Chapter 5_The Challenge of New Classical Macroeconomics

7/23/2019 Chapter 5_The Challenge of New Classical Macroeconomics

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The Challenge ofNew Classical

MacroeconomicsAbdul Hadi IlmanUniversitas Teknologi Sumbawa

November 2!"

Cha#ter $Introduction to Advanced Macroeconomic%Scarth& 2'(


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Introduction in Cha#ter $& we e)amine the New Classical a##roach to business c*cle anal*sis +

more micro,based version of the market,clearing a##roach to macroeconomics& in wa##eal to stick* #rices is involved

-ur anal*sis thus far ma* have left the im#ression that all macroeconomists feel comodels which .e)#lain. short,run business c*cles b* a##ealing to some form of nom

The 0ioneer of 1new s*nthesis would regard some of underl*ing assum#tion concestick* #rice as 1heroic

New 3e*nesian4s reaction is to e)#lain to foundation of menu cost %the cost of chan#rices(& and to elaborate how other features& such as real rigidities and strategiccom#lementarities& make the basing of business c*cle theor* on seemingl* small ma##ealing after all

New Classical4s reaction to the #ro#osition that menu costs .seem. too small to e)#c*cles is to investigate whether cycles can be explained without any referencrigidities at all/


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Introduction The cha#ter is organi5ed as follow6

!/ The original real business c*cle model

2/ 7)tension of the basic model

8/ -#timal in9ation #olic*

"/ Harberger tiangles vs -kun4s :a#


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The -riginal ;eal rms slide back and forth alabour demand curve/ Thus& the model #redicts that the real wage moves con%and this is not observed(& and because the labour market is not clearing& it mlabour su##l* curve irrelevant for determining the level of em#lo*ment/

New Classicals prefer to assume that wages are exible and that the market always clears/ To their critics& a model which assumes no involuntarunem#lo*ment is an .obviousl*. bad idea/ rst antici#ated b* 3e*nesians/

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The -riginal ;eal eld ne)t #eriod shifts the labour demand curve back to the left/ Thto this view& business cycles are interpreted as shifts in the position ofdemand curve& not movements along a >)ed labour demand curve/

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The -riginal ;eal


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The -riginal ;eal


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The -riginal ;eal t over time/ So the* increase consum#tion b* less than their incoincreased initiall*& and as a result& some of the new out#ut goes into ca#ital ac

It is im#ressive that these ver* sim#le calibrated models can mimic the actuaof investmentBs higher volatilit* relative to consum#tion

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The -riginal ;eal


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7)tensions to the rst e)tension we consider is an alteration in the utilit* function/ Thin eDuation %$/!( embodies the assum#tion that the marginal utilit* of le#eriod is not aected b* the amount of leisure en?o*ed in other #eriods

The modern a##roach to ada#ting the utilit* function %central to much rClassical work( is to s#ecif* that toda*Bs utilit* de#ends on both toda*Bsconsum#tion and toda*Bs level of habits/ Habits evolve over time accordfollowing relationshi#6

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Another e)tensions6

Indivisible labour/ At the macro level& then& variation in em#lo*ment comchanges in the number of #eo#le working& not from variations in average howorker/ This means that the macro correlations are not #inned down b* neeconsistent with evidence from micro studies of the hours su##lied b* each i%that show a ver* small elasticit*(/

Non-market activity/ .home. #roduction is a ver* signi>cant amount of re

activit*/


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Variations in government spending/ This work involves adding an a

%demand( shock %in addition to technolog* shocks( to the model for e)a

is added to the s*stem& and the market clearing condition is changed t

Increases in government s#ending raise interest rates& and higher intere

decrease the #resent value of working in the future/ @ith the relative reworking in the current #eriod thereb* increased& the current,#eriod labocurve shifts to the right/ @ith these su##l*,side shifts in the model& somvariations in em#lo*ment are e)#lained b* shifts along a given labour dcurve/ @ith this additional source, of em#lo*ment 9uctuation& the magntechnolog* shocks does not need to be as great for the calibrated modegenerate realistic changes in em#lo*ment/

7)tensions to the


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he variability of price mark-ups over the cycleis an e)ademand,shift mechanism& we know that the mark,u# of #rice omarginal cost falls during booms because of the entr* of new >fact causes the labour demand curve to shift to the right during

!ouseholds shifting between market-oriented employmhome production is an e)am#le of a su##l*,shift mechanism

"ayment lag/ If >rms have to #a* their wage bill one #eriod breceiving their sales revenue& the labour demand function beco

(W/P)(1+r) so variations in the interest rate shift the #osition olabour demand curve/

7)tensions to the


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It is interesting to note the convergence involved with #arts of New 3e*nNew Classical work/

3e*nesians have been taking e)#ectations and micro foundations more im#rove the logical consistenc* of their s*stems&

while Classicals are embracing such things as autonomous e)#enditure vim#erfect com#etition and #a*ment lags to im#rove the em#irical succesmodels/

=es#ite this convergence& however& there is still a noticeable dierence Classical models have the #ro#ert* that the observed 9uctuations in emhave been chosen b* agents& so there is no obvious role for governmenout#ut variation below what agents have alread* determined to be o#tim#resum#tion of social o#timalit* is ina##ro#riate& however& if markets faireason %such as e)ternalities& moral ha5ard& or im#erfect com#etition(/

7)tensions to the


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Hansen and @right %!''2( have shown that when all of te)tensions are combined& a sim#le aggregative model cagenerate data that re9ects fairl* well the main features oreal,world real wageem#lo*ment correlations after all/

t the facts well enough& so

#ioneers of this a##roach %for e)am#le& :oodfriend and 3%!''J( have called for the New Neoclassical S*nthesis intem#oraril* stick* #rices are added to the real business model/ @e consider this s*nthesis in some detail in Cha#

7)tensions to the


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It ma* seem sur#rising that New Classicals have embraced the hallm3e*nesian anal*sis + stick* #rices/ @h* has this ha##ened

0erha#s because there is one fact that a##ears to su##ort the relevanominal rigidities + the well,documented correlation between changnominal mone* su##l* and variations in real out#ut/ 7ither this is efavour of nominal rigidities& or it is evidence that the central bank alaccommodates + increasing the mone* su##l* whenever more is w%during an u#swing(

-ne >nal consideration is that real and nominal e)change rates are correlated/ Man* economists argue that there a##ears to be no wa*for this fact other than b* embracing short,run nominal rigidities/

7)tensions to the


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3e*nesians welcome this convergence of research a##roaches& *et %at thelevel( the* remain concerned about the lack of market failure involved in ttradition/ Also& the* have some em#irical concerns6

The real business c*cle a##roach is based on the notion of intertem#oral substlabour su##l*/ However& micro studies of household behaviour suggest that leiconsum#tion of goods are com#lements& not substitutes %as assumed in New Ctheor*(/

Another awkward fact is that& in the United States at least& onl* !$ #ercent of a

market se#arations are Duits/ The rest of se#arations are la*os/ In addition& thDuits indicates that the* are higher in booms/ The real business c*cle model #se#arations are Duits and that the* are higher in recessions/

Ginall*& it is a fact that a high #ro#ortion of unem#lo*ment involves individualsbeen out of work for a long time + an outcome that does not seem consistent assum#tion of random se#arations/

It is im#ossible to observe the technolog* shocks directl*/

7)tensions to the


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Given these problems, wh !oes real business"ccle theor apman o# the best oun$ min!s o# the pro#ession%

rm basis in microeconomic #rinci#les and its abilit* to matcsigni>cant features of real,world business c*cles

7)tensions to the


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To ?ustif* a 5ero,in9ation target& man* anal*sts make the following argument/ Since in9ation is a ta) on the holders of mone*& and since ta)es create a loss of consu

known as an .e)cess burden. + that ta) %in9ation( should be eliminated/

The #roblem with this argument is that if one ta) is eliminated& the government must ta) %and that other ta) creates an e)cess burden of its own(/

;ecogni5ing this& the standard a##roach in #ublic >nance is to recommend the .inversrule. for setting ta)es/

Since e)cess burdens are bigger when ta)es cause large substitution eects& the ecifor ?udging ta)es sti#ulates that the largest ta) rates should a##l* to the items that hasmallest #rice elasticities of demand/

Since the interest rate is the %o##ortunit*( cost of holding mone*& and since the estimaelasticit* of mone* demand is ver* small& the inverse elasticit* rule can be used to derelativel* large ta) on mone*/

In other words& it su##orts choosing an in9ation rate that is %#erha#s well( above 5ero/

-#timal In9ation 0olic*0art 8


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The full,eDuilibrium bene>ts of low in9ation are inde#endthe com#le)ities of the transition #ath that the econom*reach the long run %such as those caused b* nominal riga result& all anal*sts agree that a basic version of the NeClassical model is the a##ro#riate vehicle to use for estimthe bene>ts of that #olic*/

Since our focus is on the longterm bene>ts of low in9atioan e)am#le of New Classical work that highlights mone*Mansoorian and Mohsin %2"(/



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Households ma)imi5e a standard utilit* function/ As usuainstantaneous utilit* is a weighted average of leisure andconsum#tion

U P %&In%! , N( Q %! , &( ln '(&

and there is a constant rate of time #reference& E/

The budget constraint is

Consum#tion is the sum of wage and em#lo*ment incomthe transfer #a*ments received from the government& R&the in9ation ta) incurred b* holding real mone* balancesminus asset accumulation/



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The full,eDuilibrium version of the model is described b* the following eDuations6

The >rst eDuation is the ;amse* consum#tion function when consum#tion growthfollows from the household dierentiating with res#ect to variable C(/

The second eDuation is what emerges when the labour su##l* function %that follohousehold dierentiating with res#ect to variable N( is eDuated with the >rmsB lafunction/

The third eDuation is the #roduction function& and

the fourth is the other relationshi# that follows from #ro>t ma)imi5ation + that cato the #oint that its marginal #roduct eDuals the interest rate/

The >nal three eDuations can be used to determine how consum#tion& em#lo*meca#ital stock res#ond to dierent in9ation rates/



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As noted& the government budget constraint is

This eDuation states that lum#,sum transfer #a*ments& T& areindividuals& and in aggregate& these transfers are >nanced b* in9ation ta)

@ith R endogenous& cutting inflation is unambiguousl* .goodin9ation eliminates ta) that distorts the household saving decno other distortion is introduced b* the government having toother ta) to acDuire the missing revenue/ Consum#tion& em#loout#ut and the ca#ital stock all increase b* the same #ercentathe in9ation rate is reduced/ S#eci>call*&



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Mansoorian and Mohsin calibrate the model with standard real,buassum#tions6 P /"& E P /"2& P /8 and the* assume an iinflation rate of 5ero6 P / These assum#tions allow them to evin9ation multi#lier/ The result is that creating in9ation of 2V lowestate consum#tion b* !/8JV/ This outcome is an annual annuit*/

@ith no growth and a discount rate of /"2& the #resent value of

loss in consum#tion is /!8JW/"2 P 82V of one *earBs level ofconsum#tion/

Most anal*sts regard this magnitude as Duite large/ The #olic* imthat even a two,#ercent in9ation rate should not be tolerated/



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7)#erience has shown %see


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In diagrammatic terms& thereasoning is illustrated in Gigure $/!&where we continue to abstract froman* ongoing growth/ New Classicalanal*sis is used to estimate the shiftu# in the #otential :=0 line thataccom#anies disin9ation& and theshort,run s*nthesis model %in which

#otential :=0 is e)ogenous( is usedto calculate the tem#orar* dro#%and then later recover*( in actual:=0/



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-ne una##ealing as#ect of this estimate of the long,termof low in9ation is that it involves the assum#tion that themonetar* authorit* can dictate to the >scal #olic* makerinsist that the latter must cut transfer #a*ments in the fadisin9ation(/

How is the anal*sis aected if we assume that this is not

To e)#lore this Duestion& we add a ta) on wage income/ A%as we have alread*( that the wage eDuals the marginal of labour& we re,e)#ress the government budget constra



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There is one change in household budget constraint& since it must now sti#uhouseholds receive onl* the after,ta) wage/ This results in onl* one changeeDuation in our list of the modelBs relationshi#s becomes6

It is more dicult for disin9ation to be su##orted in this case& since one distwage,ta)( is re#lacing another %the in9ation ta)(/ Indeed& in this case& for thassumed b* Mansoorian and Mohsin& it turns out that the .bene>t. of lower

to be negativeX =isin9ation forces the >scal authorit* to rel* more heavil* on a more distor

revenue source than the in9ation ta)/ Similar results in more elaborate calibmodels are re#orted in Coole* and Hansen %!''!(/ It would therefore a##ea#ublic,>nance a##roach %that sim#li>es b* using a New Classical model witgrowth( does not lead to a solid under,#inning for a 5ero in9ation target/



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A somewhat more reliable argument for choosing a ver* low irate %#erha#s 5ero( as .best&. concerns the eect of in9ation in a growth conte)t/ Most ta) s*stems are not full* inde)ed fo

To a##reciate wh* this is im#ortant& su##ose *ou have a Y!gives *ou a nominal return of !V/ Su##ose that in9ation is $that the interest rate on *our bond would be $V if in9ation w

At the end of the *ear& the >nancial institution sends *ou a taindicating that *ou received Y! of interest earnings& and thegovernment ta)es *ou on the entire Y!/ In fact& however& onthe Y! is interest earnings/ The other Y$ is com#ensation fothat the #rinci#al value of *our investment has shrunk with in



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An interest income ta) s*stem should ta) onl* interest innot the saverBs de#reciation e)#enses/ An inde)ed ta) s*would do ?ust this/

Thus& in9ation reduces the incentive to save& so that indliving in the future inherit either a smaller ca#ital stock %which to work( or a larger foreign debt to service& or both

According to this anal*sis& then& to avoid a lowering of fuliving standards& we should #ursue a .5ero. in9ation targ

The case for 5ero in9ation is far from com#lete



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Much of this book has focused one)#lanations of the business c*cleand an evaluation of stabili5ation#olic*/ It has been im#licit thatthere would be signi>cant gainsfor societ* if the business c*cle

could be eliminated

@ithout business c*cles& actualout#ut& *& would coincide with thenatural rate& & and both serieswould follow a smooth growth

#ath such as the straight line

Harberger Triangles vs/ -ku:a#

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Chapter 5_The Challenge of New Classical Macroeconomics