1、.Notes on Classical EconomicsThe first fact that one associates Classical Economics with is a “hands-off” policy prescription. In particular, the Classical economists believe that we are better off with a hands-off approach as opposed to trying to fine tune the economy through countercyclical policy

2、 (the Keynesian philosophy). In the simplest terms, the Classical economists believe in perfectly flexible prices and wages (both of these are nominal variables) so that all markets clear all the time. The result is a vertical aggregate supply curve (in the short and long run). Real Business Cycle T

3、heoryReal Business Cycle Theorists argue that the re-current fluctuations that occur in economic activity (i.e., business cycles) are caused by productivity shocks (supply shocks) and not shocks to aggregate demand (Keynesians argue that business cycles are caused by shocks to aggregate demand the a

4、nimal spirits argument).We consider two episodes, each with clear productivity shock implications. The first is the well known stagflation in the US in the 70s / Japan earthquake example where we have an adverse shock to the production function (aka, adverse supply shock). For the US 1970s example,

5、it would be due to an oil shock (oil is part of “l(fā)and”) and for the Japan example, the adverse shock is due primarily to all the physical capital (K) that was destroyed by mother nature. In the series of graphs below, we ignore the demand side effects but consider them later in a new economy example

6、, the second episode that we consider. Note importantly, that inflationary pressures (the “flation” part) of stagflation in Japan will occur only if aggregate demand remains relatively stable. Of course, this is an unrealistic assumption and to be more complete, we would let aggregate demand fall du

7、e to all the real estate wealth that was destroyed, the lack of consumer and investor confidence, low expected wealth and income, and probably a fall in the expected marginal product of capital, all of these result in aggregate demand falling which would certainly lesson if not reverse the inflation

8、ary effects associated with the adverse supply shock.We consider two shocks to the production function the first set of graphics ignores any demand side shocks and is the standard stagflation example. The second set of graphs considers positive productivity (supply) shocks as well as positive shocks

9、 to aggregate demand. This is a New Economy example that explains the facts extremely well!STAGFLATION How do the implications of Real Business Cycle theory match the business cycle factsReal Business Cycle (RBC) theory does very good in explaining the business cycle facts. There are a few contradic

10、tions that RBC theorists have to address:1) Inflation is pro-cyclical according to the facts but countercyclical according to the theory. RBC theorists argue that the empirical results, (i.e., that inflation is procyclical) are sensitive to the sample period chosen. In other words, this is no biggie

11、 in terms of a weakness in the theory according to the RBC theorists.2) Average labor productivity is “too” procyclical in the RBC theory that is, in reality, average labor productivity is weakly procyclical. RBC theorists fix this by considering the effects on the cyclicality of average labor produ

12、ctivity when considering fiscal policy shocks (see the bar chart below).3) Government Purchases are procyclical according to the business cycle facts this is a problem for RBC theorists, since they believe that the aggregate supply curve is vertical and so demand side policies will not effect real v

13、ariables such as output so according to RBC theorists, G should be acyclical (i.e., does not mater, neutral). The RBC theorists have a neat fix for this apparent weakness in their theory. In fact, their fix takes care of problems 2) and 3) together its like killing 2 birds with one stone.4) The fina

14、l weakness is that according to the business cycle facts, money is procyclical and leading, implying that money is not neutral in reality. Of course this is a huge pitfall if true, since the linchpin of classical economics is money neutrality. The RBC theorists again, come up with a clever way to de

15、al with this apparent shortfall while maintaining the money neutrality assumption.5. The biggest shortfall of RBC theory and classical economics in general is that they cannot explain cyclical unemployment/involuntary unemployment. They argue that constant productivity shocks cause matching problems

16、 and thus, the amount of structural unemployment changes constantly, explaining the up and downs of unemployment. Most economists find this observation interesting and worthy of thought, but few really believe that matching problems can push the unemployment rate above 9%, as it was during the Great

17、 Recession. Keynesian economic theory gets the gold star here, as their model does a much better job explaining cyclical/involuntary unemployment. We will explain the Keynesian theory when we complete our discussion of classical economics.Dealing with 2) and 3) Average labor productivity is “too pro

18、cyclical” according to the theory and Government purchases are procyclical.The RBC theorists simply argue that higher G makes people poorer, since they either have to pay higher taxes now or in the future, to pay for the higher G. When people feel (are) poorer, they will be willing to work more at a

19、ny given real wage i.e., the labor supply curve (Ns) will shift to the right. If we add this notion to the theory, we fix two of the shortfalls at once 1) higher G is indeed procyclical and 2) average labor productivity is countercyclical in this particular case. When you add in supply shocks as in

20、our previous analysis, the combination of supply shocks and government spending shocks result in average labor productivity being weakly procyclical, consistent with the facts. The first graphic shows that the RBC theory matched the facts extremely well except for the average productivity correlatio

21、n. FISCAL SHOCK RBC THEORYThe Final issue that the RBC theorists had to “deal with” is that according to the facts, money is leading and procyclical. The RBC theorists are the first ones to point out that correlation does not imply causation. The example they use is a storm window example. Just beca

22、use homeowners put up storm windows before winter comes certainly does not imply that they, by putting up storm windows, are causing winter to arrive. Actually, it is the other way around (the fact that winter is coming causes people to put up storm windows). The RBC theorists refer to this phenomen

23、on as “reverse causation.” To apply and understand the concept of reverse causation in the money output correlation, we must recall the traditional way many think that monetary policy is supposed to work (this is Keynesian). The traditional thought is that increases in the money supply lower real ra

24、tes and thus stimulate C, I, and NX., and thus, Y rises. This process takes time which explains why money is a leading variable. Reverse causation suggests that changes in output (Y) is causing changes in money. Note importantly that money is a leading and procyclical variable so that changes in mon

25、ey must occur before changes in output. The way that RBC theorists deal with this short coming is to assume that L (real money demand) is not only a positive function of current Y but also a function of future expected income denoted Yf. The idea is that if firms expect higher output in the future,

26、they will demand more money now for raw materials, wages, etc. The increase in economic activity will not show up in data until later, but firms need the money now. This is where it gets clever. The increase in money demand today will shift the LM curve to the left as the money market will clear at

27、a higher interest rate. Importantly, this occurs before there is any change in output that comes later. The Fed seeing this has two choices: 1) they can sit on their hands and let prices fall, because that is the adjustment that has to take place given the shock to L (real money demand). or 2) they

28、can accommodate the shock to real money demand by conducting open market purchases to keep the price level from falling. Of course, the Fed has a dual mandate and half of that mandate is stable prices so the RBC theorists argue that if the Fed is doing their job, we will see money increasing today a

29、nd output rising in the future, consistent with the business cycle fact that money is leading and procyclical. Note importantly that money is still neutral in this example, consistent with the linchpin of classical economic theory. Output is going up in the future due to perhaps a positive shock to

30、the production function. Whether or not the Fed did anything, it doesnt matter, output is still going up, they just increase the money supply to prevent the deflation that would occur otherwise. In terms of the storm window example, it doesnt matter that you put up your storm windows or not, winter

31、is still coming it is prudent for you to put up the storm windows, just like increasing the money stock due to the shock to L is a prudent thing for the Fed to do. Can you show this graphically? See below:The Monetary Mis-perceptions Model, aka, the “fooling model” aka, the Lucas Island Model.Revers

32、e causation is a clever way to explain why money is a pro-cyclical and leading variable while maintaining the all important money neutrality, meaning that a “hands off: policy approach is the best. If you tried to get output to be beyond full employment output, then you will just be creating inflati

33、on, something that is undesirable and therefore welfare reducing.But there was some evidence that there was clearly causation directly from money to output, especially in during the Volcker period. This evidence was revealed in a very famous work done be Milton Friedman and Anna Schwartz “A Monetary

34、 History of the United States, 1867-1960.”The Model the fooling model is based on imperfect information. Suppose the economy was made up with a series of islands, and each island produced their own unique product. Suppose you produce loaves of bread on island B. Now the model is based on you having

35、perfect information as to your own island price (of bread) but you have imperfect information on the prices of all the other goods and services that are produced on the other islands. Given this imperfect information, you have to form expectations as to the prices of all other goods and services in

36、this economy. Importantly, you consume all these other goods and services that are produced on the other islands. Your nominal wage vs. your real wage. To really understand the island model we need to understand the difference in nominal wages and real wages. Suppose that you, the bread maker, makes

37、 (produces) 200 loaves of bread every day (say in 8 hours of work) and sell them initially for $1 each. Your nominal wage is therefore $200. What is your real wage? We know that real wages are expressed in terms of real goods and services. Since you eat more than just bread and that you consume more

38、 than just food, we could imagine a basket of goods and services made up of all the other goods and services produced in this island economy the price of the basket of all these other goods and services is referred to as the aggregate price level. Lets initially set the aggregate price level at $100

39、 (price per basket) so that your real wage from working is 2 baskets of all these other goods and services (W/P = $200/$100 = 2). We now add time and uncertainty to the analysis. Since you live on an island producing bread, you dont have timely or accurate information as to the general price level,

40、you only have perfect information as to your own island price (of bread). Given that you dont have information as to the aggregate price level, you must form expectations of the aggregate price level, through time. Suppose that overall inflation has been running at 2% for years and thus, you expect

41、over all inflation to run at 2% over the next year.Scenario #1 The price that you can sell your bread for rises to $1.02, equal to your expectation as to overall inflation. What has happened to your nominal wage? What has happened to your real wage? Nominal wage has gone up! 200 x $1.02 = $204. Your

42、 (expected) real wage, given your e=2% is now W/P = $204/$102 = 2 baskets of all other goods and services which is exactly the same as the old real wage. In this case, you do not change your behavior and thus, you produce the same amount of bread as you did before the price changes. Importantly, rem

43、ember the following: If the expected price level equals the actual price level, then the economy is operating at full employment.Scenario #2 The price that you can sell your bread for rises to $1.10, well above the overall expected rate of inflation (i.e., e = 2%). What has happened to your nominal

44、wage? W = 200 x $1.10 = $220. Your (expected) real wage is now W/P = $220/ $102 = 2.16 baskets of all other goods and services, higher than you expected. Since you think your real wages havegone up (you are not sure since you cant observe other island prices) you work more recall a positively sloped

45、 labor supply curve. In the space below, draw point A when the real wage was 2 baskets of all other goods and services and locate point B where your real wage is 2.16 baskets of all other goods and services.Expanding example: Suppose now that you hire five workers to make bread. We hold the producti

46、vity of each worker the same at 200 loaves per worker per 8 hour day. You pay each worker $100 for a days work and the revenue that is generated initially by each worker is $200 = 200 loaves x $1.00 per loaf. So in a sense, you, the owner of the bread factory is making a profit of $100 per worker. L

47、et us assume that there are taxes, insurance and all other kinds of costs associated with running this business so your profit is not as large as it first appears, but lets assume that it is equal to your opportunity costs, meaning equal to the value of your next best alternative employment.Now impo

48、rtantly, each worker cares about their real wage in terms of all goods and services since they consume all the goods and services that are produced in this island economy. So the initial real wage for each worker is 1 basket of goods and services = W/P = $100/$100. Let us consider scenario #2 again.

49、 Suppose that the island price of bread jumps to $1.10 as before and the workers expect the general price level to rise by only 2%. We know that to keep the workers from complaining, that the boss better give them a raise in nominal wages to compensate them for the 2% expected rise in the cost of li

50、ving. Here is where it gets interesting. The worker cares about the real wage based on all other goods and services but the boss pays real wages in terms of their output, bread! This asymmetry is important to remember and is crucial in understanding how this model works. Consider the following exper

51、iment: The boss decides to give each worker a 5% increase in their nominal wage. Are the workers happy? Yes! Since they think the over all price level is only rising by 2%, they are happy with a 5% bump in nominal wages since real wages go up anytime %W >%P. In terms of numbers, the workers real

52、wage rose from $100/$100 = 1 to $105/$102 = 1.03. Given that the price of leisure has risen with the real wage, each worker will desire to work more (assuming the substitution effect in labor supply dominates the income effect of labor supply). So workers will rationally want to work more but will t

53、he boss be willing to allow them to work more? Please show on a diagram labeling point A where real wage = 1 and point B where the real wage = 1.03.The Boss: Again, the boss pays real wages in terms of their product and not the overall price level. Originally, the real wage they paid in terms of bre

54、ad was W/PB = $100/$1 = 100 loaves of bread. With the price changes as above, the real wage that the firm pays now is $105/$1.10 = 95.45 loaves of bread. So in effect, the firm is paying lower real wages and thus will rationally want to expand labor input by letting workers work over time or by hiri

55、ng more workers. We explained this phenomenon many times at the same level of labor input, W/P is now less than the MPN, hire more to lower MPN to the new lower real wage!. Please draw another diagram in real wage space showing point A with a real wages of 100 loaves and point B as the real wage at

56、95.45 loaves.Bottom line: If the actual price level PA is greater than the expected price level Pe, then firms and workers will rationally produce/work more. In fact, we can represent this model with what is referred to as the Lucas Aggregate Supply Curve. Y = Y* + b (PA Pe)B is a positive parameter

57、 so that when PA > Pe then Y > Y*Lets do a problem to get a feel for this modelProblem 4 from chapter 10 tweaked a little4.The AD And AS equations are given belowAD: Y = 300 + 30(M/P), AS: Y = Y* + 10(P Pe), M = 400.Full employment Y = Y* = 500, M=400, and Pe = 60a) What are the equilibrium va

58、lues of P and Y(answer for a)Pe = 60. Setting AD = AS to eliminate Y, we get 300 + 30(M/P) = 500 + 10(P Pe). Plugging in the values of M and Pe gives 300 + (30 ´ 400/P) = 500 + 10(P 60), or 300 + (12,000/P) = 500 + 10P 600, or 400 + (12,000/P) = 10P. Multiplying this equation through by P/10 gives 40P + 1200 = P2, or P2 40P 1200 = 0. This can be factored into (P 60)(P + 20) = 0. P cant be negative, so the