Monetary Business Cycles

Introduction:

The New Keynesian Model in the context of Macro Theory

Monetary business cycles

� Continuation of Real Business cycles (A. Pommeret)

� 2 problem sets� Common exam� Martina.Insam@unil.ch, Extranef 123� Kenza.Benhima@unil.ch, Extranef 250

Broader context

� What are the sources of macroeconomicfluctuations?

� Should we and how do we use policy?

Main subject: the short-run relationship

between nominal and real variables

� Theory:� Question of the neutrality of money Lucas (Nobel Lecture):« This tensions between two incompatible ideas – that

changes in money are neutral unit changes and thatthey induce movements in employment and production in the same direction – has been at the center of monetary theory at least since Hume wrote »

� Corner stone of macro theory

Main subject: the short-run relationship betweennominal and real variables

� Empirical studies tend to confirm thispositive link between money and income

� Important to understand how monetarypolicy works and how to use it

Reminder of the context

� Consensus: IS/LM with fixed prices + Phillips curve

� Limits� Empirical: stagflation in the 70’s� Theoretical: lack of microeconomic foundations

� Expectations� Origin of nominal rigidities

RBC

� Rational expectations� Optimizing representative agent� Flexible prices� Perfect competition

Implications of RBC

(1) Output is driven by supply shocks(productivity shock)

(2) No effect of money in the economy

(3) Cycles at equilibrium

Implications of RBC

(1) Output is driven by supply shocks(productivity shock)

� Why?

� Central role of intertemporal substitution of labor. Why?

Implications of RBC

(2) Effect of money in the economy

� Money in standard RBC: No effect or very small and negative (this course)

� + Imperfect information (see Advanced Macro course): effects are positive but short-livedExample: Lucas Island model

Implications of RBC

(3) Cycles at equilibrium

� no cost of fluctuations

� no room for policy

Very successful models

� Highly parcimonious and rigorouslymicroeconomically founded

� Natural extension of the standard intertemporalgeneral equilibrium model

� Mimic most macroeconomic variables quite well

� Prescott: « The business cycle is not a puzzle; rather, it would be a puzzle if we did not observe business cycles »

Criticism of RBC

(1) Empirical limits

(2) Policy irrelevance

Criticism of RBC

(1) Empirical limits

� Criticism of productivity shocks as the main sources of fluctuations

� Intertemporal substitution of labor is low

� Effect of money on the economy is positive and long-lived (ex. Volcker disinflation)

� Existence of nominal rigidities

Criticism of RBC

Mankiw (1989)

Criticism of RBC

(2) « No room for policy »: dangerous statement!

� Natural outcome of a model with optimizing agents and no frictions (Pareto-efficiency)

� New Keynesians keep optimizing agents, but introduce frictions

Fixed price models

� Disequilibrium analysis (Clower, Patinkin, Bénassy)

� General approach: what happens when actualprices differ from the walrasian prices?

� Parallel to the development of RBC

Fixed price models� Three possible regimes (see PS1):

� Excess supply in both the labor and good market: Keynesian unemployment

� Excess supply in the labor market and excess demandin the good market: Classical unemployment

� Excess demand in both the labor and good market: Suppressed inflation

Fixed price models

� Keynesian unemployment is of particularinterest: � Output is demand-driven, � Monetary and fiscal policy are effective� Room for policy

� Troubling resemblance with a Keynesianeconomy (IS/LM)

� But lack of microfoundations : why would the economy be in that regime in particular?

New Keynesian model(s)

� Microfoundations:� Similar to RBC (rational expectations and

optimizing agents)� But adds frictions, notably imperfect competition

� Nominal rigidities (staggered price-setting)� Demand-driven supply

� RBC� Imperfect information

Rational expectations

� IS/LM

� New Keynesian modelImperfect competition

� Fixed Price models

Nominal rigiditiesDemand-driven supply

Lucas critique ≠

New Keynesian model(s)

� « New IS/LM » with « New Phillips curve »

� Empirical implications:� Monetary shocks add to the stochastic dimension (≈

demand shocks)� Effect of money in the economy

� Room for policy (why?)

New IS/LM

� Similar to « old » IS/LM� What’s the point?

Success story

� Concepts that infused into policy practice (ex. « capacity output »)

� Shapes monetary doctrines (ex. inflation targeting)

� Considerable debate around different specifications, variants of the NK Models

� Many criticisms, notably because it is not fit to analyse crisis times

� However, still a benchmark model for policy analysis

Useful surveys:

� Mankiw, « A Quick Refresher Course in Macroeconomics » JEL (1990)

� Mankiw, « Real Business Cycles, a New KeynesianPerspective » JEP (1989)

� Blanchard, « What Do We Know About Macroeconomics That Fisher and Wicksell DidNot? », QJE (2000)

� Blanchard, « The State of Macro » (2008)

Course

� The literature has been pursuing two goals:1) Find an empirically relevant model2) Draw recommendations for monetary policy

� 2) intimately linked to 1)� We will follow the same logic

Outline

� Introduction� The neoclassical model with money (flexible

prices)� Empirical evidence on the effect of money� The neo-Keynesian model (nominal

rigidities)� Monetary policy: principles and practice � Limits