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S Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

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Page 1: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

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Real Business Cycles: A New Keynesian Perspective

By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Page 2: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

N. Gregory Mankiw

Chairman of the Economics Dept. and Prof. at Harvard

Economic Advisor to the Bush Administration

Page 3: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Goal of Paper

“My goal of this essay is to appraise this newly revived approach to the business cycle” – Mankiw

Page 4: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Walrasian Equilibriums

Walrasian equilibrium in equilibrium- prices adjust to equate supply and

demand in every market simultaneously The equilibrium determines the quantities of all goods

and services and their relative prices The level of output is already determined in the

Walrasian System Price Levels can adjust to equate supply and demand in

the money market

Page 5: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Classical Theory

By introducing price levels this way. The Walrasian System can determine real

variables, output and relative prices Classical theory ignores the money market because

nominal variables do not affect real variables the money market in the view of Classical

Theory is irrelevant

Page 6: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Classical Theory Impact on Real Business Cycle Theory

Real Business Cycles embraces the Classical Theory that the money supply is irrelevant Nominal variables, such as money supply and price

level are assumed to have no role in explaining fluctuations in real variables

Page 7: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Real Business Cycle Views of Economic Fluctuation

According to RBC Theory economic fluctuations are

only caused by the forces that change the Walrasian

equilibrium

Many disturbances can generate fluctuations in the

RBC model

But a disagreement between the RBC and

Keynesian schools of thoughts regarding the

mechanic of the disturbances exist

Page 8: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Different views of Disturbances Mechanics

Consider a temporary increase in government purchases

Page 9: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

RBC View of Mechanics

RBC’s emphasizes the inter-temporal substitution of goods and leisure A increase in government purchases increase the

demand of goods To achieve equilibrium real interest rates must rise A higher real interest rate causes labor supply to

increase Thus, causing equilibrium employment and output to

rise

Page 10: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Keynesian View of Mechanics

Also predicts an increase in the real interest rate

Resulting in an increase in employment and output due to a reduction in the amount of labor unemployed because interest rates on labor supply does not play a crucial role

Problem: Walrasian approach of RBC’s does not allow for the possibility of involuntary unemployment

Page 11: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Technological Disturbances

typical business cycle consumption and leisure move in opposite directions.

In a recession consumption falls and leisure rises and in a boom it’s opposite

Business cycle theory must explain why individuals in a recession find it rational to increase the quantity of leisure they demand while decreasing the quantity of goods they demand.

Page 12: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Technological Disturbances cont.

With the production function unchanging, diminishing marginal returns would then produce a countercyclical real wage.

This is not the pro-cyclical real wage that is necessary to explain the fluctuations in consumption and leisure

Real business cycle theory describes the fluctuations as the Walrasian equilibrium changing. This is saying that the fluctuations are in fact efficient. 

Page 13: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Technological Disturbances cont.

The levels of employment, output, and consumption cannot be improved.

Attempts by the government to alter the allocations of private market, such as policies that are made to stabilize employment are best ineffective but worst case can do harm by impeding the "invisible hand."

Page 14: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Technological Disturbances cont.

optimality of economic fluctuations is the most shocking because the level of welfare is actually lower in a recession than it is in the boom that follows it.

Page 15: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Evidence on Technological Disturbances

The standard presumption increase in the economy's technological opportunities take place gradually over time but in fact there are substantial short-run fluctuations in the production function

Prescott states that there are substantial fluctuations in the Solow residual

Like Prescott, Mankiw found substantial fluctuations in measured total factor productivity

This shows that measured productivity is highly cyclical. Every year that output fell, total factor productivity also fell.

The Evidence on Technological Disturbance

Page 16: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Evidence on Technological Disturbances cont.

The standard explanation of cyclical productivity is that it reflects labor hoarding and other "off the production function" behavior.

when the economy experiences large real shocks, these shocks are easily identifiable and much discussed.

Page 17: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Real Business Cycles Theories with Multiple Sectors

Now, let’s take a look at multiple sectors and their interactions.

Page 18: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Real Business Cycles Theories with Multiple Sectors

Even if shocks to sectors are independent, the outputs move closer together. A negative shock to a sector decreases the overall wealth of the individuals and thus they reduce their demand for all goods.

For example: An adverse shock to one sector reduces the wealth of the individuals in the economy; these individuals respond by reducing their demand for all goods. An observer would see an aggregate business cycle, even without a single aggregate shock.

Page 19: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Real Business Cycles Theories with Multiple Sectors

1939-1944 total factor productivity grew an average of 7.6 percent. Demand or Supply shocks?

Solow Residual (empirical productivity growth), is not a good measure for short run and year to year comparison of production technology.

The existence of large fluctuations in the available technology is a crucial and but unjustified assumption of RBC theory.

Page 20: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Money and Prices over the Business Cycles

Before real business cycles theory was created both historical discussion and formal econometric work agreed on the conclusion that money matters.

Both discussions pointed to the Federal Reserve as an important source of macroeconomic disturbances causing a controversy as to weather systematic monetary policy could stabilize the economy, but universally accepting bad monetary policy could be destabilizing

Page 21: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Money and Prices over the Business Cycles

King and Plosser (1984): money supply endogenously responds to fluctuations of output.

M1 mostly inside money, or money created by the banking system.

K&P suggest transaction services of this inside money should be viewed as the “output” of the banking sector.

An increase in productivity in any sector will increase transaction services, and increase the output of more money by the Fed.

Page 22: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

Money and Prices over the Business Cycles

Therefore, the pro-cyclical behavior of standard monetary aggregates cannot necessarily be interpreted as evidence that changes in outside money caused by the monetary authority have real effects.

Page 23: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Tradeoff Between Internal and External Consistency

A good theory has two characteristics: internal consistency and external consistency.

An internally consistent theory is one that is has the least assumptions as possible, and invokes no peculiar axioms.

An externally consistent theory is one that fits the facts; it makes empirically refutable predictions that are not refuted.

Page 24: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Tradeoff Between Internal and External Consistency

The choice between the RBC and NK theories of the business cycle is partly a choice between internal and external consistency.

Page 25: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Tradeoff Between Internal and External Consistency

RBC theory extends the Walrasian paradigm, the most widely understood and taught model in economics, and provides a unified explanation for economic growth and economic fluctuations.

New Keynesian theory, in its attempt to mimic the world more accurately, relies on nominal rigidities that are observed but with only little understood.

NKT sometimes suggests to understand the business cycle one might have to reject the axiom rational and optimization of individuals, which jeopardizes the internal consistency.

Page 26: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The Tradeoff Between Internal and External Consistency

Mankiw’s forecast for each model:

RBC will fail to produce convincing evidence that there are substantial shocks to technology and that leisure is highly substitutable over time.

NKT has made substantial progress in providing rigorous microeconomics (fatal flaw since 1960).

Although RBC has served an important factor in provoking the scientific debate, it will ultimately be discarded.

Page 27: Real Business Cycles: A New Keynesian Perspective By N. Gregory Mankiw Presented by: Scott Pecora, Sam Parent and Bruce Heytens

The End