Econ 116b. Problem Set 10.

Schools of Macroeconomic Thought

Due April 20, 1998 (Monday) in class.

A. Keynesians, Monetarists and Supply-Siders

Do Question 1 at the end of Chapter 19 (p.453) in the Case and Fair textbook.

B. Real Business Cycle Model

In the IS-LM (Keynesian) model that we studied earlier, we assumed that the price level is fixed in the short-run. In contrast to Keynesian theorists, a small but influential group of economists, called the new classical economists, believes that we can explain short-run economic fluctuations while maintaining the ‘fully flexible prices’ assumption of the classical model. The leading new classical explanation of economic fluctuations is called the theory of real business cycles. To explain fluctuations in real variables, real-business-cycle theory emphasizes real changes in the economy, such as changes in fiscal policy and shocks to production technologies. Here’s a central tenet of real business cycle theory:

"With fully flexible prices and wages, the level of output Y is determined by the supply of the factors of production and the production technology available."

  1. Explain the last statement. Why is output equal to potential output when prices and wages are perfectly flexible? Is there any involuntary unemployment?
  2. Under these conditions, what is the effect of an (anticipated) increase in the money supply on output, the price level and the interest rate. Show the effects in the AS/AD and IS/LM diagrams.

    3. We know that employment fluctuates substantially over the business cycle. If we want to maintain the classical assumption that the labor market clears, as new classical economists do, then we must examine what may cause these fluctuations in the quantity of labor supplied. That is, how do workers change their labor supply in response to changing economic conditions? To answer this question, we need to introduce a theory of labor supply.

    The primary reason why labor supply fluctuates is the change in the real wage over the business cycle. If the real wage is relatively high today, workers reallocate hours of work over time by working more today and less tomorrow. (Conversely, they consume less leisure today and more tomorrow). This is called the intertemporal substitution of labor. In a two-period model, labor supply today is dependent on the relative wage wtoday/wtomorrow.

  3. If workers engage in intertemporal substitution of labor, which of the following two will have a bigger impact on today’s labor supply: (i) a permanent increase in the real wage (wtoday and wtomorrow go up equally) or (ii) a transitory increase in the real wage (wtoday goes up, but wtomorrow is expected to stay the same)? Explain.
  4. Use the concept of intertemporal substitution of labor to explain how in increase in the interest rate should lead to an increase in current labor supply (holding real wages constant).

    5. Because of the effect in question 4, we can summarize the goods market in the standard real business cycle model in the following picture:

    The curve labeled real AD is just the standard IS curve, while the real AS curve depicts the positive relation between aggregate supply and the real interest rate due to the effect in question 4: a higher interest rate increases labor supply, which in turn increases the quantity of output supplied. The LM curve is left out because the money market only determines the price level in the real business cycle model.

  5. Using the Real AD-Real AS framework, show the effects of a fiscal expansion (say a rise in government spending) on output and the real interest rate. (Hint: Try to figure out whether the Real AD curve or Real AS curve has shifted.) Are the effects the same as those you saw in the IS-LM model? What causes the changes in r and Y in each model?

    6. Finally, according to real-business-cycle theory, permanent and transitory shocks should have very different effects on the economy. Let’s compare the effects of a transitory technology shock (such as good weather) and a permanent technology shock (such as the invention of a new production process). Let’s say that a technology shock, by expanding the production possibility frontier, raises both output and, because production is more profitable, labor demand, in the period(s) affected.

  6. Which shock would raise the current real wage above the expected future real wage? Which shock would cause the larger shift in real aggregate supply? Explain briefly.

    7. To see what happens to aggregate demand in the real business cycle model, we need to look at investment. Assume that firms are forward looking and, because investment takes time, invest today in order to keep the capital stock in line with expected future output (say, in the next few years). Now:

  7. Which shock would have the larger impact on the demand for investment goods? Which shock would cause the larger shift in real aggregate demand? Explain briefly.
  8. Compare the effects of the two shocks on output and the real interest rate. Use the Real AD-Real AS diagram to assist in your explanation.