CHAPTER SUMMARY
1. Classical business cycle analysis uses the classical IS-LM model along with the assumption that wages and prices adjust quickly to bring the economy into general equilibrium.
2. The real business cycle (RBC) theory is a version of the classical theory that emphasizes productivity shocks (shocks to the production function) as the source of business cycle fluctuations. In the classical IS-LM model, a temporary decline in productivity reduces the real wage, employment, and output, while raising the real interest rate and the price level. The RBC theory can account for the observed procyclical behavior of employment, real wages, and labor productivity. However, the prediction of the RBC theory that prices are countercyclical is viewed by some as a failing.
3. The Solow residual is an empirical measure of total factor productivity, A, in the production function. It increases as a result of technical progress that increases the amount of output that can be produced with the same amounts of labor and capital services (inputs). The Solow residual also changes as a result of changes in the utilization rates of capital and labor. It is procyclical at least partly because the utilization rates of capital and labor are procyclical. The procyclical behavior of the utilization rate of labor may reflect labor hoarding, which occurs when firms continue to employ workers during recessions but use them less intensively or on tasks, such as maintenance, that don't contribute directly to measured output.
4. Classical business cycle analysis allows for other shocks to the economy besides changes in productivity, including changes in fiscal policy. According to the classical IS-LM model, an increase in government purchases raises employment, output, the real interest rate, and the price level. Including both fiscal and productivity shocks in the classical model improves its ability to fit the data.
Although fiscal policy can affect employment and output, classical economists argue that it should not be used to smooth the business cycle because the invisible hand leads the economy to an efficient outcome without government interference. Instead, decisions about government purchases should be based on comparisons of costs and benefits.5. In the basic classical model (which includes RBC theory), money is neutral, which means that changes in the nominal money supply change the price level proportionally but do not affect real variables such as output, employment, and the real interest rate.
6. The basic classical model can account for the procyclical and leading behavior of money if there is reverse causation—that is, if anticipated changes in output lead to changes in the money supply in the same direction. For example, if firms increase their money demand in anticipation of future output increases, and if the Fed (to keep the price level stable) supplies enough extra money to meet the increase in money demand, increases in the money stock precede increases in output. This result holds even though changes in the money stock don't cause subsequent changes in output.
7. Examination of historical monetary policy actions suggests that money isn't neutral. Friedman and Schwartz identified occasions when the money supply changed for independent reasons, such as gold discoveries or changes in monetary institutions, and changes in output followed these changes in the money supply in the same direction. Later experiences, such as the severe economic slowdown that followed Federal Reserve Chairman Volcker's decision to reduce money growth in 1979, also provide evidence for the view that money isn't neutral.
8. The misperceptions theory is based on the idea that producers have imprecise information about the current price level. According to the misperceptions theory, the amount of output supplied equals the fullemployment level of output, Y, only if the actual price level equals the expected price level.
When the price level is higher than expected, suppliers are fooled into thinking that the relative prices of the goods they supply have risen, so they supply a quantity of output that exceeds Y. Similarly, when the price level is lower than expected, the quantity of output supplied is less than Y.9. The short-run aggregate supply (SRAS) curve based on the misperceptions theory slopes upward in describing the relationship between output and the actual price level, with the expected price level held constant. In the long run, the price level equals the expected price level so that the supply of output equals Y; thus the long-run aggregate supply (LRAS) curve is a vertical line at the point where output equals Y.
10. With the upward-sloping SRAS curve based on the misperceptions theory, an unanticipated increase in the money supply increases output (and is thus nonneutral) in the short run. However, because the long-run aggregate supply curve is vertical, an unanticipated increase in the money supply doesn't affect output (and so is neutral) in the long run. An anticipated increase in the money supply causes price expectations to adjust immediately and leads to no misperceptions about the price level; thus an anticipated increase in the money supply is neutral in both the short and long runs.
11. According to the extended classical model based on the misperceptions theory, only surprise changes in the money supply can affect output. If the public has rational expectations about macroeconomic variables, including the money supply, the Fed cannot systematically surprise the public because the public will understand and anticipate the Fed's pattern of behavior. Thus classical economists argue that the Fed cannot systematically use changes in the money supply to affect output.
►