9. business cycle in neoclassical macroeconomics

9. business cycle in neoclassical macroeconomics - Business...

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Business Cycle in Neoclassical Macroeconomics 14 October 2010 1 Reading Chapter 10 of Abel/Bernanke/Croushore 2 Adverse Demand Shock In this lecture, we focus exclusively on neoclassical macroeconomics; i.e., we assume that GE holds at all times. In a world of neoclassical macroeconomics then, what may cause a recession? Consider a negative shock to one, two, or all components of AD : C d , I d ,and G. For example, people cut consumption spending because they worry about the future; businesses cut investment spending because they perceive that future demand would be weak. For each Y, adecreasein C d and/or G means that S d = Y C d G goes up. There is a lower interest rate then in the saving—investment equilib- rium. There is similarly a lower interest rate in the saving—investment equilib- rium from a decline in investment demand. If for each Y ,thereisalower r ,the IS curve shifts in and to the left. If the economy is initially in GE, at point a. The AD shock dislocates it and moves it point b . There is a lower interest rate and a lower output level. Firms, seeing a decline in demand, lower prices. This leads to an increase in M/P .In the f nancial market, people begin to dispose of the excessive real balance for non—monetary assets, bidding up asset prices and lowering the interest rate at each Y :the LM curve shifts out and to the right. Price adjustment is completed when the IS—LM equilibrium is right at Y ,atpo int c . Free of frictions and with perfectly F exible prices, the price adjustment should be very rapid. The output decline would be at most for a very short period of time if it should persist for any positive length of time at all. AD shocks in the NCM cannot cause a recession. The economy is self—correcting from any such demand shocks. 1
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Figure 1: Increase in S Figure 2: Decrease in I 2
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Figure 3: AD demand shock in NCM 3 Adverse Supply Shock From a position of initial equilibrium, the economy is hit by an adverse supply shock. In the labor market where MPN falls at each level of employment, there will be a lower real wage and a lower level of equilibrium employment. In turn, output Y = AF ³ K, N ´ falls: the FE curve shifts to the left. There is now not a single point in the Y r space that satis f es equilibrium in all three markets simultaneously. In the absence of any kind adjustment, the output level associated with the IS-LM equilibrium exceeds the new level of full—employment output. The excess demand for goods would give rise to an increase in the price level. If M has not changed, the supply of real balance M/P decreases as P increases. Here the decline in the supply of real balance is a leftward shift of the LM curve: at each Y , there has to be a higher r to lower the demand for real balance to restore asset market equilibrium. The price level increase will cease when there is no longer any excess demand for goods; i.e., when AD on the IS curve is just equal to AS on the curve. At the new equilibrium b , output is falling by as much as supply has fallen. There is a
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This note was uploaded on 11/07/2010 for the course ECONOMICS econ2102 taught by Professor Proftse during the Spring '10 term at HKU.

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9. business cycle in neoclassical macroeconomics - Business...

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