Chapter 10
Classical Business Cycle Analysis:
Market-Clearing Macroeconomics

Goals of Chapter 10

A) Use the IS-LM model with rapidly adjusting wages and prices to present the classical model

B) Examine the relationship between money and the business cycle

I.   Business Cycles in the Classical Model (Sec. 10.1)

A) The real business cycle theory

1. Two key questions about business cycles

a. What are the underlying economic causes?

b. What should government policymakers do about them?

2. Any business cycle theory has two components

a. A description of the types of shocks believed to affect the economy the most

b. A model that describes how key macroeconomic variables respond to economic shocks

3. Real business cycle (RBC) theory (Kydland and Prescott)

a. Real shocks to the economy are the primary cause of business cycles

(1)        Examples:

a.   Shocks to the production function,

b.   the size of the labor force,

c.   the real quantity of government purchases,

d.   the spending and saving decisions of consumers (affecting the IS curve or the FE line)

(2) Nominal shocks are shocks to money supply or demand (affecting the LM curve)

b. The largest role is played by shocks to the production function, which the text has called supply shocks, and RBC theorists call productivity shocks

(1)        Examples:

a.   Development of new products or production techniques,

b.   introduction of new management techniques,

c.   changes in the quality of capital or labor,

d.   changes in the availability of raw materials or energy,

e.   unusually good or bad weather,

f.     changes in government regulations affecting production

(2) Most economic booms result from beneficial productivity shocks; most recessions are caused by adverse productivity shocks

c. The recessionary impact of an adverse productivity shock:

(1)        Results from Chapter 3:

a.   Real wage,

b.   employment,

c.   output,

d.   consumption, and

e.   investment decline,

f.     while the real interest rate and price level rise.

(2) So an adverse productivity shock causes a recession (output declines), whereas a beneficial productivity shock causes a boom (output increases); but output always equals full-employment output

d. Real business cycle theory and the business cycle facts

(1) The RBC theory is consistent with many business cycle facts

(a)              If the economy is continuously buffeted by productivity shocks, the theory predicts recurrent fluctuations in aggregate output, which we observe

(b)              The theory correctly predicts procyclical employment and real wages

(c)      The theory correctly predicts procyclical average labor productivity. If booms weren’t due to productivity shocks, we would expect average labor productivity to be countercyclical because of diminishing marginal productivity of labor

(2) The theory predicts countercyclical movements of the price level, which seems to be inconsistent with the data

(a)      But Kydland and Prescott, when using some newer statistical techniques for calculating the trends in inflation and output, find evidence that the price level is countercyclical.

(b)     Although the Great Depression appears to have been caused by a sequence of large, adverse aggregate demand shocks, Kydland and Prescott argue that since World War II, large adverse supply shocks have caused the price level to rise while output fell

(c)      The surge in inflation during the recessions associated with the oil price shocks of 1973–1974 and 1979–1980 is consistent with RBC theory

4. Application: Calibrating the business cycle

a. A major element of RBC theory is that it attempts to make quantitative, not just qualitative, predictions about the business cycle

b. RBC theorists use the method of calibration to work out a detailed numerical example of the theory

(1) First they write down specific functions explaining the behavior of people in the economy; for example, they might choose as the production function for the economy, Y = AKaN1–a

(2) Then they use existing studies of the economy to choose numbers for parameters like a in the production function; for example, a = 0.3

(3) Next they simulate what happens when the economy is hit by various shocks to different sectors of the economy

(4)        Prescott’s computer simulations (text Figures. 10.1 and 10.2) match post–World War II data fairly well

5. Are productivity shocks the only source of recessions?

a. Critics of the RBC theory suggest that except for the oil price shocks of 1973, 1979, and 1990, there are no productivity shocks that one can easily identify that caused recessions

b. One RBC response is that it doesn’t have to be a big shock; instead, the cumulation of many small shocks can cause a business cycle (text Figure 10.3)

7. Technology shocks may not lead to procyclical productivity

a. Research by Basu and Fernald shows that technology shocks are not closely related to cyclical movements in output

b. Shocks to technology are followed by a transition period in which resources are reallocated

c. Initially, less capital and labor are needed to produce the same amount of output

d. Later, resources are adjusted and output increases

8. Also, the critics suggest that shocks other than productivity shocks, such as wars and military buildups, have caused business cycles

B) Fiscal policy shocks in the classical model

1. The effects of a temporary increase in government expenditures (Figure 10.1; like text
Figure 10.4)

Figure 10.1

a. The current or future taxes needed to pay for the government expenditures effectively reduce people’s wealth, causing an income effect on labor supply

b. The increased labor supply leads to a fall in the real wage and a rise in employment

c. The rise in employment increases output, so the FE line shifts to the right

d. The temporary rise in government purchases shifts the IS curve up and to the right as national saving declines

e. It’s reasonable to assume that the shift of the IS curve is bigger than the shift of the FE line, so prices must rise to shift the LM curve up and to the left to restore equilibrium

f. Since employment rises, average labor productivity declines; this helps match the data better, since without fiscal policy the RBC model shows a correlation between output and average labor productivity that is too high

g. So adding fiscal policy shocks to the model increases its ability to match the actual behavior of the economy


A temporary increase in government purchases leads to a rise in





While average labor productivity (Y/N) and investment falls

How Does this Model do with respect to Business Cycle Facts?

(a) The business cycle fact is that employment is procyclical. The model is consistent with this fact, since employment rises when government purchases rise, causing output to rise.

(b) The business cycle fact is that the real wage is mildly procyclical. The model is inconsistent with this fact, since it shows a decline in the real wage when government purchases rise and output rises.

(c) The business cycle fact is that average labor productivity is procyclical. The model is inconsistent with this fact, since it shows a decline in average labor productivity when government purchases rise and output rises.

(d) The business cycle fact is that investment is procyclical. The model is not consistent with this fact, as investment falls when government purchases rise and output rises.

(e) The business cycle fact is that the price level is procyclical. The model is consistent with this fact, as the price level rises when government purchases increase and output increases.

2. Should fiscal policy be used to dampen the cycle?

a. Classical economists oppose attempts to dampen the cycle, since prices and wages adjust quickly to restore equilibrium

b. Besides, fiscal policy increases output by making workers worse off, since they face higher taxes

c. Instead, government spending should be determined by cost-benefit analysis

d. Also, there may be lags in enacting the correct policy and in implementing it

(1) So choosing the right policy today depends on where you think the economy will be in the future

(2) This creates problems, because forecasts of the future state of the economy are imperfect

e. It’s also not clear how much to change fiscal policy to get the desired effect on employment and output

C) Unemployment in the classical model

1. In the classical model there is no unemployment; people who aren’t working are voluntarily not in the labor force

2. In reality measured unemployment is never zero, and it is the problem of unemployment in recessions that concerns policymakers the most

3. Classical economists have a more sophisticated version of the model to account for unemployment

a. Workers and jobs have different requirements, so there is a matching problem

b. It takes time to match workers to jobs, so there is always some unemployment

c. Unemployment rises in recessions because productivity shocks cause increased mismatches between workers and jobs

d. A shock that increases mismatching raises frictional unemployment and may also cause structural unemployment if the types of skills needed by employers change

e.   So the shock causes the natural rate of unemployment to rise; there’s still no cyclical unemployment in the classical model

4. Davis and Haltiwanger show that there is a tremendous amount of churning of jobs both within and across industries

5. But this worker match theory can’t explain all unemployment

a. Many workers are laid off temporarily; there’s no mismatch, just a change in the timing of work

b. If recessions were times of increased mismatch, there should be a rise in help-wanted ads in recessions, but in fact they fall

6. So can the government use fiscal policy to reduce unemployment?

a. Doing so doesn’t improve the mismatch problem

b. A better approach is to eliminate barriers to labor-market adjustment by reducing burdensome regulations on businesses or by getting rid of the minimum wage

D. Household production

1. The RBC model matches U.S. data better if the model accounts explicitly for output produced at home

2. Household production is not counted in GDP but it represents output

3. Rogerson and Wright used a model with household production to show that such a model yields a higher standard deviation of (market) output than a standard RBC model, thus more closely matching the data

4. Parente, Rogerson, and Wright showed that after household production is accounted for, income differences across countries are not as large as the GDP data show

II. Money in the Classical Model (Sec. 10.2)

A) Monetary policy and the economy

Money is neutral in both the short run and the long run in the classical model, because prices adjust rapidly to restore equilibrium

B) Monetary nonneutrality and reverse causation

1. If money is neutral, why does the data show that money is a leading, procyclical variable?

a. Increases in the money supply are often followed by increases in output

b. Reductions in the money supply are often followed by recessions

2. The classical answer: Reverse causation

a. Just because changes in money growth precede changes in output doesn’t mean that the money changes cause the output changes

b. Example: People put storm windows on their houses before winter, but it’s the coming winter that causes the storm windows to go on, the storm windows don’t cause winter

c. Reverse causation means money growth is higher because people expect higher output in the future; the higher money growth doesn’t cause the higher future output

d. If so, money can be procyclical and leading even though money is neutral

3. Why would higher future output cause people to increase money demand?

a. Firms, anticipating higher sales, would need more money for transactions to pay for materials and workers

b. The Fed would respond to the higher demand for money by increasing money supply; otherwise, the price level would decline

C) The nonneutrality of money: Additional evidence

1. Friedman and Schwartz have extensively documented that often monetary changes have had an independent origin; they weren’t just a reflection of changes or future changes in economic activity

a. These independent changes in money supply were followed by changes in income and prices

b. The independent origins of money changes include such things as gold discoveries, changes in monetary institutions, and changes in the leadership of the Fed

2. More recently, Romer and Romer documented additional episodes of monetary nonneutrality since 1960

a. One example is the Fed’s tight money policy begun in 1979 that was followed by a minor recession in 1980 and a deeper one in 1981

b. That was followed by monetary expansion in 1982 that led to an economic boom

3. So money does not appear to be neutral

4. There is a version of the classical model in which money isn’t neutral—the misperceptions theory discussed next

Analytical Problems Chapter 11

1. The discovery of a new technology increases the expected future marginal product of capital.

Expected future marginal product of capital increases, shifting the schedule to the right, increasing the desired capital stock.

Recall the investment function

Adjustment story: at ro the level of desired savings is less than the level of desired investment. That is equivalent to saying the following

i.e., the Goods Market is not in equilibrium at ro. Explain adjustment in the goods market in terms of movements along desired savings and desired investment. (Note that we are assuming that prices of the goods are not changing)

adjustment along the savings schedule:

adjustment along the investment schedule:

Now we can write out the IS function explicitly

If then the IS curve shifts up, i.e., to the right.

Note that when we consider changes in r and Y, then we are contemplating movements along the IS curve!

When an exogenous variable changes, we are considering what happens to the equilibrium interest rate for a given level of output, .

Asset Market Equilibrium:

       Recall our money demand function

In equilibrium                               




Now we can graph this relationship

Money supply changes: shifts the money supply curve to the left

Adjustment Story: at r1 the quantity of money demanded exceeds the quantity of money supplied. As money holders sell some of their nonmonetary assets so they can hold more money in their portfolios, the price of nonmonetary assets is driven down. This raises the real interest rate on nonmonetary assets. As r rises the quantity of money demanded falls (movement along a negatively sloped money demand curve), until equilibrium is reached. Show with the money demand equation.


The shift in aggregate demand causes no change in output. Why is this so? Because the model we are using assumes a vertical AS curve. What does this say about the adjustment of the LM curve after the initial shift in the IS curve? Consider

The shift in IS to the right yields intersection at point 2. What do we know about the relationship between the aggregate quantity of goods supplied and aggregate quantity of goods demanded at point 2?

At point 1: Initial general equilibrium point. After the change in the future expected marginal product of capital, this would be the short run equilibrium, where IS and LM intersect if prices did not adjust very rapidly. The classical model assumes that prices adjust very quickly. Let’s go through the adjustment process again to make sure that we are clear. At point 2 the goods market is in equilibrium since aggregate quantities of goods supplied equal the quantities demanded. Recall that firms always produce more output as aggregate quantities of goods demanded rises. But notice that the firms, though, they are meeting this demand, they are producing more output than the full-employment level of output. The full-employment level of output fell when FE shifted to the left. The full-employment level of output is determined by the firms’ labor and capital hiring decisions. But, at point 2, firms’ are producing more than their profit maximizing levels of output. So at point 2

Thus point 2 cannot be a long run equilibrium. But how will this adjust? Recall, that we have taken prices to be fixed. But now that will no longer be the case. Firms will raise their prices since the aggregate quantity of goods demanded exceeds what firms want to produce.

Price level rises:

How do we explain the movement along the IS curve?

Now consider the graph below on the next page.

The shift in the LM curve represents the movement along the AD curve. Recall that every point on the AD curve represents equilibrium in the goods market. As the LM curve shifts along the stable IS curve, it traverses the various interest rate output combinations that all coincide with goods market equilibrium (since these are points on the IS curve) and they also represent equilibria in the asset market (since they coincide with points on the LM curve).

b. Find the effects of the expected future marginal product of capital using the misperceptions theory.

Note that W is the nominal wage, not the real wage.

In the short run the wage earners misperceive their real wage, confusing a rise in the nominal wage with a rise in the real wage. They are “fooled” into offering more labor hours than they would have offered otherwise. Eventually the workers will catch on (how fast depends on the type of expectations assumption that one makes, i.e., how do agents update their expectations.) and the SRAS curve will shift to the left as laborers will reduce their supply of labor.

In the long-run, actual output is equal to the potential level of output as in the classical model.

2. Permanent increase in government spending. How does it affect labor supply? Recall our model and the labor supply/labor demand analysis that we utilized in that model.

(Note that here ‘w’ is the real wage.)

Where the labor supply and labor demand functions are


The Reasoning

  1. When government purchases increase permanently, the present value of taxes increases. Here we are assuming that agents realize that they will have to pay for the increased government spending now and in the future.
  1. They realize that their expected future income is no lower than it was before the change in the pattern of government expenditures.
  1. Wealth has fallen, shifting the labor supply curve to the right. A decrease in wealth decreases the amount of leisure that workers can afford.
  1. Worker’s increase their labor supply more when the government spending change is permanent than when it is temporary

b. Because the tax increase is permanent, assume that at any constant levels of output and the real interest rate consumers respond by reducing their consumption each period by the full amount of the tax increase. Under this assumption, how does the permanent increase in government purchases affect desired national saving and the IS curve?

Answer: Recall the definition of national savings a closed economy

Substitute in desired consumption for consumption

Consider the following policy experiment: increased government expenditures financed by higher current taxes.

What happens to disposable income, desired consumption and desired national savings?

The question asked us to assume that consumers respond to increased taxes by reducing their consumption each period by the full amount of the tax increase. This leaves desired national saving unchanged. Desired savings does not shift. The IS curve does not shift.

c. How does the increase in government purchases and taxes affect the model?

Answer: Labor supply increases due to falling wealth. This shifts the labor supply out along a stable labor demand schedule. The full employment level of employment rises. Thus, the full employment line shifts out rightward. Also, this means that the classical AS curve shifts to the right as well.

Note that the AD curve does not change.

Now, what happens if consumers reduce their current consumption by less than the permanent increase in government purchases?

Answer: Recall the definition of national savings a closed economy

Substitute in desired consumption for consumption

Consider the following policy experiment: increased government expenditures financed by higher current taxes.

What happens to disposable income, desired consumption and desired national savings?

The fall in desired consumption does not offset the increase in government spending so desired national savings falls.

Desired savings falls

Now combine this shift in the IS curve with

When we combine the above graph with the shift in the IS curve we shall see that the real interest rate and the price level will fall by less than in the case in which current consumption falls dollar for dollar with the rise in taxes. And the real interest rate and the price level may even rise if the IS curve shifts by a lot as shown below.

Reasoning for the Above Graph:

  1. If consumption falls less than the increase in government purchases, the IS curve shifts up and to the right from IS1 to IS2.

  1. As a result of the shift in the IS curve, the real interest rate and the price level will fall by less than in the case in which current consumption falls by the same amount as government expenditure rises, and

  1. in fact, the real interest rate and the price level may even rise if the IS curve shifts by a lot, as shown in the figure above and below.