The Business Cycle with Flexible Prices and Wages

Question 1

What does the Real Business Cycle say?

Answer 1

• Business cycles are caused by fluctuations in z and z’
• There is not role for government in smoothing business cycles - they are just optimal responses to the technology shocks
• Model fits the data well, but z is exogenous

Question 2

What is the overall effect of a z increase in the Real Business Cycle model with money?

Answer 2

• 1. ↑z → ↑ND = ↑YS
     - ↑YS b/c 1. > 2.
• 2. ↑π → ↓NS
• 3. ↓r clearing → S↓ → ↓NS
• 4. ↑w clearing
• Result: Y↑, N↑, w↑, r↓
• 5. Y↑ + r↓ → MD↑ = P↓ = deflation

Question 3

What is the overall effect of a z decrease in the Real Business Cycle model with money?

Answer 3

• 1. ↓z → ↓ND = ↓YS
     - ↓z → ↓MPN
     - ↓YS b/c 1. > 2.
• 2. ↓π → ↑NS
• 3. ↑r clearing → ↑S → ↑NS
• 4. ↓w clearing
• Result: Y↓, N↓, w↓, r↑
• 5. Y↓ + r↑ → MD↓ = P↑ = inflation

Question 4

What is the fiscal policy response to a z decrease?

Answer 4

• z↓ → G↑
  
  • 1. G↑ = YD↑
  • 2. (T, T’)↑ → NS↑ = YS↑
  • 3. r↑ clearing → S(r)↑ = NS↑
  • 4. w↓ clearing = ND↑ + NS↓
  • Result: G↑ → Y↑, N↑, w↓, r↑
  • 5. Y↑ + r↑ → ambiguous effect on MD and P (inflation or deflation)
  • Result: G↑ → Y↑, N↑, w↓, r↑
  • 5. Y↑ + r↑ → ambiguous effect on MD and P (inflation or deflation)

Question 5

What is true of monetary stabilisation policy?

Answer 5

In reality the money demand curve is highly volatile and mostly unpredictable - chasing the demand with supply can make the issue worse

Question 6

What are the two interlinked concepts important to monetary policy output and employment maintenance?

Answer 6

• Classical Dichotomy

* Neutrality of money

Question 7

What is the classical dichotomy?

Answer 7

• Real and nominal markets are separate - labour and goods market go not rely on the price level
• There is no effect on the real economy from a change in the money supply

Question 8

What is the neutrality of money?

Answer 8

• In the monetary inter temporal model, the central bank can’t affect output and employment
• A level increase in the money supply increases the price level and the nominal wage in proportion, but has no effect on any real variable
• The real side (goods market and current labour model) can affect the nominal side (money market) but the nominal side can’t affect the real side

Question 9

What does the money market equilibrium imply about the monetary inter temporal model?

Answer 9

In a money market equilibrium, MS = MD = P(Y-(1+q)X) implies that P is fully flexible to respond to changes in M and thus the real element (Y-(1+q)X) is totally unaffected by M