Classical Business Cycle Theories

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Classical Business Cycle Theories

• Simple Classical
• Real Business Cycles
• Classical Model of Fiscal Policy
• Monetary Misperceptions

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• Classical Theories
• - Market Clearing Models Markets (labor,
  goods, money) adjust rapidly to equilibrium
• - Emphasizes Price Flexibility and the Long-Run

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Simple Classical Model

• Adam Smith The Wealth of Nations (1776)
• Assumption Economy is always at full employment
  (long-run).
• Implications
• (1) Y and there are no business cycles.
• (2) No need for government intervention.
  Self- correcting economy and the invisible hand
• (3) The nominal money supply is neutral.

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Real Business Cycle (RBC) Theory

• A Classical Theory developed by F. Kydland and E.
  Prescott (2004 Economics Nobel Winners) and
  Charles Plosser (Philly Fed President).
• Claims most business cycles can be explained by
  temporary supply shocks (A)
• Y AF(K,N) AK0.3N0.7
• ? A Y/K0.3N0.7
• Terminology
• Supply Shock
• (Total Factor) Productivity (TFP) Shocks
• (Solow) Residual

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RBC Theory

• Examples of productivity shocks
• Development of new products or production
  techniques
• Introduction of new management techniques
• Changes in the quality of capital or labor
• Changes in the price/availability of raw
  materials or energy
• Unusually good or bad weather
• Changes in government regulations affecting
  production

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Total Factor Productivity (A) the United States
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Deviations from Trend Real GDP and the Solow
Residual or Supply Shock (A)
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Total Productivity or Supply Shock (A) 2005Q3
2009Q3
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RBC Model Positive (Temp) Supply Shock
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• RBC Models imply that business cycles are
  fluctuations in full employment GDP ( ) and not
  GDP around full employment.

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Claibration

• Calibration Testing an RBC Model
• Supply Shocks (A)
• ? Model Predictions for N, w, Y, r, C, I, P

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GDP
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• Comparison with Facts
• (1) Overall volatility of GDP close to US data.
• (2) C, I are procyclical
• (3) w, N, and labor productivity (Y/N) are
  procyclical
• (4) P and inflation are countercyclical (X)
• (5) r is countercyclical (X)

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Consumption
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Investment
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Employment
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• Other Shortcomings
• (1) Need very flat NS curve to explain large
  employment fluctuations. NS curve is steep in
  U.S. labor markets.
• (2) All unemployment is natural no cyclical
  unemployment.
• (3) No role for fiscal or monetary policy (money
  is still neutral).

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Classical Model of Fiscal Policy

• Original classical theory had no role for fiscal
  (or monetary) policy.
• Government and individuals are forward-looking.
  Government purchases must be financed by current
  or future taxes
• G T
• An increase in G gt higher taxes and lower
  private saving gt lower current and future wealth
  gt increase in NS.

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Classical Model of Fiscal Policy Temporary
Increase in G
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• Economy always at long-run.
• An increase in G in IS-LM-FE Model
• Temporary increase in G
• Y increases, r increases, P increases
• Permanent increase in G
• Y increases, small effect on r and P.

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• Evidence
• (i) Temporary G shocks wartime spending and
  interest rates in the UK
• (ii) Permanent changes in G Historical growth
  in size of government.
• 1930 1990
• G/GDP 8 20
• Gov Spend/GDP 10 33
• Real Interest Rate 4.5 5

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The Growth Rate of U.S. Real Gross Domestic
Product since 1870
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• Comparison with Facts
• (1) G and N are procyclical
• (2) P is procyclical. r is procyclical (?)
• (3) C is ambiguous and I is countercyclical (X)
• (3) w and (Y/N) are countercyclical (X).
• (4) Ms is neutral (X)
• Classical economists consider this theory to be
  complementary (not a substitute) to RBC. It
  explains why G is procyclical.

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• Policy Implication Even though fiscal policy
  can create economic expansions they are
  destabilizing and undesirable. An increase in G
  (and T)
• (i) reduce private wealth and leisure
• (ii) crowds out private spending
• The nominal money supply has no effect on real
  GDP (neutral).

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How About Monetary Policy?

• Original, RBC, Classical w/ Fiscal Policy gt
  money supply is neutral!
• BC fact is that Ms is procyclical and leading.
• Two Classical Explanations
• (i) Reverse Causation
• (ii) Monetary Misperceptions

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Percentage Deviations in M1 (black) and Real GDP
(blue line)
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Figure 8.9 nominal money growth and inflation
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Reverse Causation

• Reverse causality Y (future) ? change in Ms
  (current), NOT change in Ms ? change in Y
  (reverse causation).
• Just because sick people are around doctors
  does not mean that doctors cause people to be
  sick

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• Example Supply shock and Fed reaction.
• Economy is always in long-run.
• Business cycles are caused by supply shocks
  (RBC theory)
• Feds goal is to stabilize prices
• ? Increases (Decreases) Ms in response to
  positive (negative) supply shocks.
• ? Money supply is procyclical neutral!

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Monetary Misperceptions Model

• There IS considerable evidence that money is
  non-neutral. Reverse causation, while
  reasonable, cannot be only explanation.
• How can nominal money supply have an effect on
  real GDP in a Classical Model?
• Misperceptions theory originates with Robert
  Lucas (1996 Nobel Winner) at University of
  Chicago.

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• Assumptions
• (i) What matters to producers are not aggregate
  prices P but relative prices (i.e. real)
• (ii) Imperfect Information Producers do not
  have immediate information about P and must
  formulate an expected price level Pe.
• (iii) Rational expectations The expectation of
  economic variables are based upon all available
  information.

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• Two cases
• (i) Complete information (PPe) -gt AS Vertical
• (ii) Incomplete information -gt AS
  upward-sloping
• Lucas Aggregate Supply Curve

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• Monetary Policy
• - anticipated DMs gt money is neutral
• - unanticipated DMs gt money is non- neutral in
  the short-run
• - In the long-run economy returns to FE. Money
  is neutral.
• Policy Ineffectiveness Proposition Only
  unanticipated changes in Ms by Fed can affect
  real GDP. Anticipated (systematic) changes in
  monetary policy are neutral.

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• Statistically unanticipated changes in monetary
  policy have a larger effect on GDP than
  anticipated changes.
• Rational Expectations imply that stable price low
  inflation countries should have flatter SRAS
  curves than high inflation volatile price
  countries.
• Evidence International study of trade-off
  between inflation and output (Lucas 1976).

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• Lucass study of inflation and output
• Response to 1 AD shock
• Country Inflation DP DY
• Argentina 22 (Var 0.02) 1.14 0.011
• U.S. 1.9 (Var 0.001) 0.91 1.19
• Argentina had a much steeper AS curve than the
  U.S.

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• Comparison with BC Facts
• Misperceptions theory designed to explain why
  monetary policy is procyclical. Not a
  stand-alone BC theory.
• An unanticipated shock to Ms
• (i) Money supply is procycilcal and leading.
• (ii) C, I procyclical
• Policy Implication The key to economic
  stability is a systematic and predictable
  monetary policy. Fed should grow Ms at a
  constant rate (M . Friedman).

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• Shortcomings to theory
• (i) Information lags about aggregate prices are
  too short. Unlikely that misperceptions can
  explain how monetary policy causes
  large business cycles.
• (ii) No involuntary unemployment. Cyclical
  unemployment caused by misperceptions.

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Summary of Classical BC Theories

• Assumption of market-clearing equilibrium.
• Prices, wages, expectations adjust economy
  rapidly to long-run equilibrium.
• Business cycles can be caused by supply shocks
  (RBC), and shocks to government purchases or
  monetary policy (misperceptions).
• Policy Implication Government policies can be
  an important source of business cycles. They can
  do more harm than good. Key to economic
  stabilization is to minimize government
  intervention.