Macroeconomics

Sixth Canadian Edition

Chapter 13
Business Cycles

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Chapter 13 Topics
• Real Business Cycle Model.
• How the Real Business Cycle Model Fits the Data
• New Keynesian Model with Sticky Prices.
• Non-neutrality of Money When Prices are Sticky.
• Monetary and Fiscal Policy in the New Keynesian Model.
• Liquidity Trap and Negative Interest Rate Policy.

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Real Business Cycle Model
• Business cycles are caused by fluctuations in total factor
productivity.
• There is no role for the government in smoothing business
cycles – cycles are just optimal responses to the
technology shocks.
• Model fits the data well.

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Figure 13.1
Solow Residuals and GDP

The Solow residual (the red line), a measure of total factor productivity, tracks aggregate real GDP (the
blue line) quite closely.

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Figure 13.2
Effects of a Persistent Increase in Total Factor Productivity in the
Real Business Cycle Model

With a persistent increase in total factor productivity, the output supply curve shifts to the right because
of the increase in current total factor productivity, and the output demand curve shifts to the right
because of the anticipated increase in future total factor productivity. The model replicates the key
business cycle facts.

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Figure 13.3
Average Labour Productivity with Total Factor Productivity
Shocks

When output and employment are high, average labour productivity is also high, as in data.

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Table 13.1
Data Versus Predictions of the Real Business Cycle Model with
Productivity Shocks

Variable Data Model

Consumption Procyclical Procyclical
Investment Procyclical Procyclical
Employment Procyclical Procyclical
Real Wage Procyclical Procyclical
Average Labour Productivity Procyclical Procyclical

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Figure 13.4
Procyclical Money Supply in the Real Business Cycle Model with
Endogenous Money

A persistent increase in total factor productivity increases aggregate real income and reduces the real
interest rate, causing money demand to increase. If the central bank attempts to stabilize the price level,
this will increase the money supply in response to the total factor productivity shock.

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The New Keynesian Sticky Price Model
• Firms sell as much output as is demanded in the short run
at a fixed price.
• Model monetary policy as a fixed target for the interest rate
r, supported by setting the money supply appropriately.
• Employment determined as the quantity of labour required
to produce the quantity of output demanded at the fixed
price of goods.

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Figure 13.5
The New Keynesian Model

Given the fixed price level P* and the target interest rate r*, output is Y*, determined by the output
demand (IS) curve, and the central bank must supply M* units of money to hit its interest rate target.
Firms hire N* units of labour at the real wage w*. The natural rate of interest is rm, and the output gap is
Ym - Y*.

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Two Key Concepts
• The output gap is the difference between equilibrium
output (if prices were flexible) and actual output.
• The natural rate of interest is the equilibrium rate of
interest if prices were flexible.

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The Nonneutrality of Money in the New
Keynesian Model
• A reduction in the central bank’s interest rate target,
supported by an increase in the money supply, acts to
increase aggregate output and employment.
• The demand for output rises at the fixed price of goods,
and firms accommodate the increase in demand by hiring
more workers.
• Consumption, investment, real wage, increase.

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Figure 13.6
A Decrease in the Central Bank’s Interest Rate Target in the New
Keynesian Model

Money is not neutral with sticky prices. A decrease in the interest rate target results in an increase in
output, and the central bank must increase the money supply to achieve its interest rate target.
Employment, the real wage, consumption, investment, and the money supply all increase.

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Principles of New Keynesian Stabilization
Policy
• Private markets cannot work efficiently on their own. Prices
(and/or wages) do not move quickly enough to clear all
markets in short run.
• Fiscal and/or monetary policy decisions can be made
quickly enough, and policy actions work quickly enough
that the government can improve economic efficiency by
smoothing out business cycles.

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Figure 13.7
Stabilization Using Monetary Policy

Initially, the level of output is Y1 given the interest rate target r1 and the price level P1. In the long run,
the price level will fall to P2, but the central bank can achieve Y2 in the short run by reducing the
interest rate target to r2.

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Figure 13.8
Stabilization Using Fiscal Policy

Given the central bank’s interest rate target r1, an increase in government spending shifts the output
demand and supply curves to the right and restores efficiency in the short run.

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Choosing Between Monetary Policy and
Fiscal Policy
• Fiscal policy or monetary policy can achieve stabilization –
eliminating the output gap.
• But, fiscal policy has different implications than monetary
policy for the allocation of resources
• Obtain different mixes of sectoral output –
consumption/investment/government expenditure.

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Does the Keynesian Model Replicate
the Data?
• Important in the New Keynesian model to recognize that
monetary policy is endogenous.
• Since money is not neutral, the behaviour of the central
bank matters for what we will see in the data.
• Suppose that there are total factor productivity shocks, and
central bank acts to close the output gap.

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Figure 13.9
Persistent Total Factor Productivity Shocks with an Optimal
Monetary Policy Response

If the central bank responds optimally to the productivity shock, the data can behave in the same manner
as data produced by a real business cycle model.

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Hard to Distinguish Between New
Keynesian and Real Business Cycle Models
1. New Keynesian Model: Suppose central bank always
closes the output gap.
2. Real Business Cycle Model: Suppose the central bank
stabilizes the price level.
• Cases 1 and 2 produce exactly the same data under
persistent total productivity shocks.
• In both cases prices are observed to be “sticky,” and real
variables behave in the same way.

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The Liquidity Trap and Sticky Prices
• The zero lower bound on the nominal interest rate creates
a problem for the use of monetary policy as a stabilization
tool.
• Monetary policy cannot close the output gap at the zero
lower bound.

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Figure 13.10
Liquidity Trap

Initially with output equal to Y1, the nominal interest rate is zero. If firms anticipate a reduction in the
future marginal product of capital, and the nominal interest rate is constrained by the zero lower bound,
then output falls to Y2. But, if the central bank can implement negative nominal interest rates, it may be
possible to lower the real interest rate to r2 and to achieve output level Y3.

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Unconventional Monetary Policy: Negative
Nominal Interest Rates
• Zero need not be the lower bound on the nominal interest
rate.
• Effective lower bound less than zero – experience in
Switzerland, Denmark, Euro Area, Sweden, Japan with
negative interest rates.
• In New Keynesian model, may be able to eliminate the
output gap at a negative nominal interest rate.

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Taylor Rules and Unconventional Monetary
Policy
• Taylor rule for monetary policy: increase the nominal
interest rate when inflation too high, decrease nominal
interest rate when output gap too high.
• Example: R = 3.6 + 0.4i − 1.9gap
• Then some argue that, if Taylor rule predicts R < 0 then
that is the time for unconventional monetary policy.

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Figure 13.11
The Bank of Canada’s Target Interest Rate, and Predictions of a
Taylor Rule

A Taylor rule fit to the 1991–2007 data predicts well the interest rate cuts by the Bank of Canada during
the 2008–2009 recession. But in the 2011–2019 period, the actual target interest rate is much lower than
predicted by pre-2008 Bank of Canada behaviour.

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What Did the Taylor Rule Predict for
Canada?
• Taylor rule fit to pre-2008–2009 recession data.
• Rule predicts a target interest rate much higher than what
Bank of Canada did after the recession.
• Rule does not tell us that unconventional policy would
have been appropriate.

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