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Business Cycle Theory Notes

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Business Cycle Theory Summary






Real business cycle model Keynesian sticky price model Imperfect information model Segmented markets (limited participation) model Coordination failure model

Real Business Cycle Model

* Business cycle theories classified according to:
* Impulses = The source of the shocks hitting the economy
* Propagation mechanisms = The channels through which the shocks affect economic outcomes

Business cycles in the 2-period model
* Must be careful about what amount of time each "period" represents
? Natural choice is frequency that GDP is measured i.e. 1 period = 1 quarter
* First period: the current quarter
* Second period: all future quarters
? Within planning horizon of current households and firms
* [?] a temporary has very small effect on C with consumption smoothing
? MPC is small

Real business cycle theory (RBC)
* Argues that business cycles are the economy's response to exogenous shocks to TFP
? They represent the economy's efficient response to variations in its ability to produce goods and services
* Impulse:
? TFP shocks (technology shocks)
* Propagation mechanisms:
? Intertemporal substitution of leisure
? Consumption smooth
? Investment
? i.e. channels present in the dynamic model

Growth and business cycles
* In Solow model, exogenous growth in TFP is source of long-run economic growth
? With convergence dynamics driven by capital accumulation
? Solow residual is measure of TFP
? Movements in Solow residual closely related to GDP fluctuations
? [?] fluctuations in TFP could explain the business cycle
* RBC theory makes:
? exogenous TFP fluctuations the impulse of business cycles
? Capital accumulation one of the propagation mechanisms

Technology shocks RBC theory requires TFP shocks to have the following properties in order to be Course Notes Page 38

* RBC theory requires TFP shocks to have the following properties in order to be consistent with observed business cycles:
? They are exogenous
? They are relatively large and occur at business cycle frequencies
? They are neither entirely temporary nor permanent
# i.e. they are persistent (expected to dissipate gradually)
* Technology shocks = uneven pace of technological progress
? Fluctuations in anything affecting the amount of Y that can be produced for given inputs of N and K
* Sources of TFP shocks:
? Weather
? Energy prices
? Changes in regulations and institutions
* Technological shocks affect output directly through the production function
* Technological shocks also affect output through propagation mechanisms:
? Consumption smoothing
? Intertemporal substitution in both consumption and leisure
? Intratemporal substitution between consumption and leisure
? Capital accumulation What are the effects of a positive TFP shock?
? Current production function:
? Future production function:
but not by as much as z
? Shock is persistent, but neither temporary nor permanent
? Labour demand curve shifts to the right
? Income rises in the current period and in the future
# Increases the PV of the household's lifetime income stream:
? Consumption increases by less than income
? Labour supply curve shifts to the left
# Leisure is a normal good along with consumption
? Demand for investment increases
#| because z' is expected to be higher
# Demand for money increases (more transactions with higher output)Course Notes Page 39

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