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Notes to the Instructor

Chapter Summary
This chapter extends the analysis of short-run fluctuations to consider the response over
time of key macroeconomic variables. The chapter does this by constructing a dynamic model
of aggregate demand and aggregate supply in which the time dimension is explicitly
considered. A feature of the model is that it incorporates the response of monetary policy to
economic conditions, thereby providing a more realistic setting for understanding the
interaction of policy and economic outcomes.
Comments
The material presented in this chapter is more difficult than the ADAS, ISLM models
analyzed in earlier chapters. But because many of the building blocks of this model have
already been discussed, instructors should have a relatively easy time motivating the
approach, and students should readily see the connections to what they have already
learned. The model consists of five equationsa relatively large number for undergraduates
to work withbut the discussion surrounding the model requires only basic algebra.
Dynamic solution of the model is done through simulation exercises, with figures illustrating
the time paths of different variables. Faculty who dont feel comfortable with going through
the algebra of the models details can still use the chapter effectively by relying on the
simulation figures to discuss how various shocks and changes in policy affect the economy
over time.
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download annual data on the federal funds rate,
real GDP, and the GDP price index over the past 30 years. Compute the trend level of real
GDP over time by graphing it and choosing as endpoints 1979 and 2006 (cyclical peaks). Now
construct a GDP gap series by subtracting your trend GDP from actual GDP. Compute the
inflation rate using the GDP price index. Using the specification of Taylors Rule discussed
in Chapter 14, compute predictions for the federal funds rate over this time period. Now
compare your predictions with the actual federal funds rate. When are they similar and
when are they different? Does the rule fit better after the shift in 1984 to interest-rate
targeting and away from monetary-aggregate targeting by the Federal Reserve? Assess
whether your findings suggest that monetary policy may have been too expansionary in the
early to mid-2000s, during the time when real estate prices began to rise sharply.
Chapter Supplements
This chapter includes the following supplements:
14-1 How a Real Business Cycle Model Is Constructed
14-2 The Microeconomics of Labor Supply
337
C H A P T E R
A Dy na mi c Mode l of Aggr e ga t e
De ma nd a nd Aggr e ga t e Suppl y
14
14-3 Quits and Layoffs
14-4 Involuntary Unemployment and Overqualification
14-5 Why Technology Shocks Are So Important in Real Business Cycle Models
14-6 Real Business Cycles and Random Walks
14-7 Inflation Inertia
14-8 Volatility and Growth
14-9 How Long Is the Long Run? Part Four
14-10 Additional Readings
338 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
Lecture Notes
Introduction
The chapter builds on the earlier development of the ADAS, ISLM models by
developing a dynamic model of aggregate demand and aggregate supply. This model
is another way to study short-run business-cycle fluctuations and the effects of
fiscal and monetary policies. The model is simplified version of the sorts of models
used by policymakers in formulating macroeconomic policy.
14-1 Elements of the Model
Many of the variables in the model are familiar from previous chapters, but now we
will use a t subscript to denote the time period. Thus, total output and national
income in period t will be given as Y
t
and, similarly, in period t 1 it is given as
Y
t 1
. The model is composed of five equations, which we describe below.
Output: The Demand for Goods and Services
The demand for goods and services in the economy is determined by:
Y
t
Y

t
(r
t
)
t
,
where Y
t
is the total output of goods and services, Y

t
is the economys natural level
of output, r
t
is the real interest rate,
t
is a random demand shock, and and are
parameters greater than zero. This equation is similar to the IS equation from
Chapter 10. An increase in the real interest rate lowers demand through a
reduction in both investment spending by business firms and consumption
spending by households, with the response depending on the size of the parameter
(a higher interest rate might also appreciate the real exchange rate, dampening
net exports). The demand for goods and services grows with the natural level of
output. This feature allows us to consider long-run economic growth in this model.
Finally, the demand shock represents exogenous shifts in spending that include
shifts in fiscal policy. The parameter is the natural rate of interest, which is the
value of the real interest rate when the demand for goods and services equals the
natural level of output.
The Real Interest Rate: The Fisher Equation
We define the real interest as equal to the nominal rate minus expected inflation:
r
t
i
t
E
t

t 1
which is similar to the Fisher equation presented in Chapter 4. The variable E
t

t 1
represents the period t expectation of inflation for period t 1. Notation and timing
reflect the convention of dating variables by when they are known. Accordingly, the
ex ante real interest rate r
t
and the nominal interest rate i
t
are known at time t and
represent returns between period t and t 1, and the inflation rate
t 1
, which is
a function of prices in period t and t 1, is known at t 1. The expectation of
inflation in period t is, therefore, known in period t.
Inflation: The Phillips Curve
The model uses a standard Phillips curve, similar to the one derived in Chapter 13:

t
E
t 1

t
(Y
t
Y

t
)
t
.
Lecture Notes 339
As in Chapter 13, inflation depends on expected inflation, the gap between output
and its natural level, and a supply shock
t
. The parameter determines how
responsive inflation is to changes in the output gap.
Expected Inflation: Adaptive Expectations
Expectations of inflation are formed adaptively, so that last periods inflation rate is
used as the expectation for inflation in the current period:
E
t 1

t

t 1
.
As discussed in Chapter 13, this assumption about expectations ignores the
possibility that people are forward-looking and use all available information to form
their expectations. An alternative approach, known as rational expectations,
assumes forward-looking behavior but is more complicated mathematically (and its
empirical validity is open to question). Using adaptive expectations simplifies the
analysis of the model while maintaining its key implications.
The Nominal Interest Rate: The Monetary Policy Rule
The last equation of the model is a rule for monetary policy in which the central
bank sets a target for the nominal interest rate based on inflation and output:
i
t

t

(
t

t
*)
Y
(Y
t
Y

t
).
The policy rule assumes that the central bank responds to deviations in
inflation from its target inflation rate
t
* and to deviations in output relative to its
natural level Y

t
. Policy parameters,

and
Y
, determine how much the central
bank responds to these deviations. In the absence of deviations from target
inflation (
t

t
*) and from the natural level of output (Y
t
Y

t
), the central bank
sets the real interest rate, i
t

t
, equal to the natural rate of interest . (Recall that
r
t
i
t
E
t

t 1
i
t

t
under adaptive expectations.) Thus, when inflation exceeds
its target (
t

t
*) or output is above its natural level (Y
t
Y

t
), the real interest
rate rises. And when inflation is below its target or output is below it natural level,
the real interest rate falls.
Unlike earlier chapters that focused on changes in the money supply as the
policy instrument for the central bank, here the policy instrument is the interest
rate. The implicit assumption here is that the central bank adjusts the money
supply as necessary to achieve its target for the interest rate. Choosing the interest
rate as the policy instrument is more realistic as it closely matches the practice of
central banks around the world.
Case Study: The Taylor Rule
The Fed chooses a target for federal funds rate using two general guidelines: When
inflation rises, the federal funds rate should rise, and when economic activity slows
down, the federal funds rate should fall. Economist John Taylor has proposed a
simple rule for the federal funds rate following these guidelines:
Nominal Federal Funds Rate
Inflation 2.0 0.5(Inflation 2.0) 0.5(GDP gap).
The federal funds rate responds to both inflation and the GDP gap when using this
rule. For each percentage point by which inflation rises above 2 percent, the real
federal funds rate rises by 0.5 percent. For each percentage point by which real
GDP falls below its natural rate, the real federal funds rate falls by 0.5 percent. If
instead inflation falls below 2 percent or GDP rises above its natural rate, the
federal funds rate rises or falls accordingly. John Taylors monetary rule may be the
rule that the Federal Reserve follows in setting policy.
340 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
14-2 Solving the Model
The five equations presented above determine the paths of the models five
endogenous variables: output Y
t
, the real interest rate r
t
, inflation
t
, expected
inflation E
t 1

t
, and the nominal interest rate i
t
. Before using the model to analyze
the economys response to economic shocks, we first describe the models long-run
equilibrium.
Figure 1 The Federal Funds Rate: Actual and Suggested
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Percent
Year
Actual
Taylors rule
10
8
3
2
1
5
6
9
7
4
Table 14-1 The Variables and Parameters in the Dynamic AD-As Model
Endogenous Variables
Y
t
Output

t
Inflation
t Real interest rate
i
t
Nominal interest rate
E
t

t 1
Expected inflation
Exogenous Variables
Y

t
Natural level of output

t
* Central Banks target fro inflation

t
Shock to the demand for goods and services

t
Shock to the Phillips curve (supply shock)
Predetermined Variable

t-1
Previous periods inflation
Parameters
The responsiveness of the demand for goods and services to the real interest rate
The natural rate of interest
The responsiveness of inflation to output in the Phillips curve

The responsiveness of the nominal interest rate to inflation in the monetary-


policy rule

Y
The responsiveness of the nominal interest rate to output in the monetary-
policy rule
Source: Federal Reserve Board, U.S. Department of Commerce, U.S. Department of Labor, and authors
calculations. To implement the Taylor rule, the inflation rate is measured as the percentage change in the
GDP deflator over the previous four quarters, and the GDP gap is measured as negative two times the
deviation of the unemployment rate from its natural rate (as shown in Figure 6-1).
341
The Long-Run Equilibrium
Long-run equilibrium for the model is the situation where there are no shocks and
inflation is constant over time. Applying this to the five equations of the model
gives output and the real interest rate equal to their natural values, inflation and
expected inflation equal to the target rate of inflation, and the nominal interest rate
equal to the natural rate of interest plus target inflation (Y
t
Y

t
, r
t
,
t

t
*,
E
t

t 1

t
*, i
t

t
*). The long-run equilibrium reflects the classical
dichotomy whereby real variables are determined separately from nominal ones,
and it reflects monetary neutrality in that monetary policy does not influence real
variables.
The Dynamic Aggregate-Supply Curve
To analyze the economy in the short run, we need to derive two equations that are
the analogues of the AD and AS equations of Chapter 13. The dynamic aggregate-
supply equation is the Phillips curve, with lagged inflation substituted for expected
inflation:

t

t 1
(Y
t
Y

t
)
t
. (DAS)
This equation gives rise to an upward-sloping schedule called the dynamic
aggregate-supply curve when plotted with inflation on the y-axis and output plotted
on the x-axis. Its slope reflects the Phillips curve whereby high levels of economic
activity give rise to high inflation. The curve is drawn for given values of lagged
inflation, the natural level of output, and the supply shock. If these variables
change, DAS will shift.
342 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
Income, Output, Y
Inflation,
Dynamic aggregate
supply, DAS
t
The Dynamic Aggregate Supply Curve
Figure 2
The Dynamic Aggregate-Demand Curve
To derive the dynamic aggregate-demand curve, start with the demand for goods
services equation and substitute for the real interest rate using the Fisher
equation. Next, eliminate the nominal interest rate by using the monetary policy
equation and substitute for expected inflation using the equation for inflation
expectations. Finally, cancel terms and rearrange the equation to yield:
Y
t
Y

t
[

/(1
Y
)](
t

t
*) [1/(1
Y
)]
t
. (DAD)
This equation is represented as a downward-sloping schedule called the dynamic
aggregate-demand curve when plotted with inflation on the y-axis and output
plotted on the x-axis. Its slope reflects the response of the central bank to inflation,
whereby an increase in inflation leads to an increase in the nominal interest rate by
more than the rise in inflation, so that the real interest rate also increases, thereby
reducing the quantity of goods and services demanded. The curve is drawn for
given values of the natural level of output, the inflation target, and the demand
shock. If these variables change, DAD will shift.
The Short-Run Equilibrium
The intersection of the dynamic aggregate-demand curve and the dynamic
aggregate-supply curve determines the economys short-run equilibrium. These two
relationships determine two endogenous variables (inflation and output in period t),
given the five other exogenous (or predetermined) variables. These are the natural
level of output, the target inflation rate, the demand shock, the supply shock, and
the previous periods inflation rate. The short-run equilibrium level of output can
be less than, equal to, or greater than its natural level. In the long run, it will equal
its natural level.
Note that the short-run equilibrium rate of inflation becomes next periods
lagged inflation rate and so will influence the position of the dynamic aggregate
supply curve in period t 1. This link between periods is responsible for the
dynamic patterns of adjustment of the economy in response to shocks or changes in
policy. In other words, expectations of inflation in period t 1, which determine the
position of the dynamic aggregate-supply curve in period t 1, depend on the
outcome of inflation in period t, providing a link between time periods. This
Lecture Notes 343
Income, Output, Y
Inflation,
Dynamic aggregate
demand, DAD
t
The Dynamic Aggregate Demand Curve
Figure 3
Natural level of output, Y
t
Income, Output, Y
Inflation,
DAD
t
DAS
t
The Short-Run Equilibrium
Figure 4
Short-run
equilibrium
Y
t
Y
t
continues into the future, with inflation in period t 1 in turn determining
expected inflation in period t 2, etc.
14-3 Using the Model
We can use the model to assess the effects of change in the exogenous variables. To
simplify the analysis, the economy is assumed to initially be at its long-run
equilibrium.
Long-Run Growth
As discussed in Chapters 7 and 8, increases over time in the natural level of output,
Y

t
, may occur due to population growth, capital accumulation, and technological
progress. Both the DAD and DAS curves shift to the right by an amount equal to
the increase in the natural level of output. Output increases by the same amount
and inflation is unchanged.
344 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
An Increase in the Natural Level of Output
Figure 5
4. leading to
growth in output
5. and
stable inflation.
3. as does
the dynamic
AD curve,
1. When the natural
level of output increases,
2. the dynamic AS
curve shifts to the right,
Income, Output, Y
Inflation,
DAS
t + 1
DAD
t + 1
DAS
t
DAD
t
Y
t
Y
t
Y
t + 1
Y
t + 1
A B
A Shock to Aggregate Supply
Suppose that the aggregate supply shock variable
t
increases to 1 percent for one
period of time and then returns to zero. The DAS curve will shift to the left in
period t by exactly the amount of the shock. The DAD curve will remain unchanged.
Inflation rises and output falls in period t. These effects reflect in part the response
of the central bank through its policy rule that leads to higher nominal and real
interest rates, which in turn reduces demand for goods and services and pushes
output below its natural level. Lower output dampens inflationary pressure, so
inflation does not rise by the full extent of the supply shock.
In periods following the shock, expected inflation is higher (since it depends on
the previous periods inflation), so the DAS curve does not return immediately to its
initial position. Instead, adjustment occurs gradually with inflation declining and
output rising, as the DAS curve gradually shifts to the right. Simulation analysis
that uses realistic parameter values (see the FYI box) helps to illustrate the
adjustment path for the economy over time in response to a supply shock, including
paths for the nominal and real interest rates. The simulation analysis shows the
phenomenon known as stagflation.
Supplement 14-1,
How a Real
Business Cycle
Model Is
Constructed
Supplement 14-2,
The
Microeconomics of
Labor Supply
Supplement 14-3,
Quits and Layoffs
Supplement 14-4,
Involuntary
Unemployment and
Overqualification
Supplement 14-5,
Why Technology
Shocks Are So
Important in Real
Business Cycle
Models
Supplement 14-6,
Real Business
Cycles and Random
Walks
Lecture Notes 345
B
C
A

t + 1

t - 1
Inflation,
2. causing
inflation to
rise
3. and output to fall.
1. An adverse supply
shocks shifts the DAS
curve upward,
Income, Output, Y Y
t
Y
t + 1
Y
t - 1
= Y
all
DAD
all
DAS
t
DAS
t + 1
DAS
t - 1
A Supply Shock
Figure 6
Y
all
Figure 7
The Dynamic Response to a Supply Shock
(a) Supply Shock
v
t
-2.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
Time
(e) Nominal Interest Rate
i
t
2.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0%
Time
(d) Inflation

t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5%
Time
(b) Output
Y
t
99.0
99.5
100.0
100.5
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
101.0
Time
(c) Real Interest Rate
Y
t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
3.0%
2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.4
1.2
1.0
Time
A Shock to Aggregate Demand
Suppose that the aggregate demand shock variable equals one for five periods and
then returns to its normal value of zero. This positive shock might reflect a war
that increases government purchases or a stock-market boom that raises wealth
and consumption. More generally, a demand shock could represent any event that
changes the demand for goods and services at given values of the natural level of
output and the real interest rate. In period t, the DAD curve will shift to the right.
The DAS curve remains unchanged in period t. Output and inflation both increase.
As in the analysis of the supply shock, the effects work partly through the central
banks policy rule. In response to higher output and inflation, the central bank
raises nominal and real interest rates, thereby partly dampening the expansionary
effect of the demand shock.
346 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
FYI: The Numerical Calibration
and Simulation
The textbook uses simulation analysis to explore the adjustment of the
economy to various shocks and changes in policies. Each period is best
thought of as one year in length. The model is calibrated using numerical
values for the parameters of the model and some of the exogenous
variables. These are taken to approximate the actual U.S. economy and
the policy rule proposed by John Taylor, which broadly captures the
behavior of the Federal Reserve. Graphs of the time paths of the
endogenous variables after a shock are known as impulse response
functions.
C
B
D
E
F
G
A

t + 5

t - 1

t
Inflation,
3. and
inflation
to rise.
4. In subsequent
periods, higher
expected inflation
shifts the DAS
curve upward.
1. A positive shock
to demand
2. causes output
to increase
5. When the demand
shock disappears,
output falls, and
the economy begins
its return to its
initial equilibrium
Income, Output, Y Y
t
Y
t + 5
DAS
t + 1
DAS
t + 2
DAS
t + 3
DAS
t + 4
DAS
t + 5
DAS
t - 1, t
DAD
tt + 4
DAD
t - 1, t + 5
A Demand Shock
Figure 8
Y
all
Y
all
In subsequent periods, expected inflation is higher, and so the DAS curve shifts
upward continually, reducing output and increasing inflation. When the demand
shock disappears in period t 5, the DAS curve returns to its original position. But
the DAS curve remains higher than its original level since expected inflation
remains above its original value. As a result, the decline in demand pushes output
below its natural level. The economy then gradually adjusts to its original position
as inflation is slowly reduced and output expands.
A Shift in Monetary Policy
Suppose that the central bank lowers its target for inflation from 2 percent to 1
percent and keeps it at the lower value from then on. This will cause the DAD curve
to shift to the left (and, to be exact, downward by one percentage point). Since the
target for inflation does not enter the dynamic aggregate-supply equation, the DAS
curve does not shift initially. Output and inflation initially fall. Once again, the
response of monetary policy is behind this outcome: A lower inflation target implies
that actual inflation is now above target, so the central bank raises real and
nominal interest rates. The higher real interest rate reduces the demand for goods
and services, thereby lowering output below its natural level and lowering inflation
along the initial DAS curve.
Lecture Notes 347
Figure 9
The Dynamic Response to a Demand Shock
(a) Demand Shock
e
t
-2.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
Time
(e) Nominal Interest Rate
i
t
2.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0%
Time
(d) Inflation

t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5%
Time
(b) Output
Y
t
99.0
99.5
100.0
100.5
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
101.0
Time
(c) Real Interest Rate
Y
t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
3.0%
2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.4
1.2
1.0
Time
348
C
B
A
Z

t - 1
= 2%

final
= 1%

t
Inflation,
2. causing
output to fall
3. and
inflation to
fall as well.
4. In subsequent
periods, lower
expected inflation
shifts the DAS
curve downward.
1. A reduction in target inflation shifts
the DAD curve downward,
5. Eventually, the economy
approaches a final equilibrium, with
output at its natural level and
inflation at its new, lower target.
Income, Output, Y Y
t
Y
t - 1
=
Y
final
=
DAS
t + 1
DAS
t - 1, t
DAS
final
DAD
t - 1
DAD
t, t +1
A Reduction in Target Inflation
Figure 10
Y
all
=
Y
all
Figure 11
The Dynamic Response to a Reduction in Target Inflation
(a) Inflation Target
e
t
0.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
0.5
1.0
1.5
2.0
2.5
3.0
Time
(e) Nominal Interest Rate
i
t
2.0
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
2.5
3.0
3.5
4.0
4.5
5.0
5.5
6.0%
Time
(d) Inflation

t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5%
Time
(b) Output
Y
t
99.0
99.5
100.0
100.5
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
101.0
Time
(c) Real Interest Rate
Y
t
t-2 t t+2 t+4 t+6 t+8 t+10 t+12
3.0%
2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.4
1.2
1.0
Time
With inflation lower, expected inflation falls as well, causing the DAS curve to
shift downward. Over time, the process continues with output rising and inflation
falling until the economy reaches long-run equilibrium with output at its natural
level and inflation at the new target rate of 1 percent.
The adjustment of the economy to this change in monetary policy assumes
that expectations are formed adaptively. But if the central banks announcement of
the change in its target inflation rate is credible, then people may lower their
expectation about inflation immediately. In this case, where expectations are
formed rationally based on all available information, the DAS curve will shift
downward by the same amount and at the same time that the policy change shifts
the DAD curve, and the economy will instantly reach its new long-run equilibrium.
14-4 Two Applications: Lessons for Monetary Policy
The model developed in the previous sections can be used to motivate a discussion
about the design of monetary policy. In particular, we can consider how the values
of the parameters of the monetary policy rule influence the effectiveness of
monetary policy.
Lecture Notes 349
B
A
Inflation,
Figure 12
Large change
in ouput
Small change
in inflation
Income, Output, Y
Y
t
Y
t - 1
DAS
t
DAS
t - 1
DAD
t - 1, t
Two Possible Responses to a Supply Shock
A?
B?

t - 1

t - 1

t
Inflation,
Small change
in ouput
Large change
in inflation
Income, Output, Y
Y
t
Y
t - 1
DAS
t
DAS
t - 1
DAD
t - 1, t
Supplement 14-7,
Inflation Inertia
The Tradeoff Between Output Variability and Inflation
Variability
Consider the effect of a supply shock on the economy. As shown earlier, the initial
response is for output to fall below its natural level and inflation to rise above the
central banks target. But the extent to which output declines or inflation rises
depends importantly on the slope of the DAD curve. When the slope is steep,
inflation rises relatively more and output declines relatively less, whereas when the
slope is flat, inflation rises relatively less and output declines relatively more.
Because the slope of the DAD curve depends on the parameters of the
monetary policy rule, the central bank can affect the slope by choosing whether to
respond more or less strongly to deviations from target inflation or the natural
level of output. In particular, when

is large compared to
Y
, the DAD curve is
relatively flat and the central bank responds strongly to deviations from its
inflation target by raising interest rates a lot to keep inflation contained and
responds only weakly to deviations of output from the natural level. In this case,
a supply shock has a relatively small effect on inflation and a relatively large
effect on output. Alternatively, when the central bank responds weakly to
deviations from its inflation target and strongly to deviations of output from its
natural level, the DAD curve is relatively steep and a supply shock has a
relatively large effect on inflation and a relatively small effect on output. The
central bank thus faces a tradeoff between the variability of output and the
variability of inflation.
As discussed earlier, the central bank does not face a tradeoff between the
level of output and the rate of inflation in the long runsince the classical
dichotomy holds. But it does face a tradeoff between the variability of output and
the variability of inflation.
Case Study: The Fed Versus the European Central Bank
The legislation that created the Federal Reserve gave it the dual mandate of
stabilizing both employment and prices, whereas the European Central Bank
(ECB) is charged with the primary objective of maintaining price stability, defined
as inflation close to 2 percent over the medium term. These differences in mandates
can be interpreted in our model as being reflected in different parameters in the
monetary policy rule. For the ECB compared to the Federal Reserve, more weight is
given to inflation stability and less to output stability. The events of 2008, when oil
prices rose sharply and the world economy headed into recession, support this
interpretation: The Federal Reserve lowered interest rates from 5 percent to a
range of 0 to 0.25 percent, while the ECB cut interest rates by much less.
Apparently, the ECB was less concerned about recession and more concerned about
keeping inflation contained, whereas the Federal Reserve was more concerned
about limiting the recession. Over time, one might expect the ECBs monetary
policy to result in more variable output and more stable inflation in Europe
compared to the United States. Assessing this prediction is difficult, however,
because the ECB has only been in existence for about a decade, not long enough to
have sufficient data to determine the long-term results of its policy. Also, Europe
and the United States differ in other ways besides the policy mandates of their
central banks, and these other differences may influence output and inflation
independently from monetary policy.
The Taylor Principle
Suppose that the central bank responded to a rise in inflation above its target by
cutting the real interest rate. From the monetary policy equation, this would imply
that the parameter

is less than zero:


i
t

t

(
t

t
*)
Y
(Y
t
Y

t
).
350 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
Supplement 14-8,
Volatility and
Growth
In other words, the central bank would increase the nominal interest rate by less
than the rise in inflation. This policy response will produce a positively sloped DAD
curve. Now consider a one-period demand shock. This will shift the DAD curve to
the right and initially lead to a rise in inflation and an increase in output. Higher
inflation will lead to an increase in expected inflation for next period, which will
shift the DAS curve upward. But with a positively sloped DAD curve, output rises
further and remains above its natural level because the central bank lowers the
real interest rate in response to higher inflation. Inflation becomes unstable, rising
continually to higher levels.
To prevent inflation getting out of control, the central bank must increase the
nominal interest by more than the rise in inflation (

must be greater than zero),


so that the DAD curve is negatively sloped. The requirement that the central bank
respond to inflation by raising the nominal interest more than one-for-one is
sometimes called the Taylor Principle, after economist John Taylor, who
highlighted it as a key consideration in the design of monetary policy.
Case Study: What Caused the Great Inflation?
Inflation during the 1970s in the United States reached high levels. Paul Volcker,
who was appointed chairman of the Federal Reserve in 1978, instituted a change in
monetary policy beginning in 1979 that eventually brought inflation under control.
Volcker and his successor, Alan Greenspan, subsequently oversaw low and stable
inflation for the next 25 years. Estimates of the monetary policy rule show that the
parameter

was 0.72 during the Volcker-Greenspan regime after 1979, but 0.14
during the pre-Volcker era from 1960 to 1978. This suggests that monetary policy
did not conform to the Taylor Principle in the earlier period, possibly explaining
why inflation got out of control.
14-5 Conclusion: Toward DSGE Models
Advanced courses in macroeconomics develop a class of models known as dynamic,
stochastic, general equilibrium (DSGE) models. The dynamic ADAS model
discussed in this chapter is a simpler version of these more advanced DSGE
Lecture Notes 351
C
A
B
D

t + 2

t + 1

t - 1

t
Inflation,
Spiralling
inflation
Income, Output, Y
DAS
t + 2
DAS
t + 1
DAS
t, t - 1
Y
t + 1
Y
t + 2
Y
t
DAD
t - 1, t + 1
Figure 13
The Importance of the Taylor Principle
Y
t - 1
= Y
all
Y
all
DAD
t
models. This model illustrates how the key macroeconomic variables (output,
inflation, and real and nominal interest rates) respond to shocks, interact with each
other, and adjust over time. The model also provides insight into the design of
monetary policy, highlighting the tradeoff that central banks face between
variability in output and variability in inflation. And it suggests the important
advice that central banks need to respond strongly to inflation so that it does not
get out of hand.
352 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
Supplement 14-9,
How Long Is the
Long Run? Part
Four
353
L E C T U R E S U P P L E M E N T
14-1 How a Real Business Cycle Model Is Constructed
The dynamic ADAS model developed in Chapter 14 can be used to analyze economic growth
by considering how an increase in the natural level of output affects the economy. While this
feature can be interpreted as incorporating a long-run growth path for the economy into a
model of short-run fluctuations, it can also be interpreted as allowing for elements of the real
business cycle approach (discussed in the appendix to Chapter 8) to play a role in short-run
business cycle analysis. In this sense, the model of Chapter 14 can be viewed as a hybrid
model that includes both Keynesian features that allow money to have short-run real effects
and real business cycle elements that influence short-run fluctuations. The more advanced
dynamic, stochastic, general equilibrium (DSGE) models mentioned in the text also exhibit
these hybrid characteristics. This supplement and the several to follow discuss how real
business cycle models are constructed and tested.
Real business cycle models emphasize the role of technology shocks in driving short-run
economic fluctuations. These models generally differ from other macroeconomic models, not
only in their theoretical explanation of economic fluctuations, but also in the way they are
tested with economic data. Typically, economists test a theory by ascertaining an implication
of that theory for economic data and then applying statistical and econometric techniques to
see whether or not the data are consistent with the theory. The approach of real business
cycle theorists, however, has usually been to simulate the outcomes of their models and to
compare those simulations with actual data.
A simple illustration has been provided by the economist Charles Plosser.
1
He
considered the problem of a representative individual who has to make two decisions at any
point in time.
2
First, the individual must decide how to divide her time between leisure and
working; and, second, she must decide how to divide her output between consumption and
investment to increase future consumption. The individual makes these choices in order to
maximize her expected utility (happiness), which depends upon her consumption and leisure
now and at all times in the future.
3
Plosser assumes that the individual also has access to a
CobbDouglas production function:
Here, A
t
represents the possibility of random technology shocks.
The first step in this model is calibration, or choosing values for the parameters of the
model. In this case, Plosser has to choose values for capitals share of output () and the
depreciation rate of capital, as well as for parameters reflecting the individuals preferences.
These parameters are chosen on the basis of other information that we have about the
economy.
4
Next, Plosser solves the choice problems of the agentin essence deriving a
consumption function and a labor supply function. Finally, Plosser uses the Solow residual
as a measure of technology shocks.
Plosser then simulates the model. This means that he works out how this economy
would behave under the assumption that the representative agent sees technology shocks as
unpredictable and permanent. Plosser can then find the implied series for GDP,
consumption, investment, employment, and real wages. Figures 1 to 5 show how Plossers
simulations compare with the actual behavior of the U.S. economy.
1
C. Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives 3, no. 3 (Summer 1989): 5177.
2
If the economy is competitive (as Plosser assumes), then markets will allocate resources efficiently and we are not badly misled by simply imagining
that the economy consists of a single individual.
3
Technically, Plosser assumes that the agent maximizes the following utility function:

U =
t
[log(C
t
) + log(1 L
t
)].
t = 0
He thus assumes that the agent has one unit of time, so that 1 L
t
corresponds to leisure. The parameter measures how much the agent values the
present relative to the future, and the parameter measures how much the agent values leisure relative to consumption.
4
Specifically, Plosser chooses = 0.42, = 0.95, the depreciation rate = 0.1, and the parameter such that L
t
= 0.2 at all times.
Y A K L
t t t t
=
1
.
354 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
4
6
2
0
2
4
6
1955 1960 1965 1970 1975 1980 1985
P
e
r
c
e
n
t
Actual Predicted
Annual Growth Rate of Real Output
Figure 1
4
6
6
4
2
0
2
1955 1960 1965 1970 1975 1980 1985
P
e
r
c
e
n
t
Annual Growth Rate of Real Consumption
Figure 2
Predicted
Actual
Source: Figures 1 to 5 from C. Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives 3, no. 3
(Summer 1989): 5177.
5
10
0
10
5
1955 1960 1965 1970 1975 1980 1985
Predicted
P
e
r
c
e
n
t
Actual
Annual Growth Rate of Real Investment
Figure 3
Source: C. Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives, Summer 1989.
Source: C. Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives, Summer 1989.
6
4
2
0
2
4
6
1955 1960 1965 1970 1975 1980 1985
P
e
r
c
e
n
t
Annual Growth Rate of Hours Worked
Figure 4
Predicted
Actual
Chapter Supplements 355
356 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
Interpreting these figures is not easy, but they are quite striking. In particular,
Plossers simulations for output and consumption seem to match up very well with the
actual data, although the fit is worse for investment and labor market variables. These
pictures indicate that a competitive economy hit by technology shocks can exhibit
fluctuations that broadly resemble those experienced by the U.S. economy.
A problem with this line of research is that there has been insufficient formal statistical
analysis of what constitutes a good match between simulated results and actual data. Plossers
simulations look as if they correspond to the U.S. data, but we cannot tell from inspection
whether or not there is a good fit in a more formal statistical sense. Also, as discussed in Chap-
ter 19 of the textbook, the Solow residual may not be a good measure of technological change.
The methodology followed by Plosser is essentially that pursued by most real business
cycle theorists, except that they do not usually assume a specific series (such as the Solow
residual) for technical change. Instead, they simply suppose that there are random shocks to
the technology drawn from some statistical distribution. Rather than running just one
simulation, real business cycle theorists simulate their models many times over. By doing
this often enough, they can discover the broad patterns that their models imply for the data
(for example, the correlation between output and consumption). They then compare these
patterns with those observed in actual data.
5
Much modern research in macroeconomics
examines refinements of this basic model in an attempt to improve the match between the
models and the data. Some researchers are pursuing versions of the model that include the
sort of imperfections emphasized by new Keynesian economists. As a result, many
economists are hopeful that a synthesis of real business theory and new Keynesian
economics is starting to emerge through the development of DSGE models in which money
has effects on real variables in the short run alongside the effects of technology shocks.
5
See also Supplement 7-3, Does the Solow Model Really Explain Japanese Growth? for another use of a real business cycle model. That supplement
discusses Christianos simulation of a neoclassical growth model to investigate the hypothesis that Japanese saving behavior is explained by
postWorld War II reconstruction.
6
4
2
0
2
4
6
P
e
r
c
e
n
t
1955 1960 1965 1970 1975 1980 1985
Annual Growth Rate of Real Wage Rate
Figure 5
Actual
Predicted
Source: C. Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives, Summer 1989.
357
L E C T U R E S U P P L E M E N T
14-2 The Microeconomics of Labor Supply
Many economists are unconvinced that real business cycle theory can adequately explain
fluctuations in employment. To pursue this further, we start from two features of this
theory: first, prices are assumed to be flexible; and, second, shocks to technology are the
driving force behind economic fluctuations.
Since prices are flexible, it follows that the labor market is always in equilibrium, so
labor demand always equals labor supply. Technology shocks affect the marginal product of
labor and so cause the demand for labor to shift. Looking at the effects of shifts in labor
demand in Figures 1A and 1B, we see that steep labor supply implies little variation in
employment and large variation in the real wage; whereas if labor supply is flat, then real
wages would be relatively stable and employment would vary substantially. The data exhibit
much employment fluctuation and little real-wage variation. It follows that, to explain the
data, real business cycle theories need either a relatively flat labor supply curve or an
explanation of why technology shocks might also shift labor supply. We consider each in turn.
Neither theory nor the data provide a great deal of support for a flat labor supply curve.
An individuals labor supply decision is based on the choice between leisure and goods.
Individuals have a certain amount of time at their disposal, which they can either take as
leisure or else can use for working in order to earn income with which to buy goods. The real
wage, w, is the relative price of leisure in terms of goods. The higher the real wage, the more
goods must be forgone for an extra hour of leisure. We illustrate this in the standard
microeconomic manner in Figure 2.
w w
L
(A)
L
(B)
L
s
L
d
L
s
L
d
24w
24w
^
G
o
o
d
s
Leisure
24
L
s
A
B
Figure 2
Figure 1
We suppose that the individual has 24 hours to allocate between working and leisure.
At one extreme, she could not work at all and take all her time as leisure. At the other
extreme, the worker could work all 24 hours, have no leisure time, and consume 24w worth
of goods. The line connecting these two points is the budget line; any point on this line is a
feasible combination of leisure and goods. The optimal combination of goods and leisure is
found where the indifference curve is tangent to the budget line.
Now suppose that the real wage rises to w. We can see from Figure 2 that although
leisure has now become more expensive, the individual may increase (case A) or decrease
(case B) her supply of labor. The reason is that changes in the real wage generate income
and substitution effects that act in opposite directions. The substitution effect encourages
people to work more (that is, consume less leisure) when the wage goes up. A rise in the real
wage, however, increases the income from working, allowing the individual to consume more
leisure. Thus, the effect of an increase in the real wage on labor supply is theoretically
ambiguous. It is perhaps not surprising that the data show that changes in the real wage do
not have strong effects on labor supply. In terms of our original diagrams, therefore, the
labor supply curve is steep. Contrary to the data, we would expect to see large changes in the
real wage and small changes in employment if the economy is competitive and characterized
by changes in labor demand.
We observe a larger change in employment and a smaller change in the real wage if
technology shocks affect both labor demand and labor supply in the same direction. This can
occur if the interest rate changes or if there is a temporary change in the real wage. For
example, if the real wage is high in the present but expected to be low in the future, workers
might prefer to work very hard when the wage is high and take much leisure time when the
wage is lower. To put the same point a slightly different way, labor supply might be very
responsive to short-run fluctuations in the real wage, even if it is not responsive to long-run
changes. Similarly, if the interest rate is higher, working today looks relatively attractive.
We can illustrate this in terms of the labor market by putting the current real wage on
the axis and noting that changes in the expected future real wage or the interest rate shift
the labor supply curve, as in Figures 3A and 3B.
An increase in the future real wage (w
t + 1
) makes the current supply of labor less
attractive and so causes the labor supply curve to shift inward. An increase in the interest
rate is like a decrease in the future real wage and so shifts the labor supply curve outward.
Now, consider a temporary shock to labor demand (caused perhaps by a temporary
shock to the technology). This shock does not affect the future real wage and so leads to a
relatively large change in employment. Such a shock is unlikely to have a large effect on the
358 CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply
(A) (B)
L
t
L
d'
L
d
L
s
(w
t+1
, r)
w
t
w
t
L
s
(w
t+1
, r)
L
d
L
d'
L
t
L
s'
Figure 3
Lecture Notes 359
interest rate. On the other hand, a permanent (positive) shock to labor demand leads to
expectations of higher real wages in the future, causing the labor supply curve to shift in.
This results in a relatively small change in employment.
A focus on temporary changes in the real wage thus allows real business cycle theory to
explain fluctuations in employment while recognizing that labor supply need not be very
sensitive to real wages in the long run. Microeconomic analyses of individual labor supply,
however, are still not very supportive of strong intertemporal substitution effects of this
kindthat is, they do not indicate that labor supply is very responsive to temporary real
wage changes or to changes in the interest rate.
L E C T U R E S U P P L E M E N T
14-3 Quits and Layoffs
Job separations can occur either because workers voluntarily quit their jobs or because they
are laid off (or fired with cause). We can thus write
s = q + l,
where s is the separation rate (see Chapter 6), q is the quit rate, and l is the layoff rate.
Theories of intertemporal substitution argue that employment is lower in recessions because
the real wage (or the interest rate) falls and workers are unwilling to work at this lower
wage. Such an explanation suggests that quits should be an important component of flows
from employment to unemployment, and also that quits should be higher in recessions.
The data reveal, however, that layoffs are much more important than quits in
explaining flows into unemployment. Data suggest that less than 15 percent of the unem-
ployed become unemployed as a result of quitting their job. For example, unemployment in
2005 was 7.6 million. Of these, 3.7 million (48 percent) were unemployed as a result of
layoffs, and 0.7 million (9 percent) were new entrants into the labor force. Of the remainder,
2.4 million (31 percent) had been previously employed and were reentering the labor force
after a spell of nonparticipation. Only 0.9 million (12 percent) were job leaversthat is,
individuals who quit their jobs voluntarily.
1
Finally, the data indicate that quits are
procyclical and layoffs are countercyclical. These data do not support the belief that
employment fluctuations over the business cycle are the result of voluntary shifting of labor.
360
1
U.S. Department of Labor, Bureau of Labor Statistics.
L E C T U R E S U P P L E M E N T
14-4 Involuntary Unemployment and Overqualification
Some economists distinguish between two types of unemployment: voluntary and
involuntary. According to the usual definition, someone is voluntarily unemployed if, at the
existing wage, she does not think it worthwhile to work. A person who is involuntarily
unemployed would like to work at existing wages but cannot obtain a job.
Other economists argue that the idea of involuntary unemployment makes no sense.
After all, they suggest, an unemployed investment banker or neurosurgeon could always get
a job flipping hamburgers or waiting tables. So how can we distinguish between involuntary
and voluntary unemployment? Robert Lucas expands on this argument as follows:
1
Nor is there any evident reason why one would want to draw this distinction. Certainly the more
one thinks about the decision problem facing individual workers and firms the less sense this
distinction makes. The worker who loses a good job in prosperous times does not volunteer to be
in this situation; he has suffered a capital loss. . . . Nevertheless the unemployed worker at any
time can always find some job at once. . . . Thus there is an involuntary element in all
unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary
element in all unemployment, in the sense that however miserable ones current work options,
one can always choose to accept them.
Truman Bewley, an economist at Yale University, interviewed a large number of
businesspeople in order to learn more about their decisions about hiring workers. His
findings suggest that it may not be quite so easy for unemployed workers to find jobs, even
at lower wages
2
:
Cannot workers find jobs immediately simply by accepting sufficiently low pay? Perhaps the
clearest regularity of the survey was that large classes of unemployed workers find it very difficult
to obtain work paying substantially less than what they earned before, unless they take temporary
jobs or low-paying jobs in the secondary labor market. Most employers offering good permanent jobs
shun workers who earned significantly more previously, significantly meaning 2030 percent more.
Employers label such workers as overqualified and fear that they will be discontent, be a threat to
their supervisors, and above all, will leave as soon as they find better jobs.
Note that Bewleys findings do not completely contradict Lucass argument. They suggest
that the unemployed investment banker could indeed get a job flipping hamburgers. But they
also suggest that this unfortunate investment banker probably cannot do much better.
361
1
R. Lucas, Unemployment Policy, American Economic Review, Papers and Proceedings 68 (May 1978): 354.
2
T. Bewley, A Depressed Labor Market as Explained by Participants, American Economic Review, Papers and Proceeding 85, no. 2 (May 1995): 253.
A D V A N C E D T O P I C
14-5 Why Technology Shocks Are So Important
in Real Business Cycle Models
In any competitive flexible-price model, such as those espoused by real business cycle
theorists, labor market clearing implies that the real wage must equal the marginal product
of labor. As explained in Chapter 3, the marginal product of labor gives the firms demand
for labor and depends upon the amount of capital and labor that firms possess. In particular,
we expect to see diminishing marginal product: the marginal product of labor will be lower
when employment is higher, other things being equal. We write
MPL(K, L) = W/P.
We know that employment is procyclicalnot surprisingly, employment is higher in
booms and lower in recessions. Other things being equal, we would expect to see the
marginal product of labor falling in booms, and hence, if the economy is competitive, we
would expect to see the real wage also being lower in booms. But we also know from Case
Study 13-1 that the real wage is actually mildly procyclicalreal wages are higher in booms
and lower in recessions.
1
It follows that if we are to reconcile a procyclical real wage with diminishing marginal
product of labor in a competitive model, other things are not equal. Something must happen
in booms to raise the marginal product of labor even though employment is higher. Since the
capital stock changes only slowly and does not vary in any significant way over the business
cycle, the only possibility is that the marginal product of labor is higher in booms because of
technological improvements. This is why technology shocks are an essential ingredient of
real business cycle models.
If the economy is not competitive, these issues need not arise. First of all, the demand
for labor may depend upon other factors. For example, when prices are sticky, firms may
demand less labor in recessions because they cannot sell all their output (whereas in a
competitive model with flexible prices, firms can always sell as much as they want at the
market price).
As another example, suppose that the economy is not perfectly competitive but instead
exhibits imperfect competition. We can rewrite the earlier equation as
P = W/MPL.
This says that, in a competitive economy, the price of output equals the marginal cost of
production (since the wage is the cost of a unit of labor and the marginal product of labor
gives the amount of output contributed by the last unit of labor). Under imperfect
competition, however, firms set prices as a markup (m) over marginal cost:
P = m (W/MPL)
MPL/m = (W/P).
In this case, the real wage can be procyclical even if the marginal product of labor is
countercyclical, provided that the markup is also countercyclical. That is, if markups are
higher in recessions, then MPL/m will be lower, and so the real wage may be lower.
1
Procyclical real wages are also a necessary ingredient of real business cycle theory. If high employment in booms and low employment in recessions
arise from voluntary shifting of labor, it follows that workers are choosing to consume less leisure in booms and more leisure in recessions. But why
would they choose to consume less leisure and more consumption goods at the same time? The answer has to be that leisure is relatively more
expensive in boomsthat is, real wages must be higher.
362
Chapter Supplements 363
There are reasons for believing that markups may indeed be countercyclical. One
reason why markups may fall in booms is that higher profits when the economy is booming
cause more firms to enter an industry. The more firms in the industry, the closer it is to
being competitive, and so the lower is the markup. Another possibility is that imperfect
competition reflects collusion among firms, and firms maintain such collusion by a threat to
increase output if other firms cheat. In a boom, demand is high, so the potential gain from
cheating is greater and firms can sustain less collusion.
2
Mark Bils investigated the behavior of marginal cost and price over the course of the
business cycle. He found that marginal costs are strongly procyclical but prices do not vary
much over the business cycle. His evidence suggests that the markupthe difference
between price and marginal costis countercyclical.
3
Julio Rotemberg and Michael Woodford investigated a real business cycle model with
some imperfect competition and countercyclical markups. They carried out simulations and
argue that they were better able to match the U.S. data by their inclusion of imperfect
competition.
4
This may be an encouraging route for synthesis between real business cycle
and new Keynesian theories. Once we introduce imperfect competition, however, there is no
longer a presumption that fluctuations are efficient and there may be a case for government
intervention to stabilize the economy.
2
For theoretical exposition of these ideas, see S. Chatterjee and R. Cooper, Multiplicity of Equilibria and Fluctuations in Dynamic Imperfectly
Competitive Economies, American Economic Review, Papers and Proceedings 79 (May 1989): 35357; and J. Rotemberg and G. Saloner, A
Supergame-Theoretic Model of Price Wars During Booms, American Economic Review 76 (June 1986): 390407.
3
Mark Bils, The Cyclical Behavior of Marginal Cost and Price, American Economic Review 77 (December 1987): 83855.
4
J. Rotemberg and M. Woodford, Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity, mimeo (November 1989).
A D V A N C E D T O P I C
14-6 Real Business Cycles and Random Walks
Real business cycle theory provides a challenge to the traditional explanation of macro-
economic fluctuations. One reason why this theory has been so influential is the work of two
economists, Charles Nelson and Charles Plosser.
In an important article published in 1982, Nelson and Plosser argued that there is
evidence to suggest that U.S. GDP may follow a random walk.
1
That is, they suggested that
the behavior of real GDP over time could be described by the equation
Y
t
= Y
t 1
+ u
t
, (1)
where u
t
is a random shock that is zero on average. This equation states that the best
prediction of GDP this year is whatever value it had last year.
The conventional view of macroeconomic fluctuations is that the behavior of GDP over
time can be decomposed into a long-run natural-rate or trend component and a short-run
cyclical component. This approach underlies the models used in the textbook: the Solow growth
model explains the long-run behavior of the economy and the aggregate demandaggregate
supply model explains short-run fluctuations. In this view, shocks to the economy will push it
away from the natural rate only temporarily; the economy always has a tendency to revert to
the natural rate. But the NelsonPlosser finding challenges this characterization. If GDP does
follow a random walk, then shocks to output have permanent effects.
To see this, suppose that at some time (t = 0), GDP is at the value Y
0
, and that at t = 1
there is a one-unit shock to GDP (u
1
= 1). Suppose also that there are no further shocks (u
2
=
u
3
= . . . = 0). Then
Y
1
= Y
0
+ 1.
Now
Y
2
= Y
1
+ u
2
= Y
1
= Y
0
+ 1.
Similarly,
Y
3
= Y
0
+ 1,
and so on. The shock to GDP in period 1 persists forever. Following this shock, our best
prediction about GDP is that it will forever be one unit higher (Figure 1).
The observed fluctuations in GDP, according to this theory, are then fluctuations in the
natural rate of output, not cyclical fluctuations of output around the natural rate. Whereas
the traditional theory suggests that technological progress is a relatively smooth and
gradual process, real business cycle theory suggests that technological progress is irregular
and a source of fluctuations. Indeed, if this real business cycle characterization of the data is
accurate, then the traditional decomposition of output into cycle and trend does not really
make sense.
If GDP does not follow a random walk, then the conclusion is very different. Suppose,
for example, that the behavior of GDP can be described by the equation
Y
t
= 0.9Y
t 1
+ u
t
. (2)
364
1
C. Nelson and C. Plosser, Trends and Random Walks in Macroeconomic Time Series: Some Evidence and Implications, Journal of Monetary
Economics 10 (September 1982): 13967.
Lecture Notes 365
Then, if we carry out the same experiment, we find that the shock raises output by 1 at time
t = 1, as before. Next period, however, output is 0.9 higher as a result of the shock. In period
3, output is only 0.81 (= 0.9
2
) units higher, and so on. In other words, the impact of the shock
on GDP gradually dies out. In this representation, shocks to the economy are temporary, not
permanent, and output does tend to return to the natural rate following a shock (Figure 2).
So, if the NelsonPlosser result is right, and GDP can be well described by a random
walk, we need to think in terms of models where shocks have permanent effects. In terms of
standard aggregate demandaggregate supply models, this suggests that real or supply
shocks, such as to technology, govern the behavior of GDP; aggregate demand shocks do not
have permanent effects on output in such models. Demand shocks may, however, have
permanent effects on GDP in other models such as the hysteresis models discussed in
Chapter 13. Steve Durlauf, however, points out that if GDP follows a random walk, it is also
consistent with a world in which coordination failures are important. In this case, demand
shocks might push the economy from one equilibrium to another.
2
Unfortunately, it is very hard to distinguish in the data between equations (1) and (2),
and so we simply are not sure whether the random-walk characterization is accurate. Very
different theories will generate very similar predictions for the behavior of GDP. For
example, a world with demand shocks and very sticky prices is one in which shocks would
exhibit a great deal of persistence, so GDP might appear close to a random walk. On the
basis of GDP data alone, it is nearly impossible to distinguish between this economy and an
economy governed by real shocks.
Modern macroeconomics is making progress toward a synthesis in which it is recognized
that both demand and supply shocks have important effects on output.
3
In this view, the nat-
ural rate of output grows irregularly, as suggested by real business cycle theory, rather than
exhibiting the smooth change of the Solow growth model. Nevertheless, demand shocks may
still cause the actual level of GDP to differ from the natural rate and so may be an additional
source of variability in GDP. In principle, in such a world, there is still room for stabilization
policy in order to eliminate inefficient cyclical fluctuations. Eliminating all fluctuations is no
longer desirable, however, since some variation in GDP is an efficient response to technology
shocks. Although many economists doubt that real business cycle theory completely explains
economic fluctuations, most might agree that it teaches the important lesson that some varia-
tion in GDP is to be expected and is indeed desirable in a well-functioning economy.
2
S. Durlauf, Output Persistence, Economic Structure and the Choice of Stabilization Policy, Brookings Papers on Economic Activity 2 (1989): 69136.
3
See, for example, O. Blanchard and D. Quah, The Dynamic Effects of Aggregate Demand and Supply Disturbances, American Economic Review 79
(September 1989): 65573.
Y
Figure 1
1 Time
Figure 2
1
Y Y
Time
366
L E C T U R E S U P P L E M E N T
14-7 Inflation Inertia
The Phillips curve used in the dynamic ADAS model of Chapter 14 can be derived under
the assumption that all firms have the ability to set prices and some of those firms set their
prices one period in advance. As shown in Chapter 13, this assumption implies a Phillips
curve that relates period t inflation to the period t 1 expectation of period t inflation and
the gap between actual and the natural level of output. Introducing adaptive expectations
then allows derivation of the DAS curve, which relates period t inflation to period t 1
inflation and the deviation in output from its natural level. The effect of lagged inflation in
the DAS curve is responsible in the model for the gradual adjustment of inflation in response
to shocks.
A more sophisticated approach, known as staggered price setting, assumes that firms
all set prices in advance for two periods, with half of the firms setting prices in any given
period. Staggered price setting makes the overall level of prices adjust gradually, even when
individual prices adjust frequently. In other words, the price level will adjust fully to an
increase (decrease) in aggregate demand only after a period of time during which output
exceeds (falls short of) its natural rate. But a surprising implication of these New Keynesian
models of staggered price setting under rational expectations is that inflationthe percent
change in pricesdoes not exhibit inertia. Instead, inflation is expected to decline when
output is above its natural rate and vice versa.
1
The reason for this result is that when price-setters fix a price for the current and
future periods, they consider not only todays overall price level, but also the price level
expected to prevail in the future. The resulting Phillips curve expresses inflation as a
function of next periods inflation and the current output gap. Accordingly, a declining path
for inflation is associated with output above its natural rate.
Evidence for the United States and many other countries contradicts this implication
and supports the view that inflation is highly persistent. Periods of disinflation across
countries are overwhelmingly periods when output is below normal.
2
And estimates of the
inflation process for the United States find that lagged inflation helps explain current
inflation.
3
Various ways of reconciling New Keynesian models of price dynamics with evidence of
inflation inertia have been proposed. These include adding delays in price adjustment,
incorporating some backward-looking price-setters, indexing fixed prices to overall inflation
between adjustments, and introducing more complex dynamics in costs or markups.
Greg Mankiw and Ricardo Reis have suggested changing the basic framework from one
with sticky prices to one with sticky information.
4
Instead of assuming full information
with staggered price setting, Mankiw and Reis assume firms can always adjust prices but
are limited by the cost of obtaining and processing information. As a result, firms may
choose a path for their prices that is set until the next time they update their information.
The result leads to a Phillips curve in which past inflation affects current inflation and in
which disinflations are associated with below-normal output.
One drawback of the Mankiw-Reis approach is that it does not allow a role for fixed
prices, despite evidence of their importance in the economy. In addition, the sort of
1
This supplement draws on the discussion in Chapter 6 of David Romer, Advanced Macroeconomics, third edition, (New York: McGraw-Hill/Irwin,
2006).
2
See Laurence Ball, What Determines the Sacrifice Ratio? in N.Gregory Mankiw, ed., Monetary Policy, (Chicago: University of Chicago Press, 1994):
155-183.
3
See Jeffrey Fuhrer, The (Un)Importance of Forward-Looking Behavior in Price Specifications, Journal of Money, Credit, and Banking, 29 (August
1997): 338-350.
4
N. Gregory Mankiw and Ricardo Reis, Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve, Quarterly
Journal of Economics, 117 (November 2002): 1295-1398.
Lecture Notes 367
predetermined paths that firms choose in their model do not appear to be widespread in the
economy. Furthermore, fixed prices appear essential for explaining why shifts in aggregate
demand have smaller and shorter-lasting effects in high-inflation economies, and why the
announcement in advance of disinflation policies doesnt measurably affect the output costs
of disinflation. Most likely, a complete framework for explaining inflation dynamics will
require both fixed prices and predetermined price paths.
368
A D D I T I O N A L C A S E S T U D Y
14-8 Volatility and Growth
Garey Ramey and Valerie Ramey investigated the connection between the growth and the
volatility of GDP in a number of different countries.
1
They wished to find out if long-run
growth and short-run volatility were related. As a matter of theory, growth and volatility
could be directly or inversely related. For example, large fluctuations in output might make
firms reluctant to commit to irreversible investment, implying that growth would be lower in
countries with highly variable output. Conversely, consumers in a relatively uncertain world
might save a lot, which could lead to higher growth.
Figure 1 shows the relationship between volatility and growth in OECD countries,
measured over the period 19521988.
2
There is a strong negative relationship: countries
with highly variable output tend to be countries that grow more slowly, and conversely. One
implication of Ramey and Rameys findings is that the benefit of reducing business cycle
fluctuations might therefore be larger than is commonly supposed: stabilization of the
economy in the short run might help promote growth in the long run.
Figure 1
CAN
ITAL
USA
AUT
NLD
GBR
BEL
PAT
DEU GRC
CHE
ISL
LUX
ESP
FIN
DNK
NZL
IRL
TUR
3.82
Standard deviation of output growth
2.03
2.02
AUS
SWE
JPN
FRA
NOR
4.07
M
e
a
n

o
u
t
p
u
t

g
r
o
w
t
h
Source: G. Ramey and V. Ramey, Cross-Country Evidence on the Link Between Volatility and Growth, American Economic
Review 85, no. 5 (December 1995): 1143.
1
G. Ramey and V. Ramey, Cross-Country Evidence on the Link Between Volatility and Growth, American Economic Review 85, no. 5 (December
1995): 113851.
2
In constructing this figure, Ramey and Ramey controlled for a number of factors that could cause differences in growth rates, including initial real
GDP, initial human capital, average investment rates, and population growth rates.
369
L E C T U R E S U P P L E M E N T
14-9 How Long Is the Long Run? Part Four
Macroeconomists traditionally decompose the overall behavior of GDP through time into its
long-run growth (or trend) and its short-run fluctuations (or cycle). That is the approach
followed in the textbook. Chapters 3 to 8 explain the determination of the natural level of
output at a point in time and show how the natural level of output grows through time as
the economys resources and technology change. Chapters 9 to 13 explain how actual GDP
may differ from the natural level in the short run because of shocks to aggregate demand
combined with an upward-sloping aggregate supply curve (as a result of price stickiness or
information imperfections). Thus, Chapters 3 to 8 explain the trend growth of GDP, whereas
Chapters 9 to 13 explain the business cycle.
The simple dynamic model presented in Chapter 14 incorporates elements of both
short-run business cycle fluctuations and long-run economic growth into a unified
framework. It does so by allowing for growth over time in the natural level of output within
a model that has sticky prices in the short run. Economists have developed much more
sophisticated models, known as stochastic, dynamic, general equilibrium models, in which
this traditional decomposition between trend and cycle can be misleading. Both the short-
run fluctuations in output and the long-run growth of output are, according to this view,
in part manifestations of the same phenomenonthe response of the economy to technology
shocks. To put it another way, output sometimes fluctuates because the natural level of
output fluctuates. But it may also fluctuate because of shifts in aggregate demand arising
from changes in the money supply when prices are sticky. Hence, DSGE models are hybrids
that combine both Keynesian elements and real business cycle elements into a single
approach.
L E C T U R E S U P P L E M E N T
14-10 Additional Readings
The Summer 1989 issue of the Journal of Economic Perspectives 3, no. 3, contains two
articles on real business cycle theory: one by Charles Plosser, a proponent of the theory,
Understanding Real Business Cycles, pages 5177; and one by Greg Mankiw, who is more
skeptical, Real Business Cycles: A Keynesian Perspective, pages 7990. A useful, but more
technical, survey is B. McCallum, Real Business Cycle Models, in R. Barro (ed.), Modern
Business Cycle Theory (Cambridge, Mass.: Harvard University Press, 1989).
The Fall 1986 issue of the Federal Reserve Bank of Minneapolis Quarterly Review 10,
no. 4, contains a debate on the topic between Edward Prescott and Lawrence Summers.
Rodolfo Manuellis introduction is also very useful.
Much work on real business cycles has focused on the labor market. For a survey, see
G. Hansen and R. Wright, The Labor Market in Real Business Cycle Theory, Federal
Reserve Bank of Minneapolis Quarterly Review 16, no. 2 (Spring 1992).
There are a number of good surveys of the current state of macroeconomics, including
Robert Gordon, What Is New-Keynesian Economics? Journal of Economic Literature 28
(September 1990); Bennett McCallum, Post-War Developments in Business Cycle Theory: A
Moderately Classical Perspective, Journal of Money, Credit, and Banking 20 (August 1988);
Greg Mankiw, A Quick Refresher Course in Macroeconomics, Journal of Economic
Literature 28 (December 1990): 164560; Greg Mankiw and D. Romer, Introduction, in G.
Mankiw and D. Romer, eds., New Keynesian Economics (Cambridge, Mass.: MIT Press,
1991). The Mankiw and Romer volumes also contain many of the important papers on new
Keynesian economics.
The Journal of Economic Perspectives 7, no. 1 (Winter 1993), contains a symposium on
Keynesian Economics Today that includes articles by avowed new Keynesians David
Romer, Bruce Greenwald, and Nobel Prize winner Joseph Stiglitz; self-described old
Keynesian and Nobel Prize winner James Tobin; and Robert King, who is skeptical of the
new Keynesian approach.
370