Notes on Classical Economics
The first fact that one associates Classical Economics with is a “hands-off” policy prescription. In particular, the Classical economists believe that we are better off with a hands-off approach as opposed to trying to fine tune the economy through countercyclical policy (the Keynesian philosophy). In the simplest terms, the Classical economists believe in perfectly flexible prices and wages (both of these are nominal variables) so that all markets clear all the time. The result is a vertical aggregate supply curve (in the short and long run).
Real Business Cycle Theory
Real Business Cycle Theorists argue that the re-current fluctuations that occur in economic activity (i.e., business cycles) are caused by productivity shocks (supply shocks) and not shocks to aggregate demand (Keynesians argue that business cycles are caused by shocks to aggregate demand – the animal spirits argument).We consider two episodes, each with clear productivity shock implications. The first is the well known stagflation in the US in the 70s / Japan earthquake example where we have an adverse shock to the production function (aka, adverse supply shock). For the US 1970s example, it would be due to an oil shock (oil is part of “land”) and for the Japan example, the adverse shock is due primarily to all the physical capital (K) that was destroyed by mother nature. In the series of graphs below, we ignore the demand side effects but consider them later in a new economy example, the second episode that we consider. Note importantly, that inflationary pressures (the “flation” part) of stagflation in Japan will occur only if aggregate demand remains relatively stable. Of course, this is an unrealistic assumption and to be more complete, we would let aggregate demand fall due to all the real estate wealth that was destroyed, the lack of consumer and investor confidence, low expected wealth and income, and probably a fall in the expected marginal product of capital, all of these result in aggregate demand falling which would certainly lesson if not reverse the inflationary effects associated with the adverse supply shock.
We consider two shocks to the production function – the first set of graphics ignores any demand side shocks and is the standard ‘stagflation’ example. The second set of graphs considers positive productivity (supply) shocks as well as positive shocks to aggregate demand. This is a New Economy example that explains the facts extremely well!
STAGFLATION
How do the implications of Real Business Cycle theory match the business cycle facts
Real Business Cycle (RBC) theory does very good in explaining the business cycle facts. There are a few contradictions that RBC theorists have to address:
1) Inflation is pro-cyclical according to the facts but countercyclical according to the theory. RBC theorists argue that the empirical results, (i.e., that inflation is procyclical) are sensitive to the sample period chosen. In other words, this is no ‘biggie’ in terms of a weakness in the theory according to the RBC theorists.
2) Average labor productivity is “too” procyclical in the RBC theory – that is, in reality, average labor productivity is weakly procyclical. RBC theorists fix this by considering the effects on the cyclicality of average labor productivity when considering fiscal policy shocks (see the bar chart below).
3) Government Purchases are procyclical according to the business cycle facts – this is a problem for RBC theorists, since they believe that the aggregate supply curve is vertical and so demand side policies will not effect real variables such as output– so according to RBC theorists, G should be acyclical (i.e., ‘does not mater’, neutral). The RBC theorists have a neat fix for this apparent weakness in their theory. In fact, their ‘fix’ takes care of problems 2) and 3) together – it’s like killing 2 birds with one stone.
4) The final weakness is that according to the business cycle facts, money is procyclical and leading, implying that money is not neutral in reality. Of course this is a huge pitfall if true, since the linchpin of classical economics is money neutrality. The RBC theorists again, come up with a clever way to deal with this apparent shortfall while maintaining the money neutrality assumption.
5. The biggest shortfall of RBC theory and classical economics in general is that they cannot explain cyclical unemployment/involuntary unemployment. They argue that constant productivity shocks cause matching problems and thus, the amount of structural unemployment changes constantly, explaining the up and downs of unemployment. Most economists find this observation interesting and worthy of thought, but few really believe that matching problems can push the unemployment rate above 9%, as it was during the Great Recession. Keynesian economic theory gets the gold star here, as their model does a much better job explaining cyclical/involuntary unemployment. We will explain the Keynesian theory when we complete our discussion of classical economics.
Dealing with 2) and 3) – Average labor productivity is “too procyclical” according to the theory and Government purchases are procyclical.
The RBC theorists simply argue that higher G makes people poorer, since they either have to pay higher taxes now or in the future, to pay for the higher G. When people feel (are) poorer, they will be willing to work more at any given real wage – i.e., the labor supply curve (Ns) will shift to the right. If we add this notion to the theory, we fix two of the shortfalls at once – 1) higher G is indeed procyclical and 2) average labor productivity is countercyclical in this particular case. When you add in supply shocks as in our previous analysis, the combination of supply shocks and government spending shocks result in average labor productivity being weakly procyclical, consistent with the facts. The first graphic shows that the RBC theory matched the facts extremely well except for the average productivity correlation.
FISCAL SHOCK – RBC THEORY
The Final issue that the RBC theorists had to “deal with” is that according to the facts, money is leading and procyclical. The RBC theorists are the first ones to point out that correlation does not imply causation. The example they use is a storm window example. Just because homeowners put up storm windows before winter comes certainly does not imply that they, by putting up storm windows, are causing winter to arrive. Actually, it is the other way around (the fact that winter is coming causes people to put up storm windows). The RBC theorists refer to this phenomenon as “reverse causation.” To apply and understand the concept of reverse causation in the money output correlation, we must recall the traditional way many think that monetary policy is supposed to work (this is Keynesian). The traditional thought is that increases in the money supply lower real rates and thus stimulate C, I, and NX., and thus, Y rises. This process takes time which explains why money is a leading variable. Reverse causation suggests that changes in output (Y) is causing changes in money. Note importantly that money is a leading and procyclical variable so that changes in money must occur before changes in output. The way that RBC theorists deal with this short coming is to assume that L (real money demand) is not only a positive function of current Y but also a function of future expected income denoted Yf. The idea is that if firms expect higher output in the future, they will demand more money now for raw materials, wages, etc. The increase in economic activity will not show up in data until later, but firms need the money now. This is where it gets clever. The increase in money demand today will shift the LM curve to the left as the money market will clear at a higher interest rate. Importantly, this occurs before there is any change in output – that comes later. The Fed seeing this has two choices: 1) they can sit on their hands and let prices fall, because that is the adjustment that has to take place given the shock to L (real money demand). or 2) they can accommodate the shock to real money demand by conducting open market purchases to keep the price level from falling. Of course, the Fed has a dual mandate and half of that mandate is stable prices – so the RBC theorists argue that if the Fed is doing their job, we will see money increasing today and output rising in the future, consistent with the business cycle fact that money is leading and procyclical. Note importantly that money is still neutral in this example, consistent with the linchpin of classical economic theory. Output is going up in the future due to perhaps a positive shock to the production function. Whether or not the Fed did anything, it doesn’t matter, output is still going up, they just increase the money supply to prevent the deflation that would occur otherwise. In terms of the storm window example, it doesn’t matter that you put up your storm windows or not, winter is still coming – it is prudent for you to put up the storm windows, just like increasing the money stock due to the shock to L is a prudent thing for the Fed to do. Can you show this graphically? See below:
The Monetary Mis-perceptions Model, aka, the “fooling model” aka, the Lucas Island Model.
Reverse causation is a clever way to explain why money is a pro-cyclical and leading variable while maintaining the all important money neutrality, meaning that a “hands off: policy approach is the best. If you tried to get output to be beyond full employment output, then you will just be creating inflation, something that is undesirable and therefore welfare reducing.
But there was some evidence that there was clearly causation directly from money to output, especially in during the Volcker period. This evidence was revealed in a very famous work done be Milton Friedman and Anna Schwartz “A Monetary History of the United States, 1867-1960.”
The Model – the fooling model is based on imperfect information. Suppose the economy was made up with a series of islands, and each island produced their own unique product. Suppose you produce loaves of bread on island B. Now the model is based on you having perfect information as to your own island price (of bread) but you have imperfect information on the prices of all the other goods and services that are produced on the other islands. Given this imperfect information, you have to form expectations as to the prices of all other goods and services in this economy. Importantly, you consume all these other goods and services that are produced on the other islands.
Your nominal wage vs. your real wage. To really understand the island model we need to understand the difference in nominal wages and real wages. Suppose that you, the bread maker, makes (produces) 200 loaves of bread every day (say in 8 hours of work) and sell them initially for $1 each. Your nominal wage is therefore $200. What is your real wage? We know that real wages are expressed in terms of real goods and services. Since you eat more than just bread and that you consume more than just food, we could imagine a basket of goods and services made up of all the other goods and services produced in this island economy – the price of the basket of all these other goods and services is referred to as the aggregate price level. Let’s initially set the aggregate price level at $100 (price per basket) so that your real wage from working is 2 baskets of all these other goods and services (W/P = $200/$100 = 2).
We now add time and uncertainty to the analysis. Since you live on an island producing bread, you don’t have timely or accurate information as to the general price level, you only have perfect information as to your own island price (of bread). Given that you don’t have information as to the aggregate price level, you must form expectations of the aggregate price level, through time. Suppose that overall inflation has been running at 2% for years and thus, you expect over all inflation to run at 2% over the next year.
Scenario #1 – The price that you can sell your bread for rises to $1.02, equal to your expectation as to overall inflation. What has happened to your nominal wage? What has happened to your real wage? Nominal wage has gone up! 200 x $1.02 = $204. Your (expected) real wage, given your πe=2% is now W/P = $204/$102 = 2 baskets of all other goods and services – which is exactly the same as the old real wage. In this case, you do not change your behavior and thus, you produce the same amount of bread as you did before the price changes. Importantly, remember the following: If the expected price level equals the actual price level, then the economy is operating at full employment.
Scenario #2 – The price that you can sell your bread for rises to $1.10, well above the overall expected rate of inflation (i.e., πe = 2%). What has happened to your nominal wage? W = 200 x $1.10 = $220. Your (expected) real wage is now W/P = $220/ $102 = 2.16 baskets of all other goods and services, higher than you expected. Since you think your real wages has gone up (you are not sure since you can’t observe other island prices) you work more – recall a positively sloped labor supply curve. In the space below, draw point A when the real wage was 2 baskets of all other goods and services and locate point B where your real wage is 2.16 baskets of all other goods and services.
Expanding example: Suppose now that you hire five workers to make bread. We hold the productivity of each worker the same at 200 loaves per worker per 8 hour day. You pay each worker $100 for a day’s work and the revenue that is generated initially by each worker is $200 = 200 loaves x $1.00 per loaf. So in a sense, you, the owner of the bread factory is making a profit of $100 per worker. Let us assume that there are taxes, insurance and all other kinds of costs associated with running this business so your profit is not as large as it first appears, but let’s assume that it is equal to your opportunity costs, meaning equal to the value of your next best alternative employment.