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Chapter X Classical Model

Chapter X Classical Model - Chapter X Classical Business...

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Chapter X Classical Business Cycle Analysis: Market- Clearing Macroeconomics We have two questions to ask: 1. What causes the business cycle? 2. What can be done about them? 10.1 Business Cycle in the Classical Model I. The Real Business Cycle Theory Business cycle has two components 1. Shocks a. Supply shock b. Monetary policy changes c. Fiscal policy changes 2. Model that describe how key economic variables respond to the shock The real business cycle theory argues that real shocks to the economy are the primary cause of business cycles. Real shock are disturbance to the real side of the economy such as shocks that affect the production function, the size of the labor force, the real quantity of government purchases, and the spending and saving decision of consumers. This affect the IS and FE curve. Nominal shock is a shock to money supply or money demand, which causes the LM curve to shift. Productivity shock is a change is the production function; equivalently, a change in the amount of output that could be produced using given quantities of capital and labor (AKA supply shock). Development of new product Change in production methods New management technology Change in K or L Availability of energy Change in government regulation Weather a. The Recessionary Impact of an Adverse Productivity Shock An adverse productivity shock will: 1. Lower real wages
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2. Lower employment 3. Lower output 4. Raises real interest rate 5. Consumption and investment 6. Raises the prices level How? b. Real Business Cycle Theory and the Business Cycle Facts Facts: The economy is buffeted by productivity shocks Employment is procyclical Real wages will be higher during expansion than in recessions. Average labor productivity is higher in booms than in busts Recessions are a adverse productivity shock, which tend to reduce labor productivity. Inflation tends to be high during or immediately after a recession, which contrary to the business cycle (might be due to the statistical methodology) What happens if we have adverse AD or AS shock? c. Are Productivity Shocks the Only Source of Recession? Many classical economist beliefs that productivity shocks are the only source of recession. Argument is that outside of the oil shocks 73, 79 and 91, there are no other world wide supply shock. d. Does the Solow Residual Measure Technology Shock? Solow residual is an empirical measure of total factor productivity, A. Denoted: A N K Y residual a a = = - 1 This measures the size of the production shock and technological improvement. It is called a residual because it is the part of output that cannot be directly
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