Chapter1continued: SchoolsofThought

Outline
1. Introduction 2. Schools of Thought
i. NewKeynesian school of thought

ii. Neoclassical school

1. Introduction
The reason why economic activity fluctuates remains a puzzle. There are many different hypotheses which offer different explanations of the data.

 The major differences theories lie in:

between

these

1. Assumptions about shocks that are the ultimate sources of fluctuations. Shocks are exogenous. 2. Assumptions about the mechanism by which the economy response to these shocks. Variables that depend on such shocks are called endogenous.

Shock = a surprise (unexpected) event beyond control of economic agencies, such as tsunami, new technologies (internet), etc.
4

EconomicTheory
Economic theory constitutes an explanation of how a set of exogenous variables X explain the behavior of a set of endogenous variables Y using logic L.

Here denotes the logic underlying the explanation.

5

A shock is some exogenous change in X and denoted by X. The theory provides a mechanism that shows how a change in X, denoted by X, might be expected to influence (change) the endogenous variables Y, denoted by Y:

There are many candidates for shocks that can change X:

Government spending shocks Monetary policy shocks Political uncertainty International shocks: 1973 oil price shock, 1997 Asian crisis Changes in net migration Technology shocks
7

We consider sudden price changes or financial crises as shocks even though they are results of human behaviour. We do this because we as yet can not explain them well enough. Differences in hypotheses about the sources of shocks led to different schools of thoughts.

2. Schools of thought
i. NewKeynesian wisdom") school ("conventional

ii. Neoclassical school

i.

NewKeynesian school

NewKeynesian (named after John Maynard Keynes) school is based on two premises: Shocks come from changes in private sectors expectations ("animal spirits") Markets are unable to solve difficult situations. Therefore, government policy is desirable.
10

 Explains economic growth as a process of gradual technological improvement, leading to a smooth longrun trend in GDP. This trend is referred to as potential GDP, or longrun supply. Business cycles are simply fluctuations around potential GDP driven by demand shocks. Actual GDP is referred to as "demand".
11

 Demand shocks are unexplained changes in spending patterns by households, businesses, government, or foreign sector. Causes of shocks: Changes in private sector expectations (animal spirits). Shocks get magnified by various market imperfections: Sticky prices, imperfect competition (S D). Market imperfections call for government stabilization: Monetary and fiscal policies. 12

ii. Newclassical school

Initiated by Joseph Schumpeter (1939). Technology shocks are responsible for both longrun economic growth and the (short run) business cycles. Therefore the distinction between "growth" and "business cycles" is artificial. Technologies do not arrive smoothly. They appear suddenly, often making the old technology obsolete. 13

 Therefore, technological changes that improve productivity in the longrun can have negative effects in the short run when economy has to restructure between sectors ("creative destruction"). Also, technologies that turn out to be disasters create negative technology shocks.

14

TheMainDifference
In both schools, changes in expectations result in changes in spending of households and companies. But in Neoclassical view, these are rational responses to technology shocks, etc. So changes in market sentiment are the result and not the cause of a business cycle.
15

"Rational" expectations do not mean people dont make mistakes, only that they form expectations the best way possible. Business cycle cannot be avoided. Therefore, government policy will do more harm than good.
16

Chapter2:Outputand Employment

17

Outline
1. Introduction 2. Simple Model of Labour Market
a. Household sector b. Business sector c. General equilibrium d. Policy implications
18

1. Introduction
A central feature of the business cycle is the comovement between output (real per capita GDP) and employment (or hours allocated to work activities per capita). In the shortrun, output and employment tend to move in the same direction.

19

 In fact, much of the change in GDP over the cycle is due to changes in the level of employment.
More people employed (workers) produce more output. But how does number of workers change?

Since labor productivity and real wages tend to move in the same direction as GDP (procyclical), some economists stress the role of productivity shocks.
20

 Changes in labour demand due to productivity shocks.

When productivity (= output per worker) is high, businesses want to hire more workers. This increase in labour demand raises real wages, and brings more people into work force. The opposite happens when productivity is low. The measure of productivity, output per worker = revenue per worker. So it is not necessary for a worker to become more skilled, just for them to make more goods (or services) the company sells. Measure of productivity differs from the common understanding of the term "productivity". 21

 According to this view, the productivity shocks affect output and as a result of this, employment and GDP fluctuates over business cycle. We will develop an explicit (mathematical) theory. This is useful because it lets us:
1. Check if the idea survives logical analysis. 2. Evaluate government policy. 3. Form a base for future models in this paper.
22

2. A Simple Model of Labour Market

Imagine there is only a household sector (people supplying labour) and business sector (companies demanding labour).
Note that, in factor markets, entities that demand (companies) and supply (people) are opposite to those in final goods market.

Moreover, lets say all goods are for final consumption (Investment (I) = 0). We call this a closed economy (no foreign sector) with no government and no investment. So, C Y.
23

 Although people differ in many respects, for simplicity we assume they are all the same (representative household).
Due to law of large numbers, many differences across people will tend to average out.

Make a similar representative firm assumption about business sector: This is the same as saying that all firms are the same. Assume no time only one period static model. 24

 The static model here implies that in making decisions, there is no intertemporal dimension (trade off between different periods) but only intratemporal dimension (choice within a given period).

25

a. Household sector
IndifferenceCurves People like to consume things, and having time off (leisure): Commodity bundle (c, l). What people like is represented by preferences: Ranking of how much people like different commodity bundles.
I prefer (c1, l1) to (c2, l2): (c1, l1) > (c2, l2); I am indifferent between (c2, l2) and (c3, l3): (c2, l2) = (c3, l3). 26

 Economists think that peoples preferences can be expressed with indifference curves, which capture 4 assumptions:
1. More is preferred to less. 2. c, l are normal goods (demand increases as income increases). 3. Diminishing marginal utility (additional doughnuts give me less and less satisfaction: MU/c < 0, MU/l < 0) 4. Transitive preferences: if A is preferred to B, and B is preferred to C, then A must also be preferred to 27 C.

Indifference curves graph peoples preferences Allpointsalonganindifferencecurvegiveus thesameutility(satisfaction).

28

Indifferencecurves applicationfor laboursupply

Households supply labour. Time can be spent either on leisure or on work. Households can substitute between consumption and leisure:
When you have a lot of leisure and a little consumption (poor), you would be willing to give up a large amount of leisure for some extra unit of consumption. But when you have only a little leisure and a lot of consumption (rich), you would be only willing to give up a small amount of leisure for extra unit of consumption. 29

 Rate at which you are willing to trade c for l depends on preferences.

This can be seen as a slope of the indifference curve, called the Marginal Rate of Substitution MRS(c, l). MRS(c, l) (of consumption for leisure) is decreasing in l. MRS(c, l) provides the relative valuation of consumption and leisure.
30

 Imagine taking away a small amount of leisure l from a household which had some utility u0 = u(c0, l0). Then: u(c0, l0 l) < u(c0, l0).
How much consumption c does this household need in order to be as well off as before we took away the leisure? It must satisfy: u0 = u(c0 + c, l0 l). For small l, c/l = slope of the indifference curve near (c0, l0). It tells us how much does this household value consumption relative to leisure. 31

 Peoples preferences differ. You may be willing to sacrifice a lot of leisure time for a big house, but I may not. Preferences tell us the willingness to substitute consumption for leisure. Why do we want to understand peoples preferences?
To be able to predict household behaviour (preferences can be written as a utility function). To be able to advice on the effects various government policies have on households. 32

Householdchoice LabourSupply
Households also face two resource constraints:
1. Time constraint between work (n) and leisure (l):

n+l=1
2. Budget constraint

c = nw + d
where w is real wage and d is nonlabour income (dividend).
33

 Household chooses the amount of consumption and leisure (c, l) so that it can maximize its utility u(c, l) subject to the budget constraint c + wl = w + d. The solution (cD, lD) to this maximization can be shown on a graph (we assume for simplicity that d = 0). Note that the demand for leisure implies the supply of labour (nS = 1 lD).
34

35

 How does the position of budget constraint depends on real wage w? Points outside constraint (C) are not affordable, points inside (B) are feasible but not efficient. Only points on the constraint (like A) are efficient. Given wage w on the labour market, households best choice is A.
36

 Two conditions are satisfied at point A:

1. Slope of indifference curve equals slope of budget line:

MRS(cD, lD) = w.
2. Optimal allocation lies on the budget line:

cD + wlD = w + d.

37

Effectsofchangeinrealwage
Increase in real wage w can be shown as an increase in the slope of the budget line. Consumption c will increase. Effect on labour supply l is ambiguous. Why?
38

39

 Substitution effect: Leisure becomes more expensive (relative to consumption). Therefore, households substitute into consumption (consumption up, leisure down). Wealth effect: People feel more wealthy, so they want to have more of both leisure and consumption (consumption up, leisure up). Both effects increase consumption.
40

 Two effects work in opposite directions for leisure: Leisure can increase or decrease, depending on which effect dominates. Studies find that labour supply responds positively to real wage rises, so we think substitution effect dominates wealth effect. People tend increase the amount of labour they supply when the real wage increases.
41

b. Business sector
Businesses use workers and production technology to make a final product:

y = zn (revenue)
z represents both marginal (dy/dn) and average product of labour (y/n). We will use z to represent productivity, and changes in z as productivity shocks. The costs of production is their total wage bill wn. The profits are distributed as dividends: d = (z w)n.
42

Businesssector LaborDemand
We assume businesses want to maximize their profits by choosing the right amount of workers n. The solution to this maximization is called labour demand. In this case, the solution is simple:

43

c. General equilibrium
Behaviour of households and firm together determines the number of hours worked and real wage in the economy. These amounts (c*, l*, n*, y*, w*) are called general equilibrium allocations. They must satisfy: Givenwagew,householdsdothebesttheycan(Allocation (c*, l*, n*), maximizesutilitysubjecttobudgetconstraint) Givenwagew andtechnologyz,firmsdothebesttheycan ((n*, y*) maximizesprofit). Realwagew clearsthemarket:Supplyoflabourby householdsmustequaldemandforlabourbyfirms: nS(w) = nD(w, z)
44

Generalequilibrium:Firmsand Householdstogether
Two states of exchange:
1. Exchange of labour for money 2. Exchange of money for products

45

Labourmarketequilibrium
Labour demand slopes downwards, because at high wage, firms can only hire few workers. Our labour demand is not smooth, because our production function was very simple (linear). Labour supply is increasing, because as w rises, people want to supply more work hours (substitution effect dominates wealth effect). Wages and employment are determined in the intercept (w* = z).
46

47

GeneralEquilibrium
The good thing is that we can explain all endogenous variables (c*, l*, n*, y*, w*) with only two exogenous variables (u, z). We just need to know peoples preferences and level of technology, and we can explain levels of wages, (un)employment, consumption and output of the economy.
48

MRS = w = z

49

ComparativeStatics:Technology Shocks
Technology shocks can change wages and (un)employment. Assume 3 levels of technology: low, medium and high z L < z M < z H. As productivity increases, firms want more workers (nD shifts to right). This raises wages and attracts more people into workforce. Changes in employment lead to changes in output: Business cycle! We have just created a theory that explains business cycles.
50

51

d. Policy implications
We have assumed that households are rational, and constrained by their income as well as time. Households optimize their behaviour. Also firms are behaving in an optimal profitmaximizing fashion. These two groups meet in a competitive market these are three major parts of all modern macroeconomic theories.
52

There are two kinds of policy implications: 1. Positive: about what does happen (prediction) 2. Normative: about what should happen (welfare) Should government stabilize the economy? Bad technology (productivity) shock ) people are worse off (lower indifference curve) Good technology (productivity) shock ) people are better off (higher indifference curve)
53

ParetoOptimality
We need a way to evaluate whether the equilibrium allocations we obtain are efficient. A natural efficiency criterion is Pareto optimality. An allocation is said to be Pareto optimal if it is impossible to find a feasible allocation that improves the welfare of some person without harming the welfare of others.
54

 Is the economys general equilibrium Pareto optimal? In other words, could a benevolent government do any better than what a competitive market delivers? The answer is that the equilibrium in our model economy is Pareto optimal. This is not a general result but holds here. This implies that there is no role for a government stabilization policy.
55

 In other words, even a benevolent government would choose to vary output and employment as in our model dictates. It is possible to show this result. The choice problem of a benevolent government is given by:

The solution to this problem corresponds to the equilibrium allocation.

56

 First order conditions imply that:

u / l MRS z u / c

MRS = w = z

57

 In fact, it is possible to argue that, government stabilization policies can make things worse sometimes. To see this, consider a negative productivity shock. As a result of a negative productivity shock, employment decreases. Assume that the government wants to stabilize the level of employment at its initial level.
58

59

As can be seen from the figure, government stabilization in this case makes people worse off. Hence, it is not clear that government stabilization policy helps.
Government policy can do more harm than good.

60

ExtendedModel

61