Chapter 18

Introducing
Advanced
Macroeconomics:
Growth and business
cycles EXPLAINING
BUSINESS
CYCLES

©The McGraw-Hill Companies, 2010

 THEMES

• Explaining business cycles by means of

the AS-AD model
 The Frisch-Slutzky paradigm: Impulse
and propagation
 The deterministic versus the stochastic
AS-AD model
 Supply versus demand shocks
 Permanent versus temporary shocks
 The theory of real business cycles

©The McGraw-Hill Companies, 2010

The cyclical components of real GDP and inflation in the United States
©The McGraw-Hill Companies, 2010
Growth in real per capita GDP in the USA, Germany and Japan
©The McGraw-Hill Companies, 2010
 THE FRISCH-SLUTZKY PARADIGM

 The impulses (demand and supply shocks) initiating

business cycles may be unsystematic.

 The propagation of the impulses may generate

systematic fluctuations due to the structure of the
economy.
Basic questions

 Why do movements in economic activity display

persistence?
 Why do these movements tend to follow a cyclical
pattern?

©The McGraw-Hill Companies, 2010

 RESTATING THE AS-AD MODEL

yt  y  1  gt  g    2  rt  r   vt (1)

rt  it   e
t 1 (2)

it  r    h  t     b  yt  y 
e
t 1
*
(3)

t      yt  y   st
e
t (4)

  t1
e
t (5)

©The McGraw-Hill Companies, 2010

 THE AS-AD MODEL IN COMPACT FORM

Inserting (2), (3) and (5) into (1), we get

yt  y    * t   zt ,
(6)
2h vt  1  gt  g 
 , zt 
1   2b 1   2b
which may be rearranged to give the aggregate demand curve:

1
AD: t       yt  y  zt 
*
(7)

Substituting (5) into (4), we obtain the short-run aggregate supply curve:

SRAS: t  t 1    yt  y   st (8)
©The McGraw-Hill Companies, 2010
 
LRAS

SRAS

E0
0

AD

y
y0 y

A short-run macroeconomic equilibrium with cyclical unemployment

©The McGraw-Hill Companies, 2010
The adjustment to long-run equilibrium
©The McGraw-Hill Companies, 2010
 How long is the Long Run?
Defining
yˆt  yt  y (output gap)

ˆt   t   * (inflation gap)

and assuming st = zt = 0, we may rewrite (7) and (8) as

1 2h
AD: ˆt 1     yˆt 1 ,  (9)
  1   2b

SRAS: ˆt 1  ˆt   yˆt 1 (10)

Inserting (9) into (10), we find

©The McGraw-Hill Companies, 2010
 How long is the Long Run?

1
yˆt 1   yˆt , 
1   (11)

ˆt 1  ˆt (12)

The solutions to these linear first-order difference

equations are
yˆt  yˆ0  ,
t
t  0,1, 2,..... (13)

ˆt  ˆ0  t , t  0,1, 2,..... (14)

Note that the long-run equilibrium is stable, since 0 < β < 1.

©The McGraw-Hill Companies, 2010
 THE SPEED OF CONVERGENCE

th  number of periods before half the adjustment to long-run

equilibrium has been completed

1 1 1
yˆt  yˆ0   yˆ 0   
th th
 t ln   ln   
h

2 2 2

ln 2 0.693
th    (15)
ln  ln 

According to equation (13) in Chapter 16 we have

©The McGraw-Hill Companies, 2010

CALIBRATING THE MODEL (ONE TIME PERIOD =
ONE QUARTER)

1 h 2
 
1   1  b 2

 Dr  1   Dr
2    

Y0 (1  Dy )  1  Dy  Y0 (1   )

  0.05   0.2 Dy  0.8   3.6 h  b  0.5

ln 2
From this it follows that   0.958  th    16  4 years
ln 
©The McGraw-Hill Companies, 2010
 LRAS

SRAS1

s1
SRAS2
E1 SRAS0

E2




AD

y
y1 y2 y

Effects of a temporary negative supply shock

©The McGraw-Hill Companies, 2010
Effects of a temporary negative demand shock
©The McGraw-Hill Companies, 2010
The adjustment to a temporary negative supply shock
(s1=1) ©The McGraw-Hill Companies, 2010
The adjustment to a temporary negative demand shock (z1= -1)
©The McGraw-Hill Companies, 2010
 PERMANENT SHOCKS
When analysing permanent shocks, we must account for the fact that such
shocks will change the long-run equilibrium real interest rate (the ’natural’
interest rate). Denoting the initial values of natural output and the natural
interest rate by zero subscripts, we may write our AS-AD model as

yt  y0  vt  2  rt  r0  , vt  vt  1  gt  g  (21)

t  t 1    yt  y0   st (22)

Consider an initial equilibrium where vt  st  0 and suppose that st

permanently changes from zero to some s ≠ 0. The new long-run
equilibrium level of output may then be found from (22) by inserting

t  t 1 , yt  y , st  s
to get
©The McGraw-Hill Companies, 2010
 A PERMANENT SUPPLY SHOCK
The effect of a permanent supply shock on natural output
s
y  y0  (23)

The new equilibrium real interest rate is found from (21) by setting
s
yt  y  y0  , rt  r to get


The effect of a permanent supply shock on the equilibrium

real interest rate
s
r  r0  (24)
 2

©The McGraw-Hill Companies, 2010

 A PERMANENT DEMAND SHOCK
A permanent demand shock does not affect natural output. Hence the effect on
the equilibrium real interest rate may be found from (21) by setting

yt  y0 , vt  v and rt  r to get
The effect of a permanent demand shock on the equilibrium real interest rate

v
r  r0  (25)
2
To keep inflation close to its target rate and to avoid large deviations of output
from trend, the central bank must revise the estimates of natural output and of the
equilibrium real interest rate entering the Taylor rule when the economy is hit by
permanent shocks. The adjustment of the economy to the new long-run equilibrium
will depend on how long it takes the central bank to realize the permanency of the
shock. Exercise 18.2 invites you to study these issues further.

©The McGraw-Hill Companies, 2010

 THE STOCHASTIC AS-AD MODEL

The deterministic AS-AD model considered above can explain the

persistence in macroeconomic time series, but it cannot explain the
recurrent cyclical fluctuations observed in the real world. To generate such
fluctuations, we now assume:
Stochastic demand and supply shocks
zt 1   zt  xt 1 , 0   1 (27)

xt N (0,  x2 ) , xt i.i.d .

st 1   st  ct 1 , 0   1 (28)

ct N (0,  c2 ) , ct i.i.d .
Our goal is to calibrate a stochastic AS-AD simulation model which can
reproduce the stylized business cycle facts summarized in Table 18.1.
©The McGraw-Hill Companies, 2010
Cyclical components of real GDP and inflation in the USA, 1974-2007
©The McGraw-Hill Companies, 2010
©The McGraw-Hill Companies, 2010
Simulation of the stochastic AS-AD model with static expectations and no
supply shocks ©The McGraw-Hill Companies, 2010
Expected current inflation and lagged actual inflation in the United States
©The McGraw-Hill Companies, 2010
 THE STOCHASTIC AS-AD MODEL WITH STATIC
EXPECTATIONS

Problems
 The model with demand shocks can reproduce the stylized facts
regarding output, but it generates far too much persistence of inflation

 The model with supply shocks is unable to reproduce the stylized

facts of output as well as inflation

● The assumption of static expectations implies greater fluctuations in the

expected inflation rate than what we observe in practice (see Figure 18.12)

To solve these problems we will now allow for

simultaneous demand and supply shocks as well as
adaptive expectations.

©The McGraw-Hill Companies, 2010

 ADAPTIVE EXPECTATIONS
revision of expected last period's inflation
inflation rate forecast error

 te   te1  (1   ) ( t 1   te1 ) , 0   1 (29)

For   0 we get static expectations. Eq. (29) may be rewritten as


  e
t
n 1
(1   ) t  n (33)
n 1

The AS-AD model with adaptive expectations

AD: yt  y    *  t   zt (34)

SRAS: t  te    yt  y   st (35)

Expectations: te  te1  1    t 1 (36)

©The McGraw-Hill Companies, 2010
 The AS-AD model with adaptive expectations

The model (34) through (36) may be condensed to:

yˆt 1  ayˆt   ( zt 1  zt )   st 1   st (41)

ˆt 1  aˆt   zt 1   zt   st 1   st (42)

1   1
a 1  1
1   1  

The third row in Table 18.1 shows that this model reproduces the U.S.
Business cycle reasonably well, given its simplicity.
©The McGraw-Hill Companies, 2010
The AS-AD model with adaptive expectations (top diagram)
©The McGraw-Hill Companies, 2010
versus the actual U.S. business cycle (bottom diagram)
 THE THEORY OF REAL BUSINESS CYCLES
Our AS-AD model of the business cycle emphasizes the role of
expectational errors and sluggish wage and price adjustment, and the
microfoundation for the SRAS curve implies that business fluctuations
are associated with fluctuations in involuntary unemployment. The
model also assigns an important role to demand shocks. A very
different theory is:

Real business cycle theory (basic version)

● The business cycle is mainly driven by fluctuations in the rate of

productivity growth.
● The employment fluctuations observed during business cycles reflect
voluntary movements along individual labour supply curves (intertemporal
substitution in labour supply, no involuntary unemployment).
● Economic growth and business cycles can and should be explained
within a unified model framework. To explain business cycles, there is no
need to postulate nominal and/or real rigidities.
©The McGraw-Hill Companies, 2010
 A SIMPLE RBC MODEL: TECHNOLOGY

Production function: Yt  K  At Lt  , 0    1
 1
(44)
t

Actual productivity: lnAt  gt  st , (45)

st 1  st  ct 1 , 0  <1, ct N  0, 2

c 
Trend productivity: lnAt  gt (46)

Capital accumulation: Kt  1    Kt 1  St 1 (47)

For simplicity, we will assume that δ = 1.

©The McGraw-Hill Companies, 2010
A SIMPLE RBC MODEL: ECONOMIC BEHAVIOUR

Saving: St  s  Yt , 0  s  1 (48)

 wt 
Labour supply: Lt    ,   0
s
(49)
 wt 

Yt  Kt 
Profit maximization: wt   1      (50)
Lt  At Lt 

 

Trend real wage: wt  1    cAt , c k *
(51)

Labour market clearing: Lt  L s

t
(52)
©The McGraw-Hill Companies, 2010
 A SIMPLE RBC MODEL
As shown on pp. 543-44 in the text, the model (44) through (52) may be reduced to

    1   
ˆyt    ˆyt 1    st ,  1 (59)
 1   1      1   1     1 

ˆ  ˆy
L (60)
t t
Propagation mechanism in the model: A positive productivity shock
raises current income, which in turn raises saving and capital
accumulation. This leads to a higher capital stock in the next period,
which in turn raises next period’s income and saving, and so on. In this
way a temporary productivity shock generates persistence in output and
employment. Indeed, we see from Table 18.3 that the calibrated version
of the model generates too much persistence compared to the
persistence observed in the U.S. data.
©The McGraw-Hill Companies, 2010
 Standard deviation of Autocorrelation Autocorrelation
Standard deviation (%) output relative to standard in output in hours worked
Output Hours worked deviation of hours worked t-1 t-2 t-3 t-1 t-2 t-3
RBC model1 3.42 2.84 0.83 0.75 0.50 0.23 0.75 0.50 0.23
The U.S economy2 3.47 2.88 0.83 0.76 0.38 0.08 0.73 0.29 0.06

1α = 0.33, η = 0.83, ω = 0.1, σc =

0.015

2 Annual data for the business sector.

Note: The cyclical components of output and employment have been estimated via linear OLS detrending of annual data.

Source: Economic Outlook Database, OECD.

Table 18.3: The RBC model versus the U.S. economy

©The McGraw-Hill Companies, 2010

 SOME PROBLEMS WITH BASIC RBC THEORY

• The virtue of the basic RBC model is that it is simple

and fully integrates the theory of business cycles with
the theory of economic growth. However, critics
object to the theory by raising the following
questions:
• Is technological progress really so uneven as
postulated in the RBC model?
• Is it really plausible that recessions are periods of
technological regress? (Alternative hypothesis: the
observed fluctuations in productivity reflect
fluctuations in capacity utilization caused by demand
shocks.)

©The McGraw-Hill Companies, 2010

 SOME PROBLEMS WITH BASIC RBC THEORY

• Are the observed fluctuations in employment really a

reflection of intertemporal substitution in labour
supply? To reproduce the observed volatility of
employment relative to the volatility of output, the
wage elasticity of labour supply in our simple RBC
model (ε) has to be set at 4.9, which is much higher
than the elasticity estimated by labour economists.
More generally: Is all recorded unemployment really
voluntary?

• The RBC model predicts that the real wage is

procyclical. This is in line with U.S. data, but it is not
consistent with European data.

©The McGraw-Hill Companies, 2010

 THE LASTING CONTRIBUTION OF REAL
BUSINESS CYCLE THEORY

In response to these criticisms, real business cycle theorists have

recently tried to make their models more realistic by allowing for
various frictions and rigidities, including (in some cases) nominal
rigidities.

At the methodological level RBC theorists have made a lasting

contribution by pointing out that supply shocks may play an
important part in the explanation of business cycles, and by
insisting that a satisfactory theory of the business cycle should
consist of a dynamic stochastic general equilibrium model which
is able to reproduce the most important stylized facts of the
business cycle reasonably well.

©The McGraw-Hill Companies, 2010