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Unformatted text preview: HAKAN YILMAZKUDAY ECO 641 - TOPICS IN MONETARY ECONOMICS AND POLICY Topic 2 : MODELS ON MONEY Explain the relationship between real business cycles and the dynamics of macroeconomic disequilibria and void equilibria like bubbles. Why are there periods in which the economy is in a boom, and why are there periods in which the economy is in a recession? Business cycles deals with this question. Although business cycles do not follow a deterministic cyclical pattern, they do exhibit a number of empirical regularities. An important one is that business cycles from different countries look very much alike. This is not meant to say that countries go through booms and recessions at the same time, but there are striking similarities in the length and the shape of fluctuations. The nature of business cycles seems to be largely independent of the stage of development, political system, or economic specialization of a country. Today, there are two schools: The Classical Schools and Keynesian School. According to the classical view private economic agents maximize their utility by optimization; the relative prices adjust to equate supply and demand ( Walrasian equilibrium ) and there is an efficiency of unfettered markets. Keynesian school believes that understanding the fluctuations in the economy is not just concerning with the general equilibrium but also dealing with the possibility that market failures may happen. Keynesian macroeconomics explains these market failures by destroying the classical dichotomy 1 by abandoning the assumption that wages and prices adjust instantly to clear markets. This approach is motivated by the observation that many nominal wages are fixed by long-term labor contracts and many product prices Macroeconomic Disequilibria remain unchanged for long periods of time. Once the inflexibility of wages and prices is admitted into a macroeconomic model, the classical dichotomy and the irrelevance of money quickly disappear. Thus, money matters. Under the light of Keynesian view, Clarida (1990) shows that if an economy is subject to uncorrelated real shocks, the expected liquidity overhang (excess money supply) rises without bound as the length of the time between price and wage adjustment increases. Thus we can say that the market failures are temporary, but the degree of this temporality depends on the length of the time between price and wage adjustment. In contrast to both Keynesian and the early new classical approaches 2 to the business cycle, real business cycle theory embraces the classical dichotomy... Nominal variables, such as the money supply and the price level, are assumed to have no role in explaining fluctuations in real variables, such as output and employment... Real business cycle theory thus pushes the Walrasian model farther than it has been pushed before. In evaluating whether it provides a successful explanation of recessions and booms, two questions naturally arise. First, why are there such large fluctuations in output and employment? And second, why do movements in nominal fluctuations in output and employment?...
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- Fall '11