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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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