mechanisms of New Classical economics
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Rational expectations and relative prices
New Classical Economics “Mark II”

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Lucas
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Exclusion of money in RBC a mistake
Viewed as addition to NC models
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Later says “monetary shocks just aren’t that important”
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Approves of methodology
 micro-based models and use of fully-articulated artificial economies to compare real with experimental economics
Business cycles are “minor problem” – shifts focus to Growth economics

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Barro
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RBC promising
Monetary neutrality of New Classical models a “mistake”
Shifted focus to Growth economics
Defends New Classical Achievements
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Equilibrium modeling
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Rational expectations
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Dynamic policy-making and evaluation

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Development of RBC and shift of research to Growth represent revival of interest in “supply-side” macroeconomics
Continuation of pre-Keynesian lines of business cycle research
New technology influences both longrun growth as well as producing shortrun displacements (disequilibrium?)

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Dennis Robertson emphasized real forces
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Joseph Schumpeter
“Theory of Capitalist Development”
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Knut Wicksell
Changes in marginal productivity of capital
(impulse mechanism) cause divergence of
“natural rate of interest” from “bank loan rate” leading to endogenous monetary creation
(propagation mechanism), distorting time structure of production and leading to selfreversing boom

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Supply shocks of 1970s
Two OPEC oil increases
Apparent failure of Demand-side Keynesian model
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Political emphasis of “new supply-side economics” of Reagan Administration
Tax cuts and deregulation
Renewed interest in statistical properties of economic time-series
Seminal work of Nelson and Plosser

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Conventional Approach
Imagines economy evolving along a growth path reflecting underlying trend
Fluctuations about trend due to demand shocks
Shocks “die out” over time, so economic time-series are “trend-reverting”
Y t
= g t (Y
0
) + b (Y – Y T ) t-1
+ z t

Y
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Y t
= g t (Y
0
) + b (Y – Y T ) t-1
+ z t
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At time t1, a shock of size z occurs, but it dies out over time and the growth path reverts to the trend time
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Conventional approach consistent with the natural rate hypothesis
(unanticipated changes in monetary growth produce temporary deviations from
Y
N
)

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Nelson and Plosser, “Trends and
Random Walks in Macroeconomic
Time Series: Some Evidence and
Implications,” Journal of Monetary
Economics (September 1982)
Most changes in GDP are permanent , with no tendency for Y to revert to former trend
GDP follows a random walk process with drift

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Nelson-Plosser Approach
Value in one period still dependent on previous value of the variable, but shocks (z) change output permanently
Rather than g being underlying growth rate, g is “rate of drift;” b has value of 1
– “unit root” hypothesis
Y t
= g t (Y
0
) + (Y – Y T ) t-1
+ z t

Y
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Y t
= g t (Y
0
) + (Y – Y T ) t-1
+ z t
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At time t1, a shock of size z occurs and it permanently changes the growth path of the economy time

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Observed fluctuations are fluctuations in the trend , not deviations from a trend.
In NC world, permanent changes in GNP growth cannot occur from monetary shocks since money is neutral; therefore main forces causing instability must be real shocks.
If shocks to productivity growth are frequent and random , path of Y follows a random walk that resembles the business cycle.
No distinction between trend and cycle, so theory of growth and fluctuations must be integrated .

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Unfavorable changes in the physical environment that adversely affect agricultural output
Significant changes in price of energy
War, political upheaval and labor unrest
Government regulations
Changes in the quality and quantity of capital and labor; new management techniques; new products; new production techniques =>Technological change

(1) Representative agent models; agents maximize s.t. constraints
(2) Agents form Ratex; signal-extraction problem re permanent v. temporary productivity shocks
(3) Continuous market-clearing
(4) Exogenous productivity shocks are impulse mechanism for output and employment fluctuations

(5) Propagation mechanisms vary, include consumption smoothing,
“time-to-build,” and intertemporal labor substitution
(6) Fluctuations in employment voluntary; labor and leisure highly substitutable over time
(7) Money is neutral
(8) No distinction between SR and LR

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Impulse factor – productivity shocks replace monetary shocks
Abandon price level/relative price misperception emphasis
Abandon long run/short run distinction

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Production Function
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Y t
= A t
F(K t
, L t
)
Technology Evolution Parameter
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A t+1
= þA t
+ є t+1
0 < þ < 1
Representative Agent Utility Function
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U t
= f(C t
, Le t
)
Resource Constraints
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C t
+ I t
≤ Y t
; L t
+ Le t
≤ 1
Capital Stock Accumulation Equation
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K t+1
= (1-∂) K t
+ I t

Technology Shocks and
Employment
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Technology shocks change A, shifting the production function upward; the demand for labor curve will also shift upward.
Increased labor demand will increase the real wage and employment.
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How much? Depends on supply elasticity!
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If labor supply is inelastic?
If labor supply is elastic?

Technology Shocks and
Employment
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Stylized facts of Business Cycles indicate small procyclical variations in real wage are associated with large procyclical variations in employment
Is labor supply highly elastic or inelastic with respect to real wage?
What does that indicate about the intertemporal substitution of labor for leisure?

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Lucas-Rapping: in making laborsupply decisions, workers consider future and current C and Le
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Substitution and income effects of changed real wage
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Temporary v. permanent changes in real wages

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 temporary technology shocks will lead to temporary changes in real wages; no income effect and large supply response
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Permanent technology shocks will lead to permanent changes in real wages; large income effect and small supply response

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Change in the real interest rate affects labor supply by altering relative price of income earned today v. future
L s
= L s
(W/P, r)
Intertemporal price-ratio
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(1+r) (W/P t
)
(W/P t+1
)
Increase in r increases labor supply; reduction in r reduces labor supply

r
RAS
LM/P
IS (RAD)
Y
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An IS-LM model conforming to Ratex, Continuous Market
Clearing, and Fullinformation M s
Output and employment due to real forces; RAS determined by production function and labor supply
Tech improvement shifts RAS to right and LM/P adjusts so full employment exists
Problem with model: Labor supply not dependent on r

r r e
Y e
RAS
RAD
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If labor supply is dependent on r, an increase in r increases labor supply and increases output
The RAS curve is positively sloped
Y

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Model entirely real (M and P have no impact on Y or L)
No LR-SR distinction
RAS traces out labor market equilibria r equilibrates goods market
Shifts in RAS lead to variations in Y and L
Temporary variations in RAD can cause Y and L variations

Y w w
2 w
1 a
a b
L
1
L
2
Y* b
S
L2
(r2)
S
L1
(r1)
D
L1
Y
D
L2
L
Y r r
1 r
2 a a
RAS
1
RAS
2
Y
1
Y
2 b b
Y = Y
RAD
Y
Y
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Begin in equilibrium.
Labor market clears at real wage w production function Y.
At current r
1
1 for given
, RAS and
RAD clear at Y
1
.
Favorable productivity shock increases A and production function increases to Y*.
RAS increases, driving down the interest rate.
The lower interest rate lowers the supply of labor and favorable productivity shock increases labor demand.
Labor market equilibrium moves to b, employment increases and output increases at the lower interest rate.

Y w
1 w
2 w a a
b
L
1
L
2 b
D
L1
Y
S
L1
(r1)
S
L2
(r2)
L
Y r r
2 r
1 a a b b
RAS
Y
1
Y
2
Y = Y
Y
RAD
2
RAD
1
Y
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Begin in equilibrium.
Labor market clears at real wage w production function Y.
At current r
1
1 for given
, RAS and
RAD clear at Y
1
.
Increase in government purchases shifts RAD to the right, increasing the real interest rate.
The higher interest rate increases the supply of labor and reduces the real wage rate.
Labor market equilibrium moves to b, employment increases and output increases at the higher interest rate.

Temporary v. Permanent Shocks
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In the previous model, wealth effects were ignored.
If shocks are permanent, wealth effects can’t be ignored. When permanent shocks occur, induced changes in the real wage also will led to additional changes in RAD.
A change in technology will cause RAS and RAD to move in the same direction.
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A positive technology shock that raises RAS raises the real wage, increases real income and increases RAD.
A change in expenditures will moderate the change in RAD.
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An increase in government purchases that reduces the real wage reduces real income and decreases RAD.

r r e r
2
Temporary v. Permanent Shocks
Y e
Y
2
RAS
RAS
2
RAD
RAD
2
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A positive technology shock increases RAS to RAS2.
If the shock is temporary, the wealth effect is small and
RAD increases by a small amount.
The real interest rate falls as higher output is achieved.
This does not change the prediction of the model which ignores wealth effects.
Y

r r e
Temporary v. Permanent Shocks
Y e
Y
2
RAS
RAS
2
RAD
RAD
2
Y
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A positive technology shock increases RAS to RAS2.
If the shock is permanent, the wealth effect on expenditures will be large and increase RAD by roughly the same amount as the increase in Y.
Out put increases but the interest rate remains approximately the same.
This prediction of the model is different than that which ignores wealth effects.

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Kydland and Prescott were first to show that
RBC models could generate time-series data that possessed statistical properties similar to actual US business fluctuations.
RBC theorists generally have not attempted to provide models capable of econometric testing.
Instead, RBC theorists have developed the method of calibration to test their models.

(1) Construct RBC equilibrium model
(2) Provide specific functional forms
(3) Calibrate the model
- simulate random shocks with computer generated random numbers
(4) Trace out key macroeconomic variables from exercise and compare with actual time-series

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Such exercises are able to mimic the actual economy with respect to important time-series data and replicate the stylized facts of business fluctuations
Problem: How to choose between competing models? No criteria equivalent to significance testing in econometrics to answer such a question.

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Accepted stylized fact: Positive correlation between money and output.
Generally accepted (Friedman and Schwartz) by Keynesians, Monetarists and New
Classicalists that changes in monetary growth cause changes in real output growth.
In RBC models, money is “super” neutral.
How do RBC models account for the accepted stylized fact?

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Caveat: Positive correlation between money and output may indicate that money responds to output.
But then why does it look like monetary growth comes before output growth?
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Expectations of future output growth may lead to increases in money demand that increase the quantity of money supplied.
Bank money (demand deposits) is endogenous; bank money can be produced faster than real output.
Money supply changes before output but output changes cause money supply changes.

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RBC theorists divided into two camps
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Kydland and Prescott, “Business Cycles:
Real Facts and the Monetary Myth,” FRB
Minneapolis Quarterly Review (Spring
1990)
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Denial of stylized fact that money leads the cycle
Plosser, “Understanding Real Business
Cycles,” Journal of Economic Perspectives
(Summer 1989)
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Role of money remains an “open question”

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How does one measure technological progress?
“Solow residual”
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That part of ∆Y that can’t be explained by
∆K or ∆L
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Y = A F (K, L)
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Y = A K β L 1β where 0 <
β
< 1
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∆Y/Y = ∆A/A +
β
∆K/K + (1-
β
) ∆L/L
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∆A/A = ∆Y/Y – [
β
∆K/K + (1-
β
) ∆L/L]

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Prescott (“Theory Ahead of Business
Cycle Measurement”) suggested
(∆A/A) is a random walk with drift plus serially uncorrelated error
Plosser (“Understanding Real Business
Cycles”) uses (∆A/A) and (∆Y/Y) to show that aggregate fluctuations in Y are mainly due to fluctuations in technology

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RBC literature led to a renewed effort to discover and measure the stylized facts of business fluctuations
Forced a re-evaluation of existing theories in light of the new data
Central controversies over
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Real wages
Price level

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Are real wages pro-cyclical or counter-cyclical?
Orthodox Keynesianism and Orthodox Monetarism
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Real wages are counter-cyclical
Changes in AD with sticky or lagging wages (due to adaptive expectations)
RBC
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Real wages are strongly pro-cyclical
Changes in technology shift production function and change the demand for labor
Empirics
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Real wages are slightly pro-cyclical
Problem: procyclical wages require elastic labor supply to produce observed variations in employment and output, but micro data does not support notion of elastic labor supply

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Is the price level pro-cyclical or counter-cyclical?
Orthodox Keynesianism, Monetarism, New Classical
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Price level and inflation are pro-cyclical
RBC
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Evidence from entire 1954-89 period is that price level and inflation are counter-cyclical
Empirics and Impulse Mechanisms
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Impulse determines behavior of price level and inflation
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Supply-side changes lead to counter-cyclical prices
Demand-side changes lead to pro-cyclical prices

(1) More robust case against activism
“Costly efforts at stabilization are likely to be counter-productive. Economic fluctuations are optimal responses to uncertainty in the rate of technological progress.”
- Prescott, “Theory Ahead of Business Cycle Measurement”
(2) Fiscal policy is more potent than monetary policy but should still be avoided.

Aggregate demand management has been successful in reducing the volatility of business fluctuations from demand-side disturbances compared to earlier periods; technological disturbances have emerged as a dominant source of modern business fluctuations as a consequence.
- Chatterjee, “Real Business Cycles: A Legacy of Countercyclical Policies”

(1) Evidence concerning labor supply elasticity weak
(2) Technology shocks are directly unobservable
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Doubts concerning size and frequency to produce large variations in Y and L
Doubts that technological regression occurs to produce recessions
(3) Pro-cyclical Solow residual due to other reasons
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Pro-cyclical utilization rates of labor and capital

(4) Is large unemployment really voluntary?
 pro-cyclical movement of vacancy rates and voluntary quits
(5) Is money neutral in the short-run?
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American and British dis-inflations of the
1980s
(6) Persistence (Unit-root hypothesis or lack of trend-reversion)
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AD changes can produce permanent effects if it induces technological change
Hysteresis effects

(7) No micro-economic foundation for technological change and innovation
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Plausible models of demand conditions, R&D expenditures and “learning by doing” effects
(8) Representative agent models sidestep rather than address aggregation and coordination problems
(9) Lack of robust empirical testing

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RBC refocused attention on what we actually know or don’t know about business fluctuations
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Output does not appear to be trend-reverting, but rather follows a random walk with drift
Re-integration of growth theory and theory of fluctuations
Furthered cause of building macro-models with micro-foundations
Renewal of interest concerning role of supply-side in macroeconomics