Principles of Economics and Finance (7QQMO200)

MSc in Financial Policy and Regulation

King’s Business School
King’s College London
Lecturer: G Chortareas

Tutorial 4 – Answer Key

QUESTION 1

What are the two main components of any theory of the business cycle? Describe these
two components for the real business cycle theory.

Answer key:

The two main components of any theory of the business cycle are (1) a specification of the
types of shocks or disturbances that are believed to be the most important in affecting
the economy and (2) a model of the macroeconomy that describes how key variables
respond to these economic shocks. In the real business cycle theory, productivity
shocks are the primary source of cyclical fluctuations. The model of the economy is
the classical IS–LM model.

QUESTION 2

Define real shock and nominal shock. Give an example of it. What type of real shock
do real business cycle economies consider the most important source of cyclical
fluctuations?

Answer key:

A real shock is a disturbance to the real side of the economy that affects the IS curve or the FE
line.

1
A nominal shock is a disturbance to money supply or money demand that affects the LM
curve. Real shocks include changes in the production function, in the size of the labor
force, in the real quantity of government purchases, or in the spending and saving
decisions of consumers. Real business cycle theorists consider shocks to the production
function to be the most important. These include the development of new products
or production methods, the introduction of new management techniques, changes in the
quality of capital or labor, changes in the availability of raw materials or energy,
unusually good or unusually bad weather, and changes in government regulations
affecting production.

QUESTION 3

What is the Solow residual and how does it behave over the business cycle? What
factors cause the Solow residual to change?

Answer key:

The Solow residual is the most common measure of productivity shocks. It is strongly
procyclical, rising in expansions and declining in contractions. The Solow residual changes
when total factor productivity changes, when capital utilization changes, and when labor
utilization changes.

QUESTION 4

Define efficiency wage. What assumption about worker behaviour underlies the
efficiency wage theory? Why does it predict that the real wage will remain reads it
even if there is an excess supply of labour?

Answer key:

The efficiency wage is the real wage that maximizes effort or efficiency per dollar of
real wages. It assumes that workers will exert more effort, the higher the real wage.
The real wage will remain rigid even if there is an excess supply of labor, because
firms will not reduce the wage they pay; doing so would reduce their profits,
since workers wouldn’t work as hard.

QUESTION 5

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How does the full employment level of employment defined in the tension model
differs from that defined in the classical model? How might a productivity shock
affect the full employment level of employment for the classical model but not for
the Keynesian model?

Answer key:

Full-employment output is the amount of output produced by firms with employment

determined by the labor demand curve at the point where the marginal product of
labor equals the efficiency wage.

A productivity shock does not lead to a change in the efficiency wage, since it does
not affect work effort. But it does affect the marginal product of labor, so
employment changes. A beneficial productivity shock, for example, leads to an
increase in employment. Both the employment increase and the increase in
productivity lead to an increase in full-employment output.

Labor supply changes have no effect on the efficiency wage or employment; they
simply affect the amount of unemployment. So they have no impact on full-
employment output.

QUESTION 6

How do the assumptions of prices in the Keynesian and classical theory models have
different implications on monetary policy?

Answer key:

Price stickiness is the tendency of prices to adjust only slowly to changes in the
economy. Keynesians believe it is important to allow for price stickiness to explain
why monetary policy is not neutral.

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QUESTION 7
This question is optional and you can follow the textbook by Romer (Section 7.3).

In the Taylor model of dynamic price adjustments, firms fix the same price across
two periods. (That is to also say, half of prices are set each period).

Suppose the price setting equation is given by:

1
𝑥𝑡 = (𝑝𝑡∗ + 𝐸𝑡 𝑝∗𝑡+1 )
2

where:

𝑝∗ = 𝜙𝑚 + (1 − 𝜙)𝑝

and the innovation m follows a random walk with white noise:

𝑚𝑡 = 𝑚𝑡−1 + 𝑢𝑡 (7.29)

We can use either the lag operators approach or the method of undetermined
coefficients to solve the model. Replicate the steps of Romer, using the method of
undetermined coefficients to solve for the behaviour of output:

𝑦𝑡 = 𝑚𝑡 − 𝑝𝑡

(Hint: The method of undetermined coefficients is to guess the general functional form
of the solution and to use the model in question to derive the precise coefficients).

QUESTION 7 ANSWER KEY:

4
First, substitute 𝑝∗ into 𝑥𝑡 :

1
{[𝜙𝑚𝑡 + (1 − 𝜙)𝑝𝑡 ] + [𝜙𝐸𝑡 𝑚𝑡+1 + (1 − 𝜙)𝐸𝑡 𝑝𝑡+1 ]} (7.30)
2

As we know that half of prices are set each period, 𝑝𝑡 is the average of 𝑥𝑡 and its
𝑥𝑡−1 .
m is a random walk and therefore 𝐸𝑡 𝑚𝑡+1 = 𝑚𝑡 – we can substitute this into 𝑥𝑡 :

1
𝑥𝑡 = 𝜙𝑚𝑡 + (1 − 𝜙)(𝑥𝑡−1 + 2𝑥𝑡 + 𝐸𝑡 𝑥𝑡+1 ) (7.31)
4

Solving for 𝑥𝑡 :

𝑥𝑡 = 𝐴(𝑥𝑡−1 + 𝐸𝑡 𝑥𝑡+1 ) + (1 − 2𝐴)𝑚𝑡 (7.32)

1
(1−𝜙)
Where 𝐴 ≡
2 1+𝜙

However, we must eliminate the expectation of future prices chosen by firms.

To do so we use the method of undetermined coefficients (as an alternative to lag

operators).

Suppose that 𝑥𝑡 is some linear function of 𝑥𝑡−1 and 𝑚𝑡 – we may express this
generally as (equation 7.33 in Romer):

𝑥𝑡 = 𝜇 + 𝜆𝑥𝑡−1 + 𝑣𝑚𝑡 (7.33)

We must find the unknown parameters of this equation.

As Romer (pg 321) explains:

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“Although we could now proceed to find μ,λ, and ν, it simplifies the algebra if we
first use our knowledge of the model to restrict (7.33). We have normalized the

constant in the expression for firms’ desired prices to zero, so that p*t = pt +φyt. As

a result, the equilibrium with flexible prices is for y to equal zero and for each price
to equal m. In light of this, consider a situation where xt−1 and mt are equal. If
period-t price-setters also set their prices to mt, the economy is at its flexible-price
equilibrium. In addition, since m follows a random walk, the period-t price-setters
have no reason to expect mt+1 to be on average either more or less than mt, and

hence no reason to expect xt+1 to depart on average from mt. Thus, in this situation

P*t and Et p*t+1 are both equal to mt, and so price-setters will choose xt = mt. In

sum, it is reasonable to guess that if xt−1 = mt, then xt = mt.”

Therefore, this condition becomes:

𝜇 + 𝜆𝑚𝑡 + 𝑣𝑚𝑡 = 𝑚𝑡 ∀𝑚𝑡 (7.34)

In order for this to hold, it must be the case that 𝜆 + 𝑣 = 1 and consequently 𝜇 = 0

All this now yields:

𝑥𝑡 = 𝜆𝑥𝑡−1 + (1 − 𝜆)𝑚𝑡 (7.35)

Here we must find a value for lambda that solves our model, and as this holds for
each period, we may iterate it forward to yield 𝑥𝑡+1 = 𝜆𝑥𝑡 + (1 − 𝜆)𝑚𝑡+1 , and thus
the expectation of this future price is thus 𝐸𝑡 𝑥𝑡+1 = 𝜆𝑥𝑡 + (1 − 𝜆)𝐸𝑡 𝑚𝑡+1 which is
also written as 𝐸𝑡 𝑥𝑡+1 = 𝜆𝑥𝑡 + (1 − 𝜆)𝑚𝑡 .

We may substitute the past into the expectations of the future, that is 7.35 into this:

𝐸𝑡 𝑥𝑡+1 = 𝜆[𝜆𝑥𝑡−1 + (1 − 𝜆)𝑚𝑡 ] + (1 − 𝜆)𝑚𝑡

6
= 𝜆2 𝑥𝑡−1 + (1 − 𝜆2 )𝑚𝑡 (7.36)

We can now substitute this result into our equation 7.32 that motivated the method
of undetermined coefficients:

2 2
𝑥𝑡 = 𝐴[𝑥𝑡−1 + 𝜆 𝑥𝑡−1 + (1 − 𝜆 )𝑚𝑡 ] + (1 − 2𝐴)𝑚𝑡

= (𝐴 + 𝐴𝜆2 )𝑥𝑡−1 + [𝐴(1 − 𝜆2 ) + (1 − 2𝐴)]𝑚𝑡 (7.37)

So, if price setters believe x is a linear function of its past and a random walk, then to
maximise their profits they will set their prices as a linear function of these variables.

Therefore, this result must be equal to 7.35 if:

𝐴 + 𝐴𝜆2 = 𝜆 (7.38)

and

𝐴(1 − 𝜆2 ) + (1 − 2𝐴) = 1 − 𝜆 (7.39)

One reduces to the other (7.38 to 7.39) thus we see that both are a quadratic in
lambda, which yields the solution:

1±√1−4𝐴2
𝜆= 2𝐴
, using our definition for A earlier,

The two values are:

1−√𝜙 1+√𝜙
𝜆1 = and 𝜆2 = (7.41-7.42)
1+√𝜙 1−√𝜙

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It turns out, that the most reasonable solution to lambda is 𝜆1 – that is if price setters
believe others use that rule to set prices, it is in their interest to use that same rule.

Finally, we solve for the behaviour of output, wherein:

𝑥𝑡−1 +𝑥𝑡
𝑦𝑡 = 𝑚𝑡 − 𝑝𝑡 = 𝑚𝑡 − 2
(7.43)

𝑥𝑡−1 +𝑥𝑡−2
Substituting in 7.35 and using that m is a random walk and that 𝑝𝑡−1 = 2
, we

find:

1+𝜆
𝑦𝑡 = 𝜆𝑦𝑡−1 + 2
𝑢𝑡 (7.44)

è Shocks to demand have long lasting effects on output that persist even after
firms change their prices!