EC2065 MACROECONOMICS

CHAPTER 8: NOMINAL RIGIDITIES AND BUSINESS CYCLES

Learning outcome:
By the end of the chapter, you will be able to address the following questions:

• Why does economic activity fluctuate?

• What are the shocks that cause booms and recessions?
• Can and should policymakers seek to ameliorate business cycles?
• Can changes in confidence be the driving force of business cycles?

Essential readings:

Williamson, Chapter 13 and 14.

Introduction:

This chapter investigates the causes of booms and busts – cyclical fluctuations in economic
activity. We will also explore whether policy interventions, such as monetary or fiscal policy,
should be used to tame business cycles. Economists have not reached a consensus on the
causes of business cycles, so we will present a number of different theories. We begin by
looking at an economy with nominal rigidity where markets fail to clear because prices are
slow to adjust. When an economy with nominal rigidity is hit by shocks, GDP tends to
fluctuate excessively because markets do not function efficiently. There is scope for central
banks or governments to intervene to deliver better economic outcomes.
We will also examine theories of business cycles that do not depend on nominal rigidity. We
cover real business cycle theory, which argues that the business cycle is simply the
economy’s efficient response to supply shocks. An alternative approach, the coordination
failure model, suggests business cycles are driven by self-fulfilling changes in optimism or
pessimism, rather than fundamental shocks.

1. Nominal Rigidity

• Most models we have used so far feature ‘market clearing’, with the relevant prices
in each market of the economy adjusting so that desired demand and supply are
equalised.

• However, there is an important set of ideas about how the economy works that
suggests prices change only slowly to achieve market clearing.

PREPARED BY CHEN AIDI 1

EC2065 MACROECONOMICS

• In this chapter, we will explore the implications of prices quoted in units of money
remaining fixed even when supply or demand conditions change. The term ‘nominal
rigidity’ is used to refer to any type of prices quoted in money not adjusting as
required to clear markets.

Why the focus on prices quoted in units of money?

• For prices to remain fixed, they must already have been set and specified in some
particular units. We discussed in Chapter 6 the convenience advantage of quoting all
prices in terms of money – what we called money’s ‘unit of account’ function.

• One common form of nominal rigidity is the ‘stickiness’ of retail prices faced by
consumers, although there are other nominal rigidities too such as sticky wages and
sticky producer prices.

Why would goods prices be sticky?

• One basic explanation points to physical costs of adjustment, for example, the costs
of printing new price labels. Costs of this type are known as ‘menu costs’. However,
technology and online retailing have greatly reduced such costs.

• More broadly, we can also envisage costs of making pricing decisions as a cost of
adjustment, for example, the managerial time and resources needed to select a new
price.

• Leaving a price unchanged saves costs because no new price needs to be

determined. Firms’ relationships with their customers might also create barriers to
price adjustment. For example, the coordination problem of no firm wanting to go
first with a price increase and antagonise its customers.

• Data on observations of individual prices also provides some support for the
relevance of nominal rigidity.

PREPARED BY CHEN AIDI 2

EC2065 MACROECONOMICS

• The price data shown in the following diagram suggests individual goods prices
quoted in units of money change infrequently, even during times when the economy
experiences shocks.

• Models of the economy where there is a failure of market clearing because of

nominal rigidity are often labelled ‘Keynesian’ models.

• We will study extensively what is called a ‘new Keynesian’ model. This model is ‘new’
in the sense that it has many of the features of modern macroeconomic models seen
in earlier chapters but in combination with older Keynesian ideas about the failure of
markets to clear.

• The only nominal rigidity in the new Keynesian model is stickiness of goods prices.
Having price stickiness in the model implicitly assumes prices are set by firms, not
markets. For this reason, the model also features an imperfectly competitive goods
market.

• It is important to note that the reasons for nominal rigidity are unlikely to prevent
eventual price adjustment in the long run. Prices will ultimately adjust to shocks, so
markets still clear in the long run.

• Consequently, the model will make a distinction between the short run where prices
are sticky and the long run where prices are flexible. The transition from the short
run to the long run is studied in Chapter 9.

• There is also an important difference compared to our earlier analysis of the failure of
labour-market clearing owing to efficiency wages in Chapter 5 point 2. There, firms have
incentives to pay efficiency wages at all times, so the rigidity of wages is not temporary
and does not disappear in the long run. Moreover, efficiency wages impart rigidity to
real wages, which is conceptually distinct from nominal rigidity.

PREPARED BY CHEN AIDI 3

EC2065 MACROECONOMICS

2. The New Keynesian Model:

• The new Keynesian model is essentially the dynamic macroeconomic model

introduced in Chapter 3 with nominal rigidity added to it. The goods market has
sticky prices and is treated as an imperfectly competitive market for consistency.
This is in contrast to the perfect competition and fully flexible prices of the earlier
dynamic macroeconomic model.

• We start with a simple version of the model where all prices are completely fixed
and are expected to remain so in the near term. Later in Chapter 9, we will add
partial price adjustment to analyse inflation. We can illustrate the main
consequences of nominal rigidity by only having sticky prices in the goods market.

• Nominal wages are fully flexible and we can treat the labour market as being
perfectly competitive. However, it is possible to combine our earlier analysis of
efficiency wages with the new Keynesian model and this case is also considered
later.

• Goods prices being sticky has consequences for our analysis of firms’ labour demand
and the implied level of output supply in the goods market. Recall that with perfect
competition, firms can sell as much output as they like at the market price, which
adjusts to clear the goods market.

• Each extra unit of labour allows a firm to produce 𝑀𝑃𝑁 units of output, the marginal
product of labour, so a profit-maximising firm hires labour at real wage 𝑤𝑤 up to the
point where 𝑀𝑃𝑁 = 𝑤. This is the labour demand curve with perfect competition.

• With nominal rigidity, if an imperfectly competitive firm does not change the fixed
price 𝑃̅ of the good it is selling then it cannot choose how much it sells. If demand
falls, shifting the demand curve for the firm’s product leftwards, it cannot sell as
much as before at price 𝑃̅, and as a result hires less labour.

• Even if the marginal product of labour exceeds the real wage, the firm does not hire
more labour because it cannot sell the extra output that could be produced with
additional employment. If demand rises, a firm can now sell more at the same price
𝑃̅, so it hires more labour to meet the additional demand.

• Strictly speaking, this is true only as long as 𝑤 ≤ 𝑀𝑃𝑁 , otherwise the firm would not
want to sell more, although as we will see, cases where this condition fails to hold
are not likely to be relevant in practice.

PREPARED BY CHEN AIDI 4

EC2065 MACROECONOMICS

• This logic tells us that the labour demand curve is no longer given by the marginal
product of labour but is instead perfectly wage inelastic as depicted in the right
panel of the following diagram:

• The vertical labour demand curve shifts with the aggregate demand for goods,
which we suppose affects the demand for each individual good. We truncate the
vertical labour demand curve where it goes above 𝑀𝑃𝑁 .

• The wage-inelastic labour demand curve 𝑁 𝑑 (𝑌) is determined using the production
function 𝑌=𝑧F(𝐾, 𝑁) to find what level of employment 𝑁 is needed to produce
output 𝑌 sufficient to meet demand, taking as given the stock of capital 𝐾 and TFP 𝑧.
This is shown in the left panel of the diagram above. An increase in 𝑌 shifts labour
demand to the right.

How do we analyse outcomes in the labour market when goods prices are sticky?

• Since labour demand is wage inelastic, the outcome for employment 𝑁 is directly
determined by the position of 𝑁 𝑑 (𝑌). For wages 𝑤, we need to be more specific
about how the supply side of the labour market works.

• First assume that wages are fully flexible. In that case, wages are determined by a
standard upward-sloping labour supply curve 𝑁 𝑠 (𝑟) derived from households’
(1+𝑟)𝑤
optimality conditions 𝑀𝑅𝑆𝑙,𝑐 = 𝑤 and 𝑀𝑅𝑆𝑙,𝑙′ = as explained in Chapters 1
𝑤′
and 3.

• With a representative household, Chapter 3 explains why 𝑁 𝑠 (𝑟) is unambiguously

upward sloping owing to the substitution effect of wages and shifts to the right when
the real interest rate 𝑟 increases (intertemporal substitution).

PREPARED BY CHEN AIDI 5

EC2065 MACROECONOMICS

• Although we consider a monetary economy, we ignore here the effect of money’s

medium of exchange function on 𝑁 𝑠 , that is to say, we neglect any effects coming
from money being less good as a store of value and acting as a tax on economic
activity. (Refer to chapter 6 point 5)

• With flexible wages, the real wage 𝑤𝑤 adjusts so that the labour market clears with
𝑁 𝑑 (𝑌)= 𝑁 𝑠 (𝑟) as shown in the left panel of the following diagram:

• We will see that employment fluctuates with aggregate demand, although if there
are no impediments to wage adjustment then there is no unemployment or
fluctuations in unemployment. If we want to study unemployment over the business
cycle, we can combine our earlier analysis of efficiency wages with the new
Keynesian model.

• In that case, the real wage is determined by firms’ desire to pay an efficiency wage
and remains constant. Employment is found on the inelastic labour demand curve
but desired labour supply can be higher, so unemployment exists. Given desired
labour supply, unemployment changes in the opposite direction to changes in
employment. This case is depicted in the right panel of the diagram above.

• In an economy with flexible prices, the output supply curve in the goods market
represent the production of goods and services by firms given employment at the
labour-market equilibrium. However, with sticky prices, the demand for labour
depends on the aggregate demand for goods. This means there is no independent
decision made by firms about how much to sell.

PREPARED BY CHEN AIDI 6

EC2065 MACROECONOMICS

• The supply of goods passively accommodates changes in demand and thus there is no
output supply curve relevant for determining outcomes in the goods market as long as
goods prices remain sticky.

• One caveat to this logic is that demand must not be so large that firms do not want
to meet it because wages are too high. We require that 𝑤 ≤ 𝑀𝑃𝑁 , which in the goods
market diagram is equivalent to remaining on the left of the hypothetical output
̂𝑠 ), where the real wage
supply curve with perfect competition and flexible prices (𝑌
would be exactly equal to the marginal product of labour. The hypothetical supply
curve is depicted as a dashed line in the following diagram:

This condition is not likely to be of concern in most applications of the model.

• The demand curve in the goods market simply represents the same aggregate
demand for goods and services that was found in the earlier dynamic
macroeconomic model from Chapter 3 point 12. The 𝑌 𝑑 curve represents the
equation 𝑌 𝑑 = 𝐶 𝑑 +𝐼 𝑑 + 𝐺 as before and is shown in the diagram above.

• But since prices are sticky, the economy does not have to be at the intersection of
the 𝑌 𝑑 and 𝑌 𝑠 curves. Many points on the 𝑌 𝑑 curve can be a goods-market
equilibrium in the short run. Note that in Keynesian models, the 𝑌 𝑑 curve was
traditionally known as the 𝐼𝑆 (investment = saving) curve. The equation for
investment 𝐼 being equal to national saving 𝑌 − 𝐶 − 𝐺 is equivalent to 𝑌 = 𝐶 + 𝐼 + 𝐺.

• The point on the output demand curve the economy reaches and the outcome for
real GDP 𝑌 are determined by the level of interest rates. With complete stickiness of
prices there is zero inflation (𝜋 = 0) and, hence, the Fisher equation 𝑖 = 𝑟 + 𝜋 𝑒 implies
that 𝑟 = 𝑖, so the real interest rate 𝑟 is the same as the nominal interest rate 𝑖.

PREPARED BY CHEN AIDI 7

EC2065 MACROECONOMICS

• As discussed in Chapters 6 and 7, there are various instruments of monetary policy

that can control the nominal interest rate 𝑖. With sticky prices, monetary policy also
effectively sets the real interest rate 𝑟, which selects a point on the 𝑌 𝑑 curve.

• In the goods market diagram, we represent the central bank’s choice of nominal
interest rate 𝑖 (and, hence, 𝑟) with a line that we will label 𝑀𝑀 (money and
monetary policy). The 𝑀𝑀 line is usually assumed to be flat or upward-sloping,
which is to say that the central bank either sets some particular interest rate, in
which case 𝑀𝑀 is horizontal, or we think of the central bank as systematically
adjusting interest rates up and down with GDP.

• The intersection between the 𝑌 𝑑 (𝐼S) curve and the 𝑀𝑀 line determines the real
interest rate 𝑟 and output 𝑌 as seen in the diagram above.

3. The Real Effects of Monetary Policy

What happens when the central bank changes its monetary policy according to the new
Keynesian model? Does monetary policy have real effects?

• Suppose the central bank cuts the nominal interest rate 𝑖. If prices are completely
sticky, inflation remains zero and, consequently, the real interest rate falls.
Supposing the stance of monetary policy is represented by a horizontal 𝑀𝑀 line, the
interest rate cut shifts the 𝑀𝑀 line downwards. The economy moves along the
output demand curve as shown in the figure below:

With the lower real interest rate 𝑟 stimulating consumption and investment demand.
This works through a lower cost of borrowing for firms and a substitution effect on
households’ consumption expenditure plans. GDP 𝑌 rises with the resulting increase
in aggregate demand.

PREPARED BY CHEN AIDI 8

EC2065 MACROECONOMICS

• In the labour market, the increase in aggregate demand for goods shifts the labour
demand 𝑁 𝑑 (𝑌) curve to the right. This is because firms selling goods at a fixed price
want to hire more workers when they are able sell more output. Employment rises
as a result.

• When wages are flexible, the real wage 𝑤 increases because of a movement along
the upward-sloping labour supply curve 𝑁 𝑠 (𝑟), which also shifts to the left when 𝑟
declines. If real wages are rigid owing to efficiency wages then higher employment
and lower desired labour supply imply a decline in unemployment. These two cases
are depicted in the diagrams below:

Box 8.1: The Volcker Disinflation

• The new Keynesian model predicts changes in interest rates by central banks have
real effects. Specifically, higher interest rates reduce demand and real GDP. The
most striking evidence for this is seen following substantial increase in interest rates
in USA in the early 1980s. Paul Volcker became Chairman of the US Federal Reserve
in 1979 at a time when inflation had reached double-digit levels and there was
pressure to bring inflation back down.

PREPARED BY CHEN AIDI 9

EC2065 MACROECONOMICS

• As seen in the following diagram, the shift in the Federal Reserve’s monetary policy
stance brought about by Volcker saw interest rates rise from below 10 per cent to
peak at 15 per cent in 1981. Inflation started to fall and was below 5 per cent by
1983. While we cannot yet analyse inflation using our basic new Keynesian model
with completely sticky prices, we will study inflation with partial price adjustment in
Chapter 9. For now, we focus on the effects of real interest rates on aggregate
demand and GDP. Volcker’s tightening of monetary policy led the real interest to rise
from negative levels to more than 5 per cent by 1981. This was followed by a sharp
fall in real GDP during the 1981–82 recession.

4. Business Cycles Due to Demand Shocks

• The new Keynesian model provides a framework for understanding business-cycle

fluctuations. Let us analyse how the economy would respond to an unexpected fall
in aggregate demand.

What are the possible sources of such a negative demand shock?

• One possibility is a decline in consumption demand 𝐶 𝑑 or investment demand

𝐼 𝑑 owing to lower confidence about the future. If expectations of the future are
formed rationally, this would be triggered by some specific bad news about the
economy’s future fundamentals, for example, less optimistic expectations of future
TFP 𝑧′.

• Another source of demand shocks is a worsening of credit-market imperfections.

As discussed in Chapter 4, borrowers would face a higher interest rate 𝑟𝑙 even if
there is no change in the risk-free interest rate 𝑟 received by savers.

PREPARED BY CHEN AIDI 10

EC2065 MACROECONOMICS

• Further possibilities are shifts in preferences toward saving more for the future, or
an increase in uncertainty about the future that triggers greater saving owing to
concern about future risks, which would both reduce consumption demand 𝑪𝒅 .

• Fiscal austerity, where the government reduces its expenditure 𝐺 is another

possibility.

• Consider a decline in the expected value of future TFP 𝑧′ as a specific example of a

demand shock. This leads to lower 𝑪𝒅 and 𝑰𝒅 and shifts the 𝒀𝒅 curve to the left.
Assuming no automatic or discretionary monetary policy response, that is to say, a
horizontal 𝑀𝑀 line in same position, the real interest rate 𝑟 remains the same and
GDP 𝑌 declines as shown below:

• In the labour market, lower aggregate demand 𝑌 reduces labour demand, with
𝑁 𝑑 (𝑌) shifting to the left and resulting in lower employment 𝑁. Owing to the
negative wealth effect of lower 𝑧′, the labour supply curve 𝑁 𝑠 (𝑟) shifts rightwards.
With flexible wages, the real wage 𝑤 would decline, while with a rigid efficiency
wage, higher unemployment would result. It can also be seen from the production
function that the decline in output and employment would raise average labour
productivity 𝑌/𝑁, which is the gradient of the ray from the origin to the production
function.

Box 8.2: Can the New Keynesian Model Match the Business Cycle Stylised Facts?

• It is desirable that any theory of the business cycle is consistent with empirical
evidence on the behaviour of fluctuations of various macroeconomic variables. We
can document a set of business-cycle ‘stylised facts’ using methods described in
Chapter 3 point 1.

PREPARED BY CHEN AIDI 11

EC2065 MACROECONOMICS

• Variables are detrended and their percentage deviations from trend can be
compared to those of real GDP. We have already looked at the behaviour of
fluctuations in consumption and investment in Chapter 3 and unemployment in
Chapter 5.

• Both consumption and investment are procyclical, meaning that their deviations
from trend are positively correlated with deviations of real GDP from its trend, while
unemployment is countercyclical, i.e. negatively correlated with real GDP.

• Consumption is less volatile than GDP – its percentage fluctuations are smaller than
those of real GDP – while investment is more volatile than GDP.

• We can also look at a broader range of macroeconomic variables. The figure below
shows detrended employment, which is procyclical, generally less volatile than GDP
and slightly lagging.

PREPARED BY CHEN AIDI 12

EC2065 MACROECONOMICS

• The diagram below shows real wages, for which it is harder to discern a clear pattern
but which is overall weakly procyclical and less volatile than GDP.

• The diagram below displays the data for average labour productivity, which is
procyclical and less volatile than GDP. The procyclicality of average labour
productivity reflects the fact that employment typically moves by less in percentage
terms than GDP.

PREPARED BY CHEN AIDI 13

EC2065 MACROECONOMICS

• Fluctuations of the real interest rate are shown alongside fluctuations of GDP in the
diagram below:

• The cyclicality of the real interest rate appears to change over time, generally being
countercyclical prior to the 1990s and procyclical afterwards. Taking an overview of
the whole period covered by the data, the real interest rate is weakly
countercyclical. Finally, fluctuations of inflation are shown below:

• Here again the relationship with GDP fluctuations appears to have changed over
time. There is a strong countercyclical relationship in the 1970s but at other times
inflation appears procyclical. Overall, we conclude that inflation is weakly procyclical.

PREPARED BY CHEN AIDI 14

EC2065 MACROECONOMICS

How do the predictions of the new Keynesian model compare to this evidence on
business-cycle fluctuations?

• We will consider two different types of shock studied earlier:

1. we will consider a demand shock coming from news that changes confidence about
the future, or a change in the extent of credit-market imperfections.
2. we will look at a shift in the stance of monetary policy.

• Consider the negative demand shock considered earlier that was caused by lower
confidence about the future. A lower expected value of 𝑧′ shifts the 𝑌 𝑑 curve to the
left due to declines in 𝐶 𝑑 and 𝐼 𝑑 . We assume a horizontal 𝑀𝑀 line in an unchanged
position, indicating a passive stance of monetary policy throughout.

• With reference to the diagram below:

• The model predicts that GDP 𝑌 falls and consumption 𝐶 and investment 𝐼 are lower.
Prices and inflation do not change because all prices fixed. The real and nominal
interest rates 𝑟 and 𝑖 are unchanged because of the passive monetary policy and the
absence of any change in inflation.

• The production function implies employment 𝑁 declines and the leftward shift of 𝑁 𝑑
and rightward shift of 𝑁 𝑠 in the labour market result in a lower real wage 𝑤. If we
assumed firms are paying efficiency wages instead then the real wage would remain
constant and unemployment would rise owing to the direction of the shifts of 𝑁 𝑑
and 𝑁 𝑠 .

PREPARED BY CHEN AIDI 15

EC2065 MACROECONOMICS

• Using the production function diagram, we can also see the model’s prediction for
the response of average labour productivity 𝐴LP = 𝑌/𝑁. Average labour productivity
is given the gradient of the ray from the origin to the relevant point on the
production function.

• The following diagram, shows that since the production function has a concave
shape and does not shift with a demand shock, a decline in employment and output
raises the gradient of this ray. Intuitively, the shape of the production function
comes from diminishing returns to labour, so a decline in employment raises labour
productivity.

• In summary, the new Keynesian model with demand shocks predicts that
consumption and investment are procyclical (they both move in the same direction
as real GDP), employment is procyclical and average labour productivity is
countercyclical.

• Apart from productivity, these predictions are in line with the business-cycle stylised
facts. With a competitive labour market, the model predicts a strongly procyclical
real wage contrary to the empirical evidence but this cyclicality of wages would be
weakened by integrating the model of efficiency wages into the analysis of the
labour market. Adding efficiency wages also allows the new Keynesian model to
match the countercyclicality of unemployment.

PREPARED BY CHEN AIDI 16

EC2065 MACROECONOMICS

• These predictions of the model and the corresponding stylised facts from the data
are summarised in the following table:

• Note that the model makes similar predictions for other forms of demand shock
such as a worsening of credit-market imperfections that raises interest-rate spreads.

• As the stance of monetary policy remains completely passive following the shock by
assumption, the model predicts an acyclical real interest rate. Having an upward-
sloping 𝑀𝑀 line, as discussed in Box 8.4, would result in the model predicting a
procyclical real interest rate.

• While the overall pattern in the data is weak countercyclicality, there are periods
where real interest rates appear procyclical, so the model’s predictions are not too
far from the empirical evidence.

• With completely sticky prices, the model predicts that inflation is acyclical. We will
see in Chapter 9 that adding partial price adjustment means that inflation would be
procyclical in an economy with demand shocks, which helps to match the data.

• It is also possible to consider business cycles triggered by shifts in monetary policy,

for example, the Volcker disinflation discussed in Box 8.1. Suppose the central bank
shifts the stance of monetary policy towards higher interest rates, shifting the 𝑀𝑀
line upwards.

PREPARED BY CHEN AIDI 17

EC2065 MACROECONOMICS

• The model predicts that consumption 𝐶 and investment 𝐼 fall, moving up

the 𝑌 𝑑 curve in the goods-market diagram. Real GDP 𝑌 falls and the real interest rate
𝑟 rises. It can be seen from the production function and labour-market diagrams that
employment 𝑁 and real wages 𝑤 are lower, with 𝑁 𝑑 shifting to the left and
𝑁 𝑠 shifting to the right. With efficiency wages, unemployment 𝑈 rises and the real
wage 𝑤𝑤 is constant. Prices and inflation do not change because all prices are fixed.

• The table below summarises the predictions of the model and compares them to the
business-cycle stylised facts:

• Consumption and investment are procyclical, matching the data. The real interest
rate is countercyclical, which fits the overall pattern weakly present in the data.

• Employment is procyclical, matching the data. Real wages are strongly procyclical
but that prediction can be tempered by efficiency wages, which also allows the
model to generate the countercyclical unemployment seen in the data.

• Inflation is acyclical but partial price adjustment would change that prediction to
procyclicality. As with demand shocks, the model predicts countercyclical average
labour productivity, contrary to the empirical pattern.

PREPARED BY CHEN AIDI 18

EC2065 MACROECONOMICS

• In summary, the new Keynesian model is broadly consistent with most of the
business-cycle stylised facts when the business cycle is caused by demand shocks,
including shifts in monetary policy.

• The only major failing is in accounting for the procyclicality of productivity. One
potential reconciliation with the productivity data is discussed in Box 8.3.

Box 8.3: Labour Hoarding

• Empirical evidence indicates average labour productivity (𝐴LP =𝑌/N) is a procyclical

variable, moving in the same direction as real GDP 𝑌. However, the new Keynesian
model with demand shocks predicts average labour productivity is countercyclical.

• The reason for the model’s prediction of countercyclical productivity is that the
neoclassical production function 𝑌= 𝑧F(𝐾, 𝑁) features a diminishing marginal
product of labour, while demand shocks do not shift the production function by
affecting current TFP 𝑧. As the total stock of capital 𝐾 changes relatively little over
business cycle, when 𝑁 and 𝑌 fall, the marginal product of labour 𝑀𝑃𝑁 rises. This
implies average labour productivity 𝑌/𝑁 rises as employment falls.

• The empirical evidence suggests a relationship in the opposite direction. However,

data on employment might not measure accurately the true labour input 𝑁 going
into the production function 𝑌=𝑧F(𝐾, 𝑁).

• Data on employment is a headcount of firms’ employees but does not capture how
intensively employees are working. There is data on total hours worked but, for
many jobs, this simply measures contractual hours of work, which does not fully
measure the intensity of work. A true measure of labour input 𝑁𝑁 would account for
the intensity of work.

• The claim that true labour input 𝑁 might fall substantially in a recession while firms
retain most of their staff raises the question of why firms do not lay-off workers
when fewer are needed.

• One argument for this ‘labour hoarding’ is that a recession is expected to be

temporary and firms want to avoid incurring the costs of hiring again in the future
recovery (the costly process of search and matching in hiring workers was discussed
in Chapter 5).

PREPARED BY CHEN AIDI 19

EC2065 MACROECONOMICS

• The occurrence of labour hoarding helps explain why measured average labour
productivity is procyclical. As shown in the diagram below:

• if measured labour input falls by much less than actual labour input, the drop in
output will be associated with a fall in measured productivity (calculated using data
on actual output and measured employment). This measurement problem suggests
that the observed procyclicality of productivity may not be inconsistent with the new
Keynesian model of the business cycle with demand shocks.

• An issue similar to labour hoarding arises when measuring total factor productivity
(TFP). This is done by calculating a ‘Solow residual’, that is, the change in GDP not
explained by changes in inputs of labour and capital.

• However, estimate of the capital stock do not fully capture changes in the usage of
capital by firms because utilisation of capital might vary over time. This is analogous
to the change in labour utilisation by firms when there is labour hoarding and
suggests there is bias towards detecting procyclicality in TFP.

5. The Natural Rate of Interest

• Although the objective of the new Keynesian model is to understand the functioning
of an economy with sticky prices, analysing the hypothetical case of fully flexible
prices even in the short run is nonetheless useful.

• This helps us understand the different predictions the model makes for the short
run and the long run. It also provides guidance on how monetary policy should be
conducted.

PREPARED BY CHEN AIDI 20

EC2065 MACROECONOMICS

Imperfect Competition and The Output Supply Curve:

• We have assumed the goods market is imperfectly competitive to allow for sticky
prices. Now consider how imperfectly competitive firms would set prices if they
were always free to adjust them. In doing this, we make use of a model of
monopolistic competition from microeconomics.

• Each firm faces a downward-sloping demand curve for its product because goods
produced by different firms are imperfect substitutes. Conditional on aggregate
demand, a firm can only sell more of its product by charging a lower price, unlike
perfect competition where firms are able to sell any amount at the prevailing market
price.

• Profit maximisation by imperfectly competitive firms implies they will exploit market
power to sell at a price above marginal cost. This is because firms with market power
face a downward-sloping demand curve for their product, so they can charge a
higher price by choosing to sell less.

• Given a production function 𝑌= 𝑧F(K, 𝑁) with a particular capital stock 𝐾 and level of
TFP 𝑧, the decision to supply goods 𝑌 is equivalent to a decision to hire labour 𝑁. For
an imperfectly competitive firm, the effect on real revenue of hiring an extra worker
is less than the physical marginal product of labour because the price of its product
relative to other goods needs to be lowered to sell the extra output.

• The marginal gain in real revenue from hiring an extra unit of labour is measured by
the marginal revenue product of labour 𝑀𝑅𝑃𝑁 , which is below the marginal product
of labour 𝑀𝑃𝑁 . The relationship between the two is 𝑀𝑅𝑃𝑁 = (1− 𝜖 −1)𝑀𝑃𝑁 , where 𝜖 is
the price elasticity of the demand curve for a firm’s product.

• In choosing how much labour to hire and how much output to produce, each firm
compares the real cost of hiring a worker, the real wage 𝑤, to the marginal benefit
𝑀𝑅𝑃𝑁 . Hence, firms’ demand for labour is given by 𝑀𝑅𝑃𝑁 = 𝑤 instead of 𝑀𝑃𝑁 = 𝑤
with perfect competition. Workers being paid their marginal revenue product is
equivalent to firms pricing (𝜖 − 1)−1per cent above their marginal cost 𝑤/𝑀𝑃𝑁 of
producing a unit of output.

PREPARED BY CHEN AIDI 21

EC2065 MACROECONOMICS

• Assuming each individual firm faces a demand curve for its product with a constant price
elasticity 𝜖 >1, the marginal revenue product curve 𝑀𝑅𝑃𝑁 is simply a scaling down of
the marginal product curve 𝑀𝑃𝑁 as shown in the diagram below:

• Labour demand thus behaves in the same way as with perfect competition, just at a
lower level, all else being equal. An output supply curve 𝑌 𝑠 can then be derived
exactly as earlier in the dynamic macroeconomic model from Chapter 3 point 12.

• The only difference is that 𝑌 𝑠 is lower for any given 𝑟 because imperfectly
competitive firms restrict supply to raise profits. For comparison, what the output
supply curve would look like with perfect competition is shown labelled as 𝑌 ̂𝑠 in the
diagram above.

Market Clearing in The Absence of Nominal Rigidities

• With flexible prices and wages in the goods and labour markets, the intersection of the
demand and supply curves determines equilibrium in all markets. As shown in the
diagram above, there is a market-clearing real interest rate 𝑟*. This interest rate 𝑟* is
known as the ‘natural rate of interest’.

• It is the hypothetical real interest rate that would prevail if there were no nominal
rigidities in the economy. The ‘natural’ terminology is also applied to other variables.
The ‘natural level of output’ is the market-clearing level of real GDP 𝑌* in the absence of
any nominal rigidities.

• By incorporating efficiency wages into the analysis of the labour market, there would be
a ‘natural rate of unemployment’, i.e. the unemployment rate occurring with no nominal
rigidity (note that efficiency wages are not a nominal rigidity – they explain why firms do
not want to adjust real wages).

PREPARED BY CHEN AIDI 22

EC2065 MACROECONOMICS

The Long Run and The Short Run

• We now return to the actual assumption made in the new Keynesian model that
goods prices are sticky. The model implies we should think differently about how
real GDP is determined in the short run and the long run.

• We take ‘long run’ to mean a situation where current market conditions have been
correctly foreseen and are not expected to change. Even if firms have sticky prices 𝑃̅
all prices are set appropriately for the current state of the economy.

• In this case, the new Keynesian model predicts the real interest rate and output
coincide with their ‘natural’ levels. Moreover, as long as prices do not remain sticky
forever, even if shocks do occur, the new Keynesian model predicts all variables will
tend to their respective natural levels in the long run absent any further changes or
shocks to the economy.

• The ’short run’ is the time horizon in which market conditions can deviate from what
was expected when prices were originally set in the past. Shocks result in the
economy fluctuating around its natural level of output. Note that it is possible to
have GDP above or below its natural level 𝑌*. As long as 𝑌 and 𝑟 lie to the left of the
hypothetical perfect-competition output supply curve 𝑌 ̂𝑠 (which is true for 𝑟* and
𝑌*) then 𝑤 < 𝑀𝑃𝑁 holds and firms would willingly sell more if given the chance – and
must sell less if demand falls.

• When the economy experiences a shock and the actual level of real GDP 𝑌 deviates
from its natural level 𝑌*, we say there is an ‘output gap’ between 𝑌 and 𝑌*. We will
see that there is a case for the central bank or government to use demand-
management policies to try to close the output gap, moving GDP 𝑌 towards 𝑌*.

6. Optimal Stabilisation Policy

• With sticky prices and imperfect competition, the equilibrium of the economy is not
efficient. Following a shock to the economy, it is possible to obtain a better outcome
for households through a macroeconomic policy intervention. This is an
improvement on waiting for prices to adjust.

• When the economy has a representative household, efficiency can be judged easily
by comparing the marginal product of labour 𝑀𝑃𝑁 to households’ marginal rate of
substitution between leisure and consumption 𝑀𝑅𝑆𝑙,𝑐 .

PREPARED BY CHEN AIDI 23

EC2065 MACROECONOMICS

• The 𝑀𝑃𝑁 is what can be produced if people were able to work more and the
𝑀𝑅𝑆𝑙,𝑐 is what value (in terms of goods) people put on their time.

• The economy has inefficiently low employment and production if 𝑀𝑃𝑁 >𝑀𝑅𝑆𝑙,𝑐
because the value of people’s time is less than the value they put on the extra goods
that can be produced and consumed if there were more economic activity.

• How efficiently the economy is operating can be judged from the goods market
diagram by comparing the outcome for 𝑌 and 𝑟 to the hypothetical perfectly
competitive output supply curve 𝑌̂𝑠 , on which 𝑀𝑃𝑁 = 𝑀𝑅𝑆𝑙,𝑐 . All points to the left
of ̂
𝑌 𝑠 , have 𝑀𝑃𝑁 >𝑀𝑅𝑆𝑙,𝑐 , meaning that output 𝑌 is too low. Inefficiency is thus
measured by how far the economy is to the left of the 𝑌 ̂𝑠 curve.

Why is the market equilibrium in the new Keynesian model generally not efficient?

• To simplify the analysis, we ignore some other reasons for inefficiency we have
studied elsewhere that are not central to the new Keynesian model. First, wages are
flexible, so the labour-market equilibrium is always on the labour supply curve. This
ignores the persistent unemployment that results from firms’ incentives to pay
‘efficiency wages’ as seen in chapter 5 point 2.

• Second, we ignore the implications for labour supply of needing to use money as a
medium of exchange that were studied in chapter 6 point 5. This neglects any
inefficiencies resulting from a failure of monetary policy to follow the ‘Friedman rule’
as discussed in chapter 6 point 10. The consequence of these simplifications is that
real wages 𝑤 are always equal to the marginal rate of substitution 𝑀𝑅𝑆𝑙,𝑐 between
leisure and consumption.

• There are two distinct reasons why output is inefficiently low in the New Keynesian
model:

1. The natural level of output 𝑌* is already too low because imperfect competition
gives firms an incentive to reduce production. Even without nominal rigidity,
imperfect competition would result in 𝑤 = 𝑀𝑅𝑃𝑁 < 𝑀𝑃𝑁 at 𝑌 = 𝑌*.

2. When prices are sticky, a negative demand shock pushes GDP 𝑌 below 𝑌* and, as
diminishing returns to labour then implies 𝑀𝑅𝑃𝑁 and 𝑀𝑃𝑁 rise while 𝑤 =𝑀𝑅𝑆𝑙,𝑐
falls, we have 𝑤 < 𝑀𝑅𝑃𝑁 and the economy is even further away from what is
efficient.

PREPARED BY CHEN AIDI 24

EC2065 MACROECONOMICS

How can economic policy achieve a better outcome?

• Let us consider the example studied in chapter 8 point 4 of a negative demand shock
due to a decline in expected future TFP 𝑧′. As shown in the diagram below:

• The 𝑌 𝑑 curve shifts to the left and output 𝑌 falls below 𝑌* if the 𝑀𝑀 line remains in
its original position. Now, instead of leaving monetary policy unchanged, the central
bank lowers the nominal and real interest rates 𝑖 and 𝑟. Reducing 𝑟 moves the
economy along the 𝑌 𝑑 curve, raising GDP 𝑌. Since 𝑀𝑃𝑁 >𝑀𝑅𝑆𝑙,𝑐 , the representative
household gains from this policy intervention.

• Fiscal policy could also be used to provide a stimulus to demand. An increase in

public expenditure 𝐺 would raise 𝑌, although its effects are not exactly equivalent
because the composition of aggregate demand 𝐶+ 𝐼+ 𝐺 would be different compared
to the case where monetary policy is used.

What is the best monetary policy to follow?

• To close the output gap between 𝑌 and 𝑌* exactly, the central bank should set the
nominal interest rate 𝑖 (and, hence, 𝑟) equal to the natural rate of interest 𝑟*. This
moves the 𝑀𝑀 line to where it intersects the 𝑌 𝑑 curve in the same place as the
output supply curve 𝑌 𝑠 as shown in the diagram above. Such a monetary policy
achieves the same economic outcome as if prices were flexible.

PREPARED BY CHEN AIDI 25

EC2065 MACROECONOMICS

• The policy intervention thus neutralises the negative consequences of slow price
adjustment following a shock. The central bank adjusting interest rates compensates
for the slow pace of price changes.

• To implement this optimal monetary policy, the central bank needs to know the
natural rate of interest 𝑟*. This is a practical problem because 𝑟* is not directly
observable and needs to be estimated. A more fundamental challenge is that it must
be feasible to reduce the nominal interest rate 𝑖 if 𝑟* falls. As explained in Chapter 6
point 13, nominal interest rates are subject to a lower bound, so the required
interest rate cut might not be possible if the lower bound on 𝑖 is reached. Chapter 9
discusses alternative policies that could be used if the lower bound is binding.

• The stabilisation policy described here aims to close the output gap between actual
real GDP 𝑌 and its natural level 𝑌*. But that does not mean the policy should aim for
GDP to be stable if 𝑌* itself varies over time.

• Furthermore, it might be wondered why the policy intervention should stop when 𝑌
reaches 𝑌*. That addresses only one of the two sources of inefficiency in the new
Keynesian model – remember output at 𝑌* is still inefficiently low.

Should the central bank continue to push output above 𝑌* to where 𝒀𝒅 intersects 𝒀𝒔 and
𝑴𝑷𝑵 =𝑴𝑹𝑺𝒍,𝒄 hold?

• While at first glance this appears desirable, we will argue in Chapter 9 that such a
policy would be unsustainable and give rise to negative side effects.

Box 8.4: Modelling Monetary Policy Using Taylor Rules and LM Curves

• In the new Keynesian model so far, we have represented monetary policy using a
horizontal 𝑀𝑀 line. This shifts vertically if the central bank changes the nominal and
real interest rate.

• But the shape of the 𝑀𝑀 line is not an inherent feature of the new Keynesian
model, it depends on the most appropriate way to describe the conduct of
monetary policy.

• More generally, we consider the 𝑀𝑀 (‘money and monetary policy’) line to be a

representation of how the money market and the monetary policy regime imply a
link between interest rates and GDP.

PREPARED BY CHEN AIDI 26

EC2065 MACROECONOMICS

• We can draw 𝑀𝑀 lines for monetary policies that target the money supply, or an
interest rate feedback rule such as a Taylor rule.

Money Supply Targets, the LM Curve and the IS-LM Model

• Suppose the central bank’s monetary policy is a target for the money supply 𝑀 𝑠 .
Assume the money-supply target 𝑀 𝑠 =𝑀* is exogenous. For this monetary policy
regime, the interest rate 𝑖 is endogenous. It is still the case that real and nominal
interest rates are same because prices are sticky, hence, 𝑟 = 𝑖.

• With a target for the money supply, the interest rates 𝑖 and 𝑟 and GDP 𝑌 are
determined jointly in the goods and money markets. The equivalent of the 𝑀𝑀 line
in this case represents money-market equilibrium and it is often labelled as the ‘𝐿M’
curve for this particular monetary policy.

• The 𝑀𝑀 line/ 𝐿M curve for a money-supply target is upward sloping, as shown in the
goods market diagram below:

• The 𝐿M curve is upward sloping because higher output increases the real demand
for money for transactions, as shown in the left panel of the figure representing the
money market. With a fixed nominal money supply 𝑀* and a sticky price level ̅𝑃,
there is an inelastic supply of real money balances 𝑀*/ ̅𝑃 and the nominal interest
rate 𝑖 rises to restore equilibrium in the money market. Money-market equilibrium
thus requires higher real interest rates 𝑟 when real GDP 𝑌 is higher, explaining the
upward-sloping 𝐿M curve.

PREPARED BY CHEN AIDI 27

EC2065 MACROECONOMICS

• Combining the 𝐿M curve (𝑀𝑀 line) with the output demand curve 𝑌 𝑑 in the goods
market leads to the IS-LM model, which is a special case of our new Keynesian
model. What is called the 𝐼S curve in that model is simply another label for what we
call output demand 𝑌 𝑑 .

• A change in the money-supply target causes the 𝐿M curve to shift, which has real
effects on the economy. Increasing the money supply 𝑀* implies the supply of real
money balances 𝑀*/ ̅𝑃 is larger (the price level remaining constant at ̅𝑃). Given the
real demand for money at a particular level of real GDP 𝑌, the intersection of money
supply and demand occurs at a lower nominal interest rate 𝑖 and, hence, also 𝑟.
Since the 𝐿M curve represents combinations of 𝑌 and 𝑟 where the money market is
in equilibrium, the 𝐿M curve must shift downwards and real GDP increases.

The Taylor Rule

• Another example of a monetary policy is to have the central bank adjust the nominal
interest rate 𝑖 systematically in response to inflation 𝜋 and output 𝑌, for example, by
following a Taylor rule.

• We have seen an example of a Taylor rule in Chapter 6 point 12 but that focused
only on the response of 𝑖 to inflation 𝜋. In the basic new Keynesian model, prices are
completely fixed, so there is no inflation and response of 𝑖 to 𝜋 not relevant here.

• In response to changes in real GDP, the Taylor rule calls for a higher interest rate 𝑖 in
a boom and a lower 𝑖 in a recession. With real and nominal interest rates being
equal, 𝑟= 𝑖, the positive response of 𝑖 to 𝑌 can be represented by an upward-sloping
𝑀𝑀 line as depicted in the figure below:

PREPARED BY CHEN AIDI 28

EC2065 MACROECONOMICS

Why should the central bank want to choose interest rates that are positively related to
𝑌?

• One argument is that this helps to stabilise an economy that is hit by demand shocks,
avoiding large output gaps between actual GDP 𝑌 and the natural level of output 𝑌*.
Furthermore, if 𝑌* is known or estimated, the interest-rate rule can be refined to
react to the gap 𝑌− 𝑌*, or an estimate of this output gap.

• We know from Chapter 8 point 6 that the optimal monetary policy is for the central
bank to set 𝑖 =𝑟*, where 𝑟* is the natural rate of interest. However, the central bank
may not have perfect information about 𝑟*.

• In that case, the diagram below shows having a positive response of 𝑖 to 𝑌 can yield
a better outcome for the economy than having monetary policy keep 𝑖 constant:

7. Real Business Cycle Theory

• In the new Keynesian model, the business cycle is the economy’s inefficient response
to shocks, usually demand shocks, owing to the failure of prices to adjust. This
justifies policy interventions to temper the business cycle.

• An alternative approach argues that business cycles are simply the economy’s
efficient response to variations in its ability to produce goods due to supply shocks.

• Policy intervention is futile or counterproductive in this view. This way of

understanding fluctuations in the economy is known as real business cycle (RBC)
theory.

PREPARED BY CHEN AIDI 29

EC2065 MACROECONOMICS

How does such a theory of the business cycle work?

• The RBC model is essentially just the dynamic macroeconomic model developed
earlier in Chapter 3.

• The core of the model features flexible prices and perfectly competitive markets
studied in general equilibrium.

• For completeness, we add a money market alongside the labour and goods markets
studied in the dynamic macroeconomic model. Money demand and supply come
from our analysis in Chapter 6 and we assume the central bank chooses exogenous
path of the money supply.

• This emphasises the medium of exchange function of money but has no special role
for the unit of account function owing to nominal rigidities unlike the earlier new
Keynesian model.

• For simplicity, we ignore the effect of money’s medium of exchange function on the
labour supply curve, or we assume the central bank is following the Friedman rule.
This means that the labour supply curve 𝑁 𝑠 (𝑟) derives from the household optimality
conditions 𝑀𝑅𝑆𝑙,𝑐 = 𝑤 and 𝑀𝑅𝑆𝑙,𝑙′ = (1+𝑟)𝑤/𝑤′

• The RBC approach to understanding business cycles looks at how the equilibrium of
the economy in the goods, labour and money markets shown in the diagram below is
affected by supply shocks:

PREPARED BY CHEN AIDI 30

EC2065 MACROECONOMICS

8. Business Cycles Due to Supply Shocks

• RBC theory identifies exogenous shocks to total factor productivity (TFP) as the
source of the business cycle: supply shocks (or ‘technology’ shocks).

• In the study of economic growth, technological progress was seen as driving

permanent increases in TFP. However, in RBC theory, supply shocks are increases or
decreases in TFP that are eventually reversed.

Supply Shocks:

• Supply shocks in the RBC model are usually assumed to be deviations from the trend
in TFP growth that are expected to persist beyond current time period to some
extent but which are not permanent.

• The empirical counterpart to TFP is the Solow residual, representing changes in the
level of real GDP that cannot be explained by changes in inputs of capital and labour.

• The deviations from trend of the Solow residual in the USA are shown in diagram
below alongside the deviations from trend of real GDP.

• We see that movements in the Solow residual display a clear positive correlation
with real GDP, indicating the Solow residual is procyclical. While it is less volatile
than GDP, we do see transitory fluctuations that could be a cause of business cycles.
As discussed in Box 8.3, it is possible some of this procyclicality could be the result of
measurement error in accounting for factor inputs.

PREPARED BY CHEN AIDI 31

EC2065 MACROECONOMICS

Assuming the evidence from the Solow residual correctly indicates that transitory supply
shocks are hitting the economy, what might such shocks represent?

• One possibility is an uneven pace of technological progress, where TFP might rise by
more than usual in some years, or by less in others. However, the Solow residual
often falls sufficiently far below its trend that the implied level of TFP actually
declines in absolute terms. That is hard to understand if TFP is representing
technology because we would not expect that to go backwards.

• However, there are a number of other possible sources of transitory changes in TFP:
1. Fluctuations in energy costs, which affect overall production costs
2. Supply disruptions, for example due to natural disasters, wars, pandemics
3. Changes in regulations that affect firms’ productivity
4. Weather (in an agricultural economy).

The Predictions of The RBC Model

• Representing a supply shock as a transitory change in TFP 𝑧, the effects of a negative

shock to 𝑧 are shown in diagram below:

• The production function moves down, shifting the 𝑌 𝑠 curve to the left. Lower 𝑧
implies lower 𝑀𝑃𝑁 , which shifts the 𝑁 𝑑 curve to the left and results in the 𝑌 𝑠 curve
moving further to the left.

• To the extent that the shock persists for some time, expectations of future TFP 𝑧′
decline, which implies lower 𝑀𝑃𝑘 ′ and shifts the 𝐼 𝑑 and 𝑌 𝑑 curves to the left. There
is lower 𝐶 𝑑 and higher 𝑁 𝑠 owing to the negative wealth effect of lower 𝑧 (and 𝑧′),
although there is consumption smoothing because the shock is not permanent.

PREPARED BY CHEN AIDI 32

EC2065 MACROECONOMICS

• These wealth effects imply a leftward shift of 𝑌 𝑑 and a rightward shift of 𝑌 𝑠 . The
wealth effect on labour supply is smaller than the impact of 𝑧 on 𝑌 𝑠 both directly
and through 𝑀𝑃𝑁 . Hence, the overall effects are that the 𝑌 𝑑 and 𝑌 𝑠 curves shift to
the left, so real GDP 𝑌 falls.

• In the goods market, the real interest rate 𝑟 rises if 𝑌 𝑠 shifts more than 𝑌 𝑑 . The 𝑌 𝑑
shift becomes larger if the drop in TFP lasts longer because that leads to a greater
impact on consumption and investment demand (less consumption smoothing and a
greater impact on the expected future marginal product of capital). The effect on
employment 𝑁 in the labour market is ambiguous because 𝑁 𝑑 falls but 𝑁 𝑠 can rise.

• The wealth effect on 𝑁 𝑠 is smaller when TFP is expected to recover quickly. If

𝑁 𝑑 shifts to the left and 𝑁 𝑠 shifts to the right, the real wage 𝑤 increases. A smaller
wealth effect on 𝑁 𝑠 means that 𝑤 rises by less. Finally, in the money market, 𝑀𝑑
falls with lower 𝑌, which leads to a higher price level 𝑃.

Stabilisation Policy

• When a recession occurs because of lower TFP 𝑧, this clearly makes households
worse off. While the recession is bad, in the RBC model, it does not follow that the
government should intervene.

• The model predicts that policy intervention, even if it succeeds in raising GDP, makes
households worse off:
1. With flexible prices, there is limited scope to raise GDP with monetary policy – it is
not possible to improve on following the Friedman rule.

2. While increasing public expenditure 𝐺 raises GDP 𝑌 as we saw in Box 4.2, this is
inefficient because it leads people to work more when productivity is low.

Box 8.5: Sources of Supply Shocks in The RBC Model

• Considering a transitory positive supply shock, we have seen that the RBC model
makes the following predictions:
• GDP 𝑌𝑌 rises as the 𝑌 𝑑 and 𝑌 𝑠 curves shift to the right
• The real interest rate 𝑟 falls as 𝑌 𝑠 shifts by more than 𝑌 𝑑
• Consumption 𝐶 rises because of the wealth effect and lower 𝑟
• Investment 𝐼 rises because of higher expectations of 𝑀𝑃𝑘 ′ and lower 𝑟
• Real wage 𝑤 rises as 𝑁 𝑑 shifts to the right and 𝑁 𝑠 shifts to the left

PREPARED BY CHEN AIDI 33

EC2065 MACROECONOMICS

• Employment 𝑁 rises if 𝑁 𝑑 shifts more than 𝑁 𝑠 , which occurs if the wealth effect
on 𝑁 𝑠 is weak, as would be the case for a transitory shock.

• Finally, the figure below shows that average labour productivity 𝑌/𝑁 can rise with
GDP because 𝑧 increases. This is in contrast to the prediction for (correctly
measured) average labour productivity in a model with demand shocks and a
neoclassical production function.

• The RBC model generates business-cycle fluctuations due to occurrence of transitory

supply shocks. Its predictions are summarised in the table below alongside the
empirical evidence on the business-cycle stylised facts. We see that the fluctuations
of macroeconomic variables implied by the model are consistent with business-cycle
stylised facts.

PREPARED BY CHEN AIDI 34

EC2065 MACROECONOMICS

• In spite of this success, the source of transitory supply shocks is not obvious in many
business-cycle episodes. We could consider instead supply shocks with permanent
effects that are more easily interpreted as being due to the uneven pace of
technological progress. However, it is much harder to make the RBC model
consistent with the business-cycle stylised facts when supply shocks are highly
persistent.

• A permanent productivity shock changes current and future TFPs 𝑧 and 𝑧′ by a

similar amount. Considering the case of permanent positive shock, the RBC model
predicts the following in comparison to a transitory shock:

1. Wealth effects are larger, hence, 𝑁 𝑠 shifts further to the left, and 𝐶 𝑑 rises by more,
shifting 𝑌 𝑑 further to the right

2. There is a greater incentive for firms to increase investment, and the larger increase
in 𝐼 𝑑 means 𝑌 𝑑 shifts further to the right

3. The effect on 𝑁 𝑑 is same for a permanent and transitory shock to 𝑧.

• Since 𝑌 𝑑 and 𝑌 𝑠 shift in the same direction, the RBC model can still generate
fluctuations in GDP 𝑌 with permanent shocks to TFP. However, as shown in the
diagram below, the model will struggle to generate predictions consistent with the
stylised facts.

• The main problem is that the stronger wealth effect on labour supply 𝑁 𝑠 means that
employment 𝑁 might fall when 𝑌 rises. Employment then becomes countercyclical,
which is clearly contrary to the data. Furthermore, the stronger shift of 𝑁 𝑠 in the
opposite direction to 𝑁 𝑑 implies much larger fluctuations in the real wage, which
now becomes very procyclical, contrary to the data.

PREPARED BY CHEN AIDI 35

EC2065 MACROECONOMICS

• These predictions are consistent with very long-run trends where hours worked
have fallen even though productivity and wages have risen permanently.

9. Coordination Failure Model

• An alternative approach to understanding business cycles emphasises what is called

‘coordination failure’.

• Business cycles are caused by self-fulfilling changes in beliefs – even though

everyone is rational – because the economy has multiple equilibria. This means that
the requirements for agents to make decisions rationally and for markets to clear do
not pin down unique levels of GDP, employment, wages, and interest rates.

• Business cycles result from shifts between optimism and pessimism, even if
economy’s fundamentals remain unchanged. Although an equilibrium with high GDP
is preferred by everyone, there is a difficulty of coordinating expectations on this
best outcome.

• Our earlier dynamic macroeconomic model has a unique equilibrium, so there are no
business cycles without the occurrence of exogenous shocks. This is true for both
new Keynesian and RBC models of the economy.

• In the coordination failure model, all the assumptions of the dynamic

macroeconomic model are maintained, except that the (aggregate) production
function has increasing returns to scale. This leads to strategic complementarities in
firms’ employment decisions and implies there can be multiple equilibria.

Labour Productivity Spill-over Across Firms

• At the level of an individual firm, the production function 𝑌𝑖 = 𝑧(𝑁)𝐹(𝐾𝑖 , 𝑁𝑖 ) is

assumed to have the neoclassical properties, in particular, a diminishing marginal
product of labour 𝑁𝑖 .

• Firms are competitive, so their labour demand curve is given by marginal product of
labour. The new feature of the model is that each firm’s TFP level 𝑧(𝑁) is positively
related to aggregate employment 𝑁𝑁 but each firm takes 𝑁 as given when choosing
its own 𝑁𝑖 .

• Each firm benefits from higher employment and output at other firms but this effect
is not internalised. This ‘spillover’ or externality is a source of market failure.

PREPARED BY CHEN AIDI 36

EC2065 MACROECONOMICS

Why would such positive labour productivity spill-over occur?

• Advocates of coordination-failure models point to several possibilities.

1. There could be complementarities in employment across firms, for example, if more
people are employed writing computer software, this makes computer hardware
more useful, so workers producing the hardware are now making something of
greater value. Another example is that delivery and logistics are more efficient when
such companies have more orders to fulfil.

2. ‘Thick market’ effects. This is where an increased amount of activity in a market

provides some direct benefit to market participants. For example, it is harder to
attract customers to a shopping mall when not many other shops in the mall are
open.

• The coordination failure model explores the implications of such thick-market effects
and complementarities. Of course, a priori, it is also possible to envisage negative
spill-overs across firms, so the validity of the assumption is debatable.

• The spill-over effect has important consequences for firms’ demand for labour. If an
individual firm increases its employment 𝑁𝑖 , then its marginal product of labour
declines, so the firm-level labour demand curve is downward-sloping as usual.
However, if all firms are increasing employment 𝑁𝑖 together, then aggregate
employment 𝑁 rises and 𝑧(𝑁) increases. The rise in 𝑧(𝑁) boosts the marginal product
of labour in each firm, offsetting the decline due to higher 𝑁𝑖 .

• This spill-over effect might outweigh the declining firm-level marginal product of
labour, so marginal product of labour increases with aggregate employment 𝑁. In
that case, the aggregate-level labour demand curve becomes upward-sloping. The
firm-level and aggregate-level labour demand curves are plotted below:

PREPARED BY CHEN AIDI 37

EC2065 MACROECONOMICS

• In what follows, we assume the positive spill-over effect from firms’ employment is
sufficiently strong to make the aggregate labour demand curve upward sloping.
Weaker spill-overs would mean 𝑁 𝑑 remains downward sloping, only becoming
flatter. A strong enough spill-over to make 𝑁 𝑑 upward sloping implies increasing
returns to labour at the aggregate level, and results in an aggregate production
function with a convex shape as shown in the following diagram:

• Note that we assume a spill-over effect – an externality – rather than assume firms
directly have an increasing-returns production function to maintain the framework
of perfect competition.

• Increasing returns at the firm level requires a model with imperfectly competitive
firms, similar to that used earlier in the new Keynesian model with sticky prices.

Implications for The Output Supply Curve

• The coordination failure model not only needs an aggregate labour demand curve
that is upward sloping. In addition, 𝑁 𝑑 must be steeper than labour supply 𝑁 𝑠 (𝑟), as
depicted in the figure below:

PREPARED BY CHEN AIDI 38

EC2065 MACROECONOMICS

• In the dynamic macroeconomic model studied in chapter 3 point 12, the supply of
output by firms is derived from the equilibrium level of employment in the labour
market.

• In that model, the output supply curve 𝑌 𝑠 is upward sloping, meaning that the
supply of goods is positively related to the real interest rate 𝑟. Intuitively, a higher
real interest rate is needed to induce more supply by increasing the desire to save
through earning more by supplying more labour.

• The relationship between 𝑟 and the supply of goods can be reversed with a strong
enough spill-over effect in the coordination failure model. High output and high
employment generate a strong productivity-boosting spill-over, which means firms
are willing to choose high employment even when a low interest rate 𝑟 reduces
workers’ desire to save by earning more.

• As shown below, the coordination failure model features a downward-sloping

output supply curve 𝑌 𝑠 . This profoundly changes the predictions of the model
compared to the standard dynamic macroeconomic model.

10. Multiple Equilibria and Business Cycles

• Now investigate how business cycles can occur in the coordination failure model,
even when there are no exogenous shocks to the economy’s fundamentals. The key
feature of the model is that its output supply curve is downward sloping.

• Goods-market equilibrium occurs where the 𝑌 𝑠 curve intersects the usual

downward-sloping output demand curve 𝑌 𝑑 . The derivation of the output demand
curve from chapter 3 is unchanged here because the spill-over effect in the
coordination failure model works through the supply side of the economy.

PREPARED BY CHEN AIDI 39

EC2065 MACROECONOMICS

• With output demand and supply curves both being downward sloping, there may
not be a unique equilibrium in the goods market because 𝑌 𝑑 and 𝑌 𝑠 can cross more
than once. We will focus on a case where 𝑌 𝑑 and 𝑌 𝑠 intersect twice, though this is
only one of many possibilities. This case is illustrated in the following diagram:

• When there are multiple intersections of output demand and supply curves, the
economy has multiple equilibria. Each equilibrium is consistent with utility
maximisation by households and profit maximisation by firms, and market clearing
(in both goods and labour markets because every point on the output supply curve
represents a point of labour-market equilibrium given the way the 𝑌 𝑠 curve is
constructed).

• Without more assumptions, it is not possible to say which equilibrium will be the
outcome. Usually, we derive the predictions of a model from looking at what
happens in equilibrium but that is not sufficient when there are multiple equilibria.

What explains why the coordination failure model has multiple equilibria?

• This feature is due to the presence of what is known as ‘strategic complementarity’.

• Strategic complementarity refers to a situation where one person’s desire to

perform an action increases when others are also performing the same action.

• In the model, an individual firm’s marginal product of labour rises when other firms
are expanding employment and, hence, it becomes profitable for firms to expand
employment when other firms are doing so.

PREPARED BY CHEN AIDI 40

EC2065 MACROECONOMICS

• This creates strategic complementarity in firms’ employment decisions and

sufficiently strong strategic complementarity leads to multiple equilibria because
different choices made by individuals are mutually reinforcing.

• While both equilibria in the diagram in page 40 are fully consistent with rational
optimisation by individual households and firms, nonetheless, households are
generally not indifferent between them.

• The high-output equilibrium is good. It features high consumption, and wages and
productivity are high. Leisure is low but that choice makes sense because
productivity is high. The low-output equilibrium is bad.

• Consumption is low, and wages and productivity are low, only mitigated by high
leisure but that is chosen because productivity is low. The inefficiency of the low-
output equilibrium is due to the productivity spill-over effect that individuals fail to
internalise.

• Although everyone prefers the equilibrium with high output, there can be a
coordination problem in reaching it. At a low level of output, it makes sense for all
firms in the economy collectively to switch to the high-output equilibrium.

• But at the low-output equilibrium, it is individually rational for each firm to choose
low output. Therefore, the economy could get stuck at the equilibrium with low GDP
for some time, even though everyone would gain by coordinating on the high-GDP
equilibrium. A recession can thus result from a coordination failure.

What ultimately determines which of the two equilibria prevails?

• If everyone believes the high-output equilibrium will prevail, then it will, while if
everyone believes the low-output equilibrium will prevail, then it will instead. Thus,
the outcome depends on whether people are optimistic or pessimistic about the
economy’s prospects.

• However, both of these are consistent with rational expectations. There is an

independent role for beliefs, which are not uniquely determined by requirement of
rationality.

PREPARED BY CHEN AIDI 41

EC2065 MACROECONOMICS

If the optimism or pessimism of households and firms determines which equilibrium

prevails, what explains how optimistic people should be?

• Again, the model provides no direct answer. In principle, any extraneous factor
could shift the economy from pessimism to optimism and thus cause business
cycles.

• Such extraneous factors unrelated to the economy’s fundamentals are referred to

by the term ‘sunspots’. For example, there could be a media report on an event that
triggers a wave of pessimism far beyond the importance of the event to the
economy’s fundamentals.

• Business cycles in the coordination failure model can thus occur due to exogenous
shifts in optimism and pessimism, which are consistent with rational expectations
because of multiple equilibria. These induce movements of the economy between
the low- and high-output equilibria shown in the following diagram:

• If the economy goes into a recession then the real interest rate 𝑟 rises as 𝑌 falls,
moving along both 𝑌 𝑑 and 𝑌 𝑠 curves. As seen in the figure below, employment 𝑁
falls with 𝑌 when there is a movement along the aggregate production function.

PREPARED BY CHEN AIDI 42

EC2065 MACROECONOMICS

• Owing to there being increasing returns to labour, average labour productivity 𝑌/𝑁
falls with 𝑌. Moving along the aggregate labour demand curve 𝑁 𝑑 , the real wage 𝑤
falls with 𝑌 and 𝑁.

Box 8.6: The Strength of Strategic Complementarities

• The coordination failure model of business cycles depends on strategic

complementarity in firms’ employment decisions.

• This strategic complementarity comes from a positive spill-over from aggregate

employment to each individual firm’s productivity.

But how strong does this spill-over need to be for the model successfully to generate
business cycles?

• It is clear from the workings of the model that explaining business cycles as waves of
optimism and pessimism requires multiple equilibria, which depends on the output
supply curve 𝑌 𝑠 being downward sloping.

• For this to happen, the spill-over must be strong enough that there are increasing
returns to labour at the level of the aggregate economy, i.e. an upward-sloping
aggregate labour demand 𝑁 𝑑 .

• Just having a positive spillover might not be enough to offset the usual diminishing
returns to labour, as shown in the following diagram:

PREPARED BY CHEN AIDI 43

EC2065 MACROECONOMICS

• Even if the aggregate 𝑁 𝑑 curve is upward sloping, this is not enough. If labour
supply is insufficiently wage elastic, i.e. 𝑁 𝑠 (𝑟) is too steep, then there is a unique
equilibrium even if there are increasing returns to labour in aggregate. This case is
depicted in the diagram below:

PREPARED BY CHEN AIDI 44