EXPLAINING OUTPUT-INFLATION TRADEOFFS

 The relationship between deviations of real GDP from full employment and inflation from its
expected level

 Exists mainly because of the presence of random (unforeseen) fluctuations in aggregate demand

For a given level of expected aggregate demand, there is a given Lucas aggregate supply curve.
Fluctuations in actual aggregate demand around that expected level trace out a tradeoff along the Lucas
aggregate supply curve. Fluctuations in expected aggregate demand that are small relative to those in
actual aggregate demand create a looser relationship but do not disturb the positive correlation
between price and output fluctuations.

The slope of the output-inflation tradeoff varies across economies because of the information content in
the current price level. In an economy that experiences high and volatile inflation, fluctuations in prices
are interpreted as fluctuations in the average level of prices rather than as relative price changes, and
the output-inflation tradeoff is steeper. In an economy with low and predictable inflation rate,
fluctuations in the prices in individual sectors are interpreted as relative price changes, and the output-
inflation tradeoff is flatter.

The output-inflation tradeoff is not directly visible in the raw data on inflation and real GDP fluctuations
because of changes in the expected inflation rate.

POLICY IMPLICATIONS OF NEW CLASSICAL MODEL

 First studied by Thomas Sargent and Neil Wallace

 Anticipated changes in monetary policy have no effect on employment, output, or any other real
variable; only the price level
  Only unanticipated policy changes have real effects

The new classical model implies that anticipated policy changes have no effect on real GDP. Their
ineffectiveness arises from the fact that although a policy change shifts the aggregate demand curve,
anticipation of it also shifts the short-run aggregate supply curve. If policy is exactly anticipated, both
curves shift by the same amount, changing the price level and leaving real GDP undisturbed.

POLICY SURPRISES and the BUSINESS CYCLE

New Classical Macroeconomics:

 Initially a theory of aggregate supply

 Most new classical economists came from the monetarist school of thought, and for them
money supply was the most important source of fluctuations in aggregate demand

Two important questions:

 Do unanticipated changes in the money supply generate fluctuations in aggregate economic

activity?

 Do anticipated changes in the money supply produce changes in the money supply produce
changes only in the price level, leaving the real economy undisturbed?

Observations:

 In the late 1970s, it was believed that unexpected changes in the money supply indeed generate
aggregate fluctuations
  “Unanticipated Money Growth and Unemployment in the United States” (Robert
Barro, 1977)

 It was soon discovered that aggregate fluctuations could not, it seems, be explained by
unanticipated fluctuations in money supply

 “Does Anticipated Monetary Policy matter? An Economic Investigation” (Frederic

S. Mishkin, 1982)

 Having that conclusion, most economists concluded that the Lucas version of new classical
economics was dead

 Any unanticipated component of aggregate demand, and there are many factors in addition to
the money supply that influence the position of the aggregate demand curve, can produce the
Lucas output-inflation tradeoff.

REAL BUSINESS CYCLE THEORY

 Bases its explanation of aggregate fluctuations on exogenous, random technological change

 Two papers started the RBC Theory:

 “Time to Build and Aggregate Fluctuations” (Finn Kydland & Edward Presscott,
1982)

 “Real Business Cycles” (John Long & Charles Plosser, 1983)

The basic theory:

Jumps off from the Neoclassical Growth Model:

 Emphasizes the ongoing expansion of the economy

Real Business Cycle Theory:

 Emphasizes the erratic nature of the process of economic expansion

Constraints:

 Suppose there is a given population and a fixed work force, then the real GDP produced by this
economy depends on technology and the capital stock.
Preferences:

 Everyone has the same preferences

 There is only one person in the economy that represents all people

 Depend only on consumption of the representative person each year over an infinite future
planning period

 More consumption is preferred to less, marginal utility diminishes

Steady state:

 Not changing at all

Generating Cycles:

Accelerator mechanism:

 Level of investment is connected with the change in real GDP (income)

 Change in income does not cause change in investment

 Fluctuations only arise from technological change

 Change in technology is the source of the change in both income and investment
Real interest rate:

 Also responds to a change in technology

 Equal to the marginal product of capital, which is the slope of the production function

 When zf(k) shifts upward, its slope increases

 According to the RBC theory, in an economic upturn, real GDP grows, there’ll be a burst of
investment, interest rates will be positively correlated with investment

Extensions to labor market:

 When technological change takes place, marginal product of labor also increases

 Ergo, demand curve for labor shifts to right

 Increase in labor demand increases employment and real wage rate

Real business cycles, money, and prices:

 There is a generally positive correlation between inflation and economic activity

 Money is one of the variables influencing the economy

 Change in money supply changes aggregate demand and sets up some consequential changes in
real GDP, employment, and price level

 But according to RBC, no such effects take place

 If money were grafted on to a RBC model, it would simply determine price level

 According to the RBC theory, the quantity of money increases more quickly when the economy
is expanding because the banking system responds to the expanding economy by increasing
loans and making more credit available

 With money supply increasing, prices increase

 Thus causation runs from technological change to real economic expansion to monetary
expansion to increasing prices

 The RBC Theory is still unproven to be correct but it doesn’t mean that it is completely wrong.
COMPARISON AND CONTRAST OF THE NEW CLASSICAL AND NEW KEYNESIAN MACROECONOMICS

 New classical and new Keynesian macroeconomics are best viewed as research programs rather
than established bodies of knowledge and points of view on how the economy works.

New Classical Macroeconomics New Keynesian Macroeconomics

 Pursuing a line of research designed to
improve our understanding of
macroeconomic phenomena by
developing models that share many
features of the classical macroeconomic
model
 Embarked on a parallel program that seeks
to improve our understanding by
developing models that share features of
the Keynesian model

Agreements (Microfoundations):

 All modern macroeconomists agree that models of the aggregate economy must be consistent
with models of individual household and firm behavior

Key features of microeconomic models:

 Assumption of rational maximizing households and firms

 Households and firms interact in markets – markets for goods and services, factors of
production, and financial and real assets

Agreements (Respect for the facts):

 All modern macroeconomists regard the facts as the final arbiters of the usefulness of their
models

 Macroeconomics is driven by a central goal of explaining well-documented, actual historic

episodes
Differences:

New Classical Macroeconomics New Keynesian Macroeconomics

 We will be able to understand and predict
macroeconomic fluctuations with models
that are essentially competitive in nature
and in which markets do a good job at
allocating resources
 The existence of high and persistent
unemployment is just a real phenomenon
but one that constitutes a puzzle to be
explained as arising from fully efficient
markets that have no coordination
difficulties
 We will not be able to understand
aggregate fluctuations unless we develop
models in which markets fail in their
objective
 Existence of high and persistent
unemployment is in and of itself a
symptom of a failure of that coordination
mechanism
 Keynesian macroeconomists want to
develop models that describe the
technology of coordination in such a way
as to be able to understand why that
mechanism sometimes delivers a low rate
of unemployment and at other times a
high rate

CONCLUSION:

 Modern macroeconomists agree on two things:

 Macro models should be built on the foundations of microeconomics

 Macro models should be judged by their ability to account for the facts

 Modern macroeconomists disagree on:

 Types of models that are likely to provide a better

understanding of macroeconomic performance

 New Classical Economists are attempting to show that aggregate fluctuations can be interpreted
as arising from fluctuations in timing of economic activity

 New Keynesian Economists are attempting to show that aggregate economic fluctuations arise
because markets fail in their attempt to coordinate individual choices