SEM 2 - LEC 1 - SHORT RUN FLUCTUATIONS Flashcards
Whats the standard production function and what they mean
Y=BF(K, N)
Y - OUTPUT
B - PRODUCTIVITY FACTOR
K - CAPITAL
N - LABOUR
What does Yˆ mean when factors K, N, B are set
full capacity
what do we call periods above/below the trend
above - booms
below - recessions
recessions are falls in economic activity
uk definition of a recession
two successive quarters of negative growth of real gdp
what is the output gap
it is the difference between output at time t and its potential the economy is running inefficiently (underworking/below capacity or overworking/over capacity)
why is the output gap important
understand severity of recessions, estimate cyclical and structural fiscal budget, assess need for stabilisation
how to measure potential output
- estimate trends removing/filtering the cyclical changes. Statistical techniques to “filter” output of short-term ups/downs, e.g, Hodrick-Prescott filter, Baxter-King, etc…)
- estimate production function and otain Yˆ as potential output, i.e. remove the cyclical changes in the
inputs. - “direct” measures of capacity utilisation from business surveys
what are some features of business cycles
- expansions are typically longer than contractions
- they are different across different countries, (duration and amplitude) poor countries experience Karger swings
- co movement across sectors of the economy
- co movement across regions of the economy
summarise the key business cycle features
- consumption less volatile/investment more volatile than output
- real wage less volatile/unemployment more volatile than output
- consumption, investment, employment and hours worked are pro-cyclical
- unemployment is counter-cyclical
- productivity is pro-cyclical, real wages weakly correlated to GDP
- all series are persistent over time (high first order auto-correlation)
why do some people think we should not care about business cycles
- consumption is stable (less volatile than output) due to consumption-smoothing
- investors should not be compensated for risk-taking
- the benefits from short-run stabilisation policies are small - the benefits from long-run output growth policies are large
why do some people think we should care about business cycles
- cycles can have different impact on different consumers (e.g., distributional costs by age, occupation, region, etc…)
- high output volatility may affect growth prospects
- benefits of short-run stabilisation can also be large
why do business cycles matter
• economic fluctuations are related to (un)employment
- changes un unemployment can affect economic well being
- economic fluctuations can have different effects on different groups
- economic fluctuations are associated with price changes and response of the Central Bank
- economic fluctuations also matter for public finances as they are linked to automatic stabilisers
what’s okuns law
tells us that GDP growth is related to unemployment growth.
the law states that a 2% fall in the output below potential is linked to an increase in unemployment by 1%.
how are business cycles generated
- impulse → 2. propagation mechanism → 3. business cycle
what does DSGE models stand for
D - Dynamic
S - Stochastic
G - General
E - Equilibrium
what are the general assumptions of the neoclassical benchmark model NCBM
• goods and labour markets
- perfectly competitive
- complete information
- no excess demand, no involuntary unemployment
• agents intertemporally optimise under rational expectations
what are the assumptions of the basic Real Business Cycle Model (RBCM)
• perfect competition and perfect information in goods and labour markets
- fully flexible nominal wages and prices (RBC looks at real values)
- no excess demand, all unemployment is voluntary
• economic agents are
- in large number and identical (“representative” agent)
- live forever and optimise intertemporally
- form expectations rationally (Rational Expectation Hypothesis)
• economy is disturbed by random technology shocks which die out slowly • higher saving ⇒ higher investment ⇒ higher capital stock
what are the key theoretical improvements with the RBCM
- adds microeconomic foundations
- models intertemporal behaviour
- considers expectations
- replicates several (not all) business cycles facts
- is exempt from Lucas critique (see pp. 136-138, Carlin and Soskice, 2015)
- provides more rigorous analysis of government intervention
what’s the RBCM’s methodological approach
• The RBC theory follows a deductive approach:
→ sets theory and then sees how it matches reality (BCs facts)
• note: 3-equation model follows an inductive approach:
→ microfoundations based on incomplete contracts and imperfect competition
→ these reflect the observation of equilibrium unemployment and response of output and employment to AD shocks
what are the properties of the RBCM in the long run
• long-run properties of economy as in Ramsey model, i.e. a version of Solow model
• growth driven by exogenous technological progress, x
⇒ in steady state, output per capita/labour productivity (and real wage) grow at x
• but with optimising agents:
households optimally decide saving according to Permanent Income Hypothesis (PIH)
⇒ saving is endogenous and depends on interest rate and subjective rate of time preference
- constant population growth ⇒constant employment rate (labour supply is vertical in long-run)
• this is in line with evidence (for developed countries) of rising labour productivity but no rising employment
- together with rising real wages, this is interpreted as evidence of inelastic labour supply
- hence, RBCM focuses on hours worked, not on employment
what would the RBCM: steady state growth in Ramsey look like diagrammatically
in steady state, with constant population growth, employment rate is constant (vertical LS)
• LD shifts upwards each period with technological progress x ⇒ productivity and real wages rise at constant rate, x
• in line with evidence on developed countries
- long-run productivity growth but constant employment
• rising real wages + no change in employment ⇒ inelastic (vertical) labour supply LS
how do technology shocks produce a business cycle in the short run?
• a shock hits the economy and then dies out slowly ⇒ cycle and not just quick jump
• forward-looking households maximise inter-temporal utility
→ consumption smoothing response to effects of shock on interest rate and wage
→ sustained effects of the shock on output, employment and capital stock
• note: shocks produce changes in equilibrium not deviations from equilibrium
i.e. equilibrium business cycles
how do households maximise utility over lifetime
take decisions about savings/consumption & work/leisure
• start from the PIH: intertemporal consumption/saving decisions
- depend on permanent income, real interest rate & subjective discount
rate
• add employment/leisure decisions: households decide labour supply (hours worked)
- labour market is perfectly competitive and contracts are complete
- intertemporal elasticity of labour supply plays role in propagating
shocks
how does a technology shock produces a business cycle?
• random positive shock hits the production function under perfect markets
- marginal productivity of labour goes up and marginal productivity of capital goes up, because you are in perfectly competitive markets this increases real wage (w) and real interest rate (r)
- household smoothes consumption i.e. adjusts savings and hours worked (both more attractive after +ve shock) to keep the subjective marginal rate of substitution equal to the objective marginal rate of transformation between consumption today and tomorrow
-
what’s the - Marginal Rate of Substitution
“subjective ” substitution between consumption in period 1 and consumption in period 2 to keep utility constant
what’s the Marginal Rate of Transformation
“objective” market cost of shifting consumption (saving/leisure, depending on r and w)
show the graphical analysis of random positive shock on then RBCM: short-run evolution
technology shock increases saving investment.
labour demand goes further up and people decide to supply more work because it is more convenient
what are the effects of a shock on the RBC model
• technology shock ⇒ output, wage and interest rate ↑
• consumption ↑, BUT less than output
⇒saving ↑⇒investment ↑
• hours worked ↑(intertemporal substitution⇒shift in LS)
• savings invested in new K ⇒Ld ↑ (shock amplification)
• later, shock dies out and economy gradually goes back to steady state
what’s the Cobb Douglas production function
what’s the future capital stock equation
what do (RBCM) firms do to maximise profits under perfect competition
how do consumers maximise utility (RBCM)
what’s the RBCM for consumers and workers, maximum utility? - confusing 1;30 on recap 2nd lec
l is leisure
HOW DO YOU FIND THE INTERTEMPORAL CHOICE OF CONSUMPTION
where MRS=MRT, can manipulate to get Ct
what’s the intertemporal leisure choice equation
what’s Bt in this equation
Bt : measure of productivity that considers both capital and labour (TFP)
• shifts in Bt change output for given inputs → measure of technology
what does this equation mean
what are the effects of a positive technology shock, Bt ↑
what’s the steps to model calibration to see how well abc theory fits the data
- choose functional forms for key equations, set “deep” parameters to be estimated
- “calibrate” the model: assign values to parameters based on long-run from actual data
- find Solow residual (proxy for technology shock) from historical data. See slide 26
- use Solow residual as shock to the calibrated model, simulate path of economy over time
- detrend simulations using HP-filter and obtain cyclical and trend components
- calculate statistics from cyclical component (standard deviations and correlations), and compare to actual data
what’s the slow residual formula
what are the rbcm drawbacks
• the source of the technology shocks is not modelled
• calculation of technology shock may be affected by measurement error
- Solow residual may reflect market imperfections (labour market hoarding,
monopoly power)
- firms expect recessions to be temporary and under-utilise labour (fall in TFP
= employees working less
• rbc requires very long memory shock
• aggregate hours and productivity should vary closely with output ⇒hours per worker should vary closely with output, BUT
-empirical evidence: aggregate worked hours are more variable than productivity
-changes in employment drive changes in aggregate hours worked (see again figure above)
• real wages should be strongly procyclical, BUT
- empirical evidence: only mildly procyclical or acyclical (market imperfections?)
• no role for govt consumption
• labour markets can be imperfect lead to middle procylical to real wages
what’s the households maximise inter temporal utility equATION
s.t. budget constraint
what’s the max Ut over consumption
what’s the max Ut over employment, FOC with respect to e
if you are in a competitive markets, consumers/workers cannot influence wages, what does FOC determine and what does the slope of supply curve depends on
FOC determines supply of labour for any given real wage
i.e., household choose e for each w set by the labour market
• slope of supply curve depends on disutility from work
⇒ increasing marginal disutility from work ⇒ upward sloping labour supply
i.e. household wants to be compensated for additional e with higher wages
wages ↑⇒ e ↑
what’s the equation when firm maximises profits with production function y = F(e)
how does the firm maximise profits using this equation
how do we show equilibrium in the labour market graphically
how do we show graphically the NCBM: general equilibrium in the labour + goods market
Whats the equation for IS
how can we make the IS equation for more forward looking
how do we graphically represent the IS in the NCBM with full information, perfect price flexibility and rational expectations,
what’s the implications of the NCBM microfounded forward-looking IS
how does the equilibrium in the money market work
what does the NCBM & the 3 equations IS-PC-MR look like graphically
why can the central bank constantly control inflation by controlling the growth of money supply
AD shifts alter prices, not output. why are AD shifts not amplified
- IS shocks are 100% crowded out by the real interest rate
* inflation is always equal to target inflation
what does the NCBM setting not capture
• persistent deviations of output and employment from equilibrium
• AD shocks often initially impact on real (y and e) rather than nominal
(w and p) variables
-may be amplified by subsequent changes in consumption and investment
• inflation displays inertia
(captured in IS-PC-MR by assuming backward-looking PC )
• not all equilibrium unemployment is voluntary
what are the new Keynesian features added
• imperfect labour and goods markets
- union bargains in place of workers (monopoly union model)
- firms enjoy monopoly power (differentiated products)
• implications of the introduction of imperfections
⇒involuntary unemployment in equilibrium
⇒AD shocks can cause short-run deviations of output from equilibrium
• however, we will still need to incorporate slow inflation adjustment to explain disequilibrium
- in the familiar IS-PC-MR this is assumed
- here, we will model this later (after introducing imperfections)
what’s the household problem under imperfect competition
what are the steps under trade union (TU) bargaining - bargaining under 100% right-to-manage union
how does the trade union relate to the labour supply
how do you derive the labour supply
what’s the effects of higher wages on utility
how do you find wages under perfect competition
what’s the difference between perfect vs imperfect competition in labour market
for each hour worked wages under imperfect competition are higher regardless of utility function and production function
what does labour demand look like in the imperfect goods markets
how do you find the wages as a function of e
what’s the difference between labour demand: perfect vs imperfect competition
graphically what does the abour market in involuntary unemployment in equilibrium look like
in icbm what are AD shocks offset by
price changes and y and e remain at equilibrium
BUT empirical evidence: AD shocks first affect y and e and then w and p
the goods and labour market imperfections are…
• NECESSARY conditions for output to change after AD shock
• BUT NOT SUFFICIENT:
• need slow adjustment of inflation to equilibrium
•adverse demand shock→under imperfect competition+slow
adjustment→ reduction in output
