RBC and NBC

Question 1

What is the classical macroeconomic view on how rapidly prices and wages adjust to restore general equilibrium after an economic shock?

Answer 1

Prices and wages adjust quickly to equate quantities supplied and demanded in each market, so the economy is largely self-correcting with a strong tendency to return to general equilibrium on its own when disturbed by an economic shock or a change in public policy.

Question 2

What is the Keynesian view on how rapidly prices and wages adjust to restore general equilibrium after an economic shock?

Answer 2

Keynesians think prices and wages eventually change (in long run) but believe that in the short run price and wage adjustments are incomplete. Quantities supplied and demanded are not necessarily equal in the short run and the economy may stay out of equilibrium.

Question 3

Name two business cycle facts that challenge the classical theory

Answer 3

1) Changes in money stock lead the business cycle, implying monetary non-neutrality. 2) Inflation slows during or immediately after a recession, but RBC predicts that adverse productivity shocks cause recessions and simultaneous price increases. Classicals have challenged this by arguing that only data from 1918-1941 shows this, and data from later decades confirms the RBC view. (p.370)

Question 4

What is the Real Business Cycle theory?

Answer 4

Real shocks are the primary cause of business cycles. Especially, beneficial productivity shocks cause booms and adverse productivity shocks cause recessions.

Question 5

What curves do real shocks affect?

Answer 5

FE line and IS line

Question 6

What are nominal shocks?

Answer 6

Shocks to money supply or money demand. Shifts the LM curve.

Question 7

What are real shocks?

Answer 7

Things that affect the production function/FE line: productivity shocks such as input price changes or changes in availability of raw materials, weather shocks, MPK or MPN changes, TFP), size of the labor force, and 2) things that affect the IS line: real govt purchases, spending/saving of consumers

Question 8

What happens to the FE line when there is an adverse productivity shock (ex. oil price increase)?

Answer 8

MPN falls, as does the demand for labor at any given wage. Labor demand curve shifts in. Equilibrium real wage and employment fall, so Y also falls (since employment falls and since output per worker falls). Real interest rate also increases (depressing consumption and investment) and prices go up.

Question 9

How does general equilibrium change when an adverse productivity shock reduces FE?

Answer 9

FE line shifts left, LM curve moves up and left to adjust. R and P are now higher than before. IS does not move because

Question 10

What are the two key components of any business cycle theory?

Answer 10

1) A description of the types of shocks or disturbances believe to affect the economy the most 2) A model describing how key macroeconomic variables (output, employment, and prices) respond to these shocks

Question 11

Name four business cycle facts that support RBC

Answer 11

1) Assumption that economy undergoes productivity shocks explains output variations 2) employment moves procyclically/mirrors output movements 3) Real wages are higher in booms than in recessions 4) Average labour productivity is higher in booms than in recessions (w/o underlying assumption that boom is caused by productivity shock, MPN wouldn’t increase since MPN is a decreasing function of N)

Question 12

What is the classical response to the fact that it’s hard to identify more than a few large productivity shocks, there are not enough identifiable ones to explain all the past recessions?

Answer 12

RBC response is that economywide fluctuations can be caused by the cumulative effect of a series of small productivity shocks.

Question 13

What is the classical response to the fact that money supply is a leading indicator?

Answer 13

Reverse causality. Money supply is increased in anticipation of output increases, so that increased money demand (businesses do more transactions to plan more output/production) doesn’t lead to price level increases (if trx increase and Md increases, w/o Ms increase P will go up).

Question 14

What did Friedman and Schwartz, as well as Romer & Romer, find about monetary nonneutrality?

Answer 14

F&S found that money has historically been procyclical from 1867-1960, and that monetary change often have had an independent origin (ex. gold discovery increases the money supply, institutional changes/new fed director increases money supply) so goes against reverse causation. R&R found that since 1960s there have been lots of other nonneutral episodies of Ms increases, esp. Volcker’s decreaesd inflation/supply announcement leading to strong recession.

Question 15

What are the underlying assumptions about wages and the labor market necessary for RBC theory that business cycles are due to shocks?

Answer 15

Wages adjust quickly (higher in booms and lower in recessions) and labor supply matters. Output declines in recessions and increases in booms because the full employment equilibrium has changed.

Question 16

What is the Solow residual expression with utilization rates? Is utilization proyclical?

Answer 16

A*μk^a*μn^(1-a) Utilization is procyclical, which is in line with RBC view that recessions and booms are the result of productivity shocks

Question 17

What is the explanation for the pro-cyclicality of labor and capital?

Answer 17

Labor hoarding (price of hiring, etc.)and electricity capital usage fluctuations

Question 18

What is the classical economist’s reaction to government spending in a recession?

Answer 18

Government spending crowds out private consumption and investment (SRAS is flat so if there’s only so much possible production, government takes it all up). Increase in G reduces worker’s wealth (taxes must increase today or tomorrow, so at the moment of announcement of spending people feel poorer) so labor supply increases (shifts out) so people work more and earn less. FE line shifts out, IS shifts out and past FE to temporarily boost output. Then LM shifts up and left to bring equilibrium with IS back to the new FE line, which has higher r, P and Y and employment but lower wage. Plus usually it takes time for govt spending/policy to take effect so the economy may have moved/adjusted by the time that you get the real effect anyways, increasing the distortion.

Question 19

Why do classicals think that the IS curve will shift out past the new FE line into a disequilibrium when you engage in fiscal expansions (increases in G)?

Answer 19

Aggregate quantity of goods demanded right after a G increase (by reducing desired savings) is likely to be more sensitive than the labor supply and full employment output . Worth noting that decreasing MPN means that shift out of labor supply curve means that average labor productivity goes down (higher N, lower w)

Question 20

Classicals usually think of recessions/booms only being caused by real shocks. How well does RBC explain the response of the economy to expansionary fiscal policy?

Answer 20

Pretty well. Including fiscal shocks using an RBC view predicts that GDP will temporarily increase, though workers are worse off afterwards. It also predicts that average labor productivity will go down when you increase GNP via govt spending (so negative correlation).

Question 21

What is the disagreement regarding wages in the Keynesian and Classical view?

Answer 21

Wages adjust quickly in the Classical view. This ensures labor market always clears; so if you shift the labor supply curve out, workers are worse off– higher employment at a lower wage. Wages do not adjust in the Keynesian view. Labor market does not always clear; efficiency wage says employers pay more than clearing wage so there’s always undesired unemployment and increasing employment makes workers better off.

Question 22

What is the implication of the disagreement between classicals and keynesians on the speed of wage adjustments?

Answer 22

If labor market always clears shifting the labor supply curve out, means workers are worse off– higher employment at a lower wage. Efficiency wage says employers pay more than clearing wage so there’s always undesired unemployment and increasing employment makes workers better off.

Question 23

What would be an acceptable reason to increase government spending under the classical view?

Answer 23

If the social benefits of what the spending is being done on outweighs the cost of lower wages, higher prices and higher interest rates then it’s ok.

Question 24

Name a major weakness of the RBC

Answer 24

Does not explain why unemployment rises during downturns, since in a downturn labor market should clear also. They explain this by saying that not all jobs and people are the same. Worker-job mismatch (not wage stickiness).

Question 25

What do classicals think the government should do given that job/skill mismatch is the primary source of unemployment during recessions?

Answer 25

Remove barriers to hiring like minimum wage, improving job finding programs, eliminating union contracts, etc.

Question 26

What have researchers found regarding RBC and including household production

Answer 26

It improves the model’s ability to predict output fluctuations.

Question 27

What is misperceptions theory?

Answer 27

It is a way of incorporating monetary nonneutrality into the classical view of business cycles. In this model, money is noneutral in the short run and slopes upwards; y can be higher than ybar if increase in prices is unexpected

Question 28

Why does SRAS slope upwards in misperceptions theory?

Answer 28

Because an expected increase in price means that producer will just increase their price but not change quantity. They only change quantity when they think that only the price of their goods increased (decreased) more than they expected and more (less) than the general level; then they produce more (less).

Question 29

What is the formula for misperceptions theory?

Answer 29

y= ybar + b(P-Pe)

Question 30

What is the slope of the supply curve under SRAS?

Answer 30

ΔY = b*ΔP so the slope of the aggregate supply curve equals ΔP/ΔY = 1/b. So SRAS is steep if b is small and flat if b is large.

Question 31

What if the effect of an unexpected price level change due to monetary expansion under the classical theory with misperceptions versus an anticipated one?

Answer 31

If ΔP is unexpected, output can be above y bar for a time until SRAS shifts up. If ΔP is expected, SRAS shifts up right away. Money is neutral in both short and long term if ΔP is anticipated.

Question 32

What is the assumption underlying the idea that anticipated ΔP is neutral?

Answer 32

Rational expectations. The public’s forecasts of various economic variables including the money supply, the price level, GDP are based on reasoned and intelligent examination of economic data. This also means that if you fool people once, you can’t keep on doing it forever because they will catch on to what you’re doing. So Fed can’t systematically use changes in Ms to improve GDP.

Question 33

How do you express the aggregate demand curve in terms of alphas of IS and LM, the coefficient of the nominal interest rate (l_m) in the the monday demand equation, and the betas on IS and LM?

How does the slope of IS, LM and M/P affect this?

Answer 33

Y = a_{IS -}a_LM+ (l_r)(M/P) / (ß_IS-ßL_LM)

Question 34

Why do Keynesians belive in wage rigidity?

Answer 34

They are trying to explain why higher unemployment occurs during recessions. They don’t buy the mismatch theory because if that were the case we’d see lots of people actively looking for jobs and employers actively hiring. (Job vacancy announcements decrease however and surveys indicate unemployed people don’t look so hard).

So they conclude that recessions are periods of low output and employment for both sides.

Question 35

Why might real wages be rigid?

Answer 35

Institutional factors such as minimum wage, union contracts, need to retain workers (high cost of hiring and firing)