Real Business Cycles and New
Keynesian Economics:
Chapter 13
Professor Steve Cunningham
Intermediate Macroeconomics
ECON 219
Real Business Cycle (RBC) Models

Like New Classical Economics, the
RBC theorists agree that:
–
–

Agents optimize
Markets clear
Therefore, the business cycle is an
equilibrium phenomenon, and is
optimal!
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RBC Theory


New Classicals tend to favor monetary business
cycles, caused by unexpected fluctuations in the
money supply.
In contrast, RBC theorists believe that exogenous
“real shocks” are largely responsible for
business cycles. Such real shocks include:
–
–
–
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Technology changes
Environmental conditions
Changes in real (relative) prices of basic crude materials
and energy sources (oil)
Tax rates
Individual preferences
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Typical RBC Model

Identical agents. So examine on “representative
agent” and multiply by the number of agents in
the economy.
–

This amounts to focusing on the microeconomics and
adding up the components to form the macroeconomy.
All agents maximize utility by maximizing
consumption and leisure (minimize work).
Ut  U (ct , le )

Output is given by a production function.
Yt  zt F (K t , Nt )

The term zt captures shocks to production.
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Model, continued
The agent either consumes or saves
whatever he or she produces, so:
Yt = Ct + St
 And whatever the agent saves is
invested in capital:
Kt+1 = St +(1 - )Kt

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Positive Technology Shock
P LRAS1
LRAS2
P1
P2
Y
N
Y=F(N,K)
If a shock occurs that the agent
thinks will be temporary, the agent
will save more of the increased
output for the future, resulting in
an increase in capital, affecting
future growth.
If a shock occurs that the agent
thinks will be long-lived, the agent
will likely consume a larger
proportion of the current period’s
increased output.
In either case, the effect is more
than a single period.
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RBC Policy Recommendations

Monetary Policy
–

Monetary Policy has little effect on the real
sector outcomes, but can affect inflation.
Therefore, maintain slow growth of money
supply to maintain price stability (no inflation).
Fiscal Policy
–
–
Fiscal policy does affect the real economy.
Focus should be on removing distortions
caused by taxes and inflation.
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Arguments against RBC



The explanation of business cycles does
not work. (Problem of persistence)
Technology shocks are typically limited to
individual industries, and do not have
such economy-wide effects.
The assumed (voluntary) response by the
labor force to changes in the real wage.
The real-world labor supply curve is very
steep. (Work is a necessity.)
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New Keynesian Economics


Attempts to build Keynesian arguments
based upon rational expectations and
microeconomic foundations.
Examples:
–
–
–
Contracting models
Sticky price models based upon transactions
cost or menu costs
Efficiency wage models
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New Keynesian Models (1)

Sticky Prices
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Menu costs and other transactions costs:
•
–
It costs to change prices.
A firm might hold prices constant even if
demand fell if the firm faced a cost to the price
change.
•
•
•
Costs: loss of customer good will
Potential price war
Menu costs
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New Keynesian Models (2)

Efficiency Wage Models
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–
–
Firms wish to buy worker effort, not their
“attendance”.
Instead of Y = F(K,N), the firm really operates
according to Y = F(K,eN), where N is the
number of workers or worker-hours, and e is
the effort per worker.
The firm does not seek to minimize the cost of
labor, but rather seeks to minimize the cost per
efficiency unit.
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New Keynesian Models (3)

Efficiency Wages, continued
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By paying the worker more than the equilibrium wage
for labor, the firm may reduce the cost per efficiency
unit by reducing the costs associated with:
•
•
•
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Paying supervisors (monitoring costs)
Hiring replacement workers when the current workers
leave (turnover costs)
Poor worker morale.
This leads to:
•
•
•
Shirking models,
Turnover cost models, and
Gift exchange models.
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New Keynesian Models (4)

Efficiency wage models identify a market failure:
$
eNs
Ns
Ns > Nd
Nd
N, eN
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New Keynesian Models (5)

Insider-Outsider Models and
Hysteresis
–
–
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Hysteresis: present unemployment is
highly related to past unemployment.
Past unemployment causes current
unemployment by turning insiders into
outsiders.
Outsiders cannot exert downward force
on real wages.
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