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Intermediate macroeconomics chapt19

Chapter 19:
Advances in Business Cycle

Recent Macroeconomic Ideas
Real business cycle theory
– Prices are fully flexible, even in the short-run

– Stabilizations policy must show “real” effects
New Keynesian economics
– Wages and prices are sticky in the short-run

– Managing the Aggregate Demand (IS-LM model) is
the key to economic stability

Real Business Cycle Theory
Interpretation of the labor market
Importance of technology shock
Neutrality of money

Wage and price flexibility

Interpretation of Labor Market
Intertemporal substitution of labor: workers express
preferences for the time periods they supply labor hours

Time periods: 1 and 2
W = real wage rate
r = real interest rate
Intertemporal Relative Wage = (1 + r)W1 / W2

Importance of Technology Shock
Technology refers the method of combining production factors
(labor and capital)
Robert Solow using Y = AKα Lβ attributes output growth to the
growth of production factors (L,K) and technology (A) which is
a residual factor; where
ΔA/A = α(ΔK/K) - β(ΔL/L)

Growth of technology causes the growth of output

Output and Technology Growth in the U.S.

The Neutrality of Money
Money plays a “neutral” role in economic activity even in
the short-run
Monetary policy has no significant effect on output and
employment growth; it only affects “nominal” values (e.g.,
nominal interest rate and price level change, leaving real
interest rate unaffected)
Critics of this idea assert that monetary policy appear to
have strong effects on economic stability

Wage and Price Flexibility
Wages and prices are not sticky; they are flexible even in

the short-run
The foundation of macroeconomics is microeconomics in
which wages and prices respond to changes in market

New Keynesian Macroeconomics
Menu costs
Imperfect labor markets
Aggregate Demand externalities
Recession as coordination failure
Staggering of wages and prices

Menu Costs
Prices are sticky in the short-run because of the costs
associated with price adjustments

– Printing and distributing new catalogs and menus
– Distributing new price lists to sales staff
The “menu” costs lead firms to adjust prices intermittently
rather than continuously

Imperfect Labor Markets
Nominal wages are sticky in the short-run because
markets are generally regulated by labor unions which

– Keep wages sticky downward
– Regulate employment of union members to keep
union wage rate above the market wage rate

Aggregate Demand Externalities
When a firm lowers the price it charges, it slightly lowers
the general price level, raising the real money balances
The increase in real money balances expands aggregate
income, hence increasing the demand for all products
Increased demand for products requires price adjustments
for all other firms in the market

Recessions as Coordination Failure
Each firm must decide whether to cut prices after a decline
in the money supply
Firms make this decision without knowing the strategy
other firms choose
Inferior outcomes due to coordination failure would cause
a recession

Game Theory Example
Two firms: 1 and 2
Two strategies: Cut Price, Keep High price
Firm 1’s best strategy is Cut Price to make highest
possible profit
Firm 2’s best strategy is Cut Price to make highest
possible profit

Game Theory Example
Firm 2
Cut Price

Cut Price

Keep High Price

Firm 1 makes $30
Firm 2 makes $30

Firm 1 makes $5
Firm 2 makes $15

Firm 1 makes $15
Firm 2 makes $5

Firm 1 makes $15
Firm 2 makes $15

Firm 1
Keep High Price

Coordination Failure
If both firms cut prices, the gain the highest level of profit ($30
If one firm cuts the price, the other firm would keep its price
high, a recession would follow hurting the price cutting firm the
most ($5 vs. $15 of profit)
If both firms keep their prices high, a recession would also
follow, lowering profits for both firms to $15 each. This outcome
is highly probable if firms fail to coordinate pricing decisions

Staggering Price Variations
Staggering makes the overall level of prices
adjust gradually, even when individual prices
change frequently.
Firms change prices intermittently in response to
a demand shift and change in profit . Prices
change in the
– beginning of a month
– middle of the month
– end of the month

Frequency of Price Change

Percentage of Firms

Less than 1














More than 365


Staggering Wage Variations
A decline in the money supply reduces the level of
Aggregate Demand, output, and employment.
Lower employment requires nominal wage rate to
But, workers and labor unions are reluctant to
take the wage cut. The reluctance of a worker to
be the first to take a pay cut makes the overall
level of wages slow to respond to changes in the
Aggregate Demand


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