Chapter 10
Classical Business Cycle Analysis:
Market-Clearing Macroeconomics
Learning Objectives
1. Two key questions about business cycles
a. What are the underlying economic causes?
2. Any business cycle theory has two components
a. A description of the types of shocks believed to affect the economy the most
3. Real business cycle (RBC) theory (Kydland and Prescott)
a. Real shocks to the economy are the primary cause of business cycles
(1) Examples: Shocks to the production function, the size of the labor force, the real
quantity of government purchases, 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: Development of new products or production techniques, introduction of
new management techniques, changes in the quality of capital or labor, changes in
the availability of raw materials or energy, unusually good or bad weather, changes in
of 1973–1974 and 1979–1980 is consistent with RBC theory
Data Application
The “bible” of empirical work on RBC models is by Robert King, Charles Plosser, and Sergio
Rebelo of the University of Rochester, “Production, Growth and Business Cycles: Technical
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
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
6. Does the Solow residual measure technology shocks?
a. RBC theorists measure productivity shocks as the Solow residual
(1) Named after Robert Solow, the originator of modern growth theory
(2) Given a production function, Y AKaN1–a, and data on Y, K, and N, the Solow
residual is
1
7. Technology shocks may not lead to procyclical productivity
a. Research by Basu and Fernald shows that technology shocks are not closely related to
8. Also, the critics suggest that shocks other than productivity shocks, such as wars and military
buildups, have caused business cycles
9. Models allowing for other shocks are DSGE models (dynamic, stochastic, general
equilibrium models)
Theoretical Application
For more on criticisms of the RBC theory and the RBC response to the critics, see the discussion
1. The current or future taxes needed to pay for the government expenditures effectively
reduce people’s wealth, causing an income effect on labor supply
2. The increased labor supply leads to a fall in the real wage and a rise in employment
3. The rise in employment increases output, so the FE line shifts to the right
4. The temporary rise in government purchases shifts the IS curve up and to the right as
national saving declines
5. 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
6. 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
7. So adding fiscal policy shocks to the model increases its ability to match the actual behavior
of the economy
1. Classical economists oppose attempts to dampen the cycle, since prices and wages adjust
quickly to restore equilibrium
2. Besides, fiscal policy increases output by making workers worse off, since they face higher
taxes
3. Instead, government spending should be determined by cost-benefit analysis
4. Also, there may be lags in enacting the correct policy and in implementing it
a. So choosing the right policy today depends on where you think the economy will be in
5. It’s also not clear how much to change fiscal policy to get the desired effect on employment
and output
III. Unemployment in the Classical Model (Sec. 10.3)
A. In the classical model there is no unemployment; people who aren’t working are voluntarily
1. Workers and jobs have different requirements, so there is a matching problem
2. It takes time to match workers to jobs, so there is always some unemployment
3. Unemployment rises in recessions because productivity shocks cause increased mismatches
between workers and jobs
4. A shock that increases mismatching raises frictional unemployment and may also cause
structural unemployment if the types of skills needed by employers change
5. So the shock causes the natural rate of unemployment to rise; there’s still no cyclical
unemployment in the classical model
Theoretical Application
A nice discussion of the classical view of unemployment is by Robert E. Lucas, Jr., Models of
Business Cycles, Chapter V, New York: Basil Blackwell, 1987.
1. Many workers are laid off temporarily; there’s no mismatch, just a change in the timing of
work
2. If recessions were times of increased mismatch, there should be a rise in help-wanted ads in
recessions, but in fact they fall
Data Application
Classical economists believe that unemployment is often affected by institutional factors that
encourage unemployment. Many unemployed workers find jobs once their unemployment
2010. However, the rise of long-term unemployment can be explained by a sharp decline in the
rate of transition from unemployment to employment, with a small portion explained by
1. Doing so doesn’t improve the mismatch problem
2. 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
1. After each of the last three recessions, employment continued to decline during the recovery,
so the recoveries have come to be known as “jobless recoveries”
2. The previous 5 recessions (before 1990) all featured a sharp rebound in employment as soon
as the recession ended (text Fig. 10.6)
3. For the recoveries that followed the 1990-1991 and 2001 recessions, one theory was that the
recessions were so mild that the recovery was weak because employment didn’t fall very
4. It appears that productivity growth has been strong in the jobless recoveries, so GDP has
grown even as employment declined; but this explanation doesn’t explain why the same
thing didn’t happen previously
Theoretical Application
Data Application
of 1973–1974 and 1979–1980 is consistent with RBC theory
Data Application
The “bible” of empirical work on RBC models is by Robert King, Charles Plosser, and Sergio
Rebelo of the University of Rochester, “Production, Growth and Business Cycles: Technical
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
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
6. Does the Solow residual measure technology shocks?
a. RBC theorists measure productivity shocks as the Solow residual
(1) Named after Robert Solow, the originator of modern growth theory
(2) Given a production function, Y AKaN1–a, and data on Y, K, and N, the Solow
residual is
1
7. Technology shocks may not lead to procyclical productivity
a. Research by Basu and Fernald shows that technology shocks are not closely related to
8. Also, the critics suggest that shocks other than productivity shocks, such as wars and military
buildups, have caused business cycles
9. Models allowing for other shocks are DSGE models (dynamic, stochastic, general
equilibrium models)
Theoretical Application
For more on criticisms of the RBC theory and the RBC response to the critics, see the discussion
1. The current or future taxes needed to pay for the government expenditures effectively
reduce people’s wealth, causing an income effect on labor supply
2. The increased labor supply leads to a fall in the real wage and a rise in employment
3. The rise in employment increases output, so the FE line shifts to the right
4. The temporary rise in government purchases shifts the IS curve up and to the right as
national saving declines
5. 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
6. 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
7. So adding fiscal policy shocks to the model increases its ability to match the actual behavior
of the economy
1. Classical economists oppose attempts to dampen the cycle, since prices and wages adjust
quickly to restore equilibrium
2. Besides, fiscal policy increases output by making workers worse off, since they face higher
taxes
3. Instead, government spending should be determined by cost-benefit analysis
4. Also, there may be lags in enacting the correct policy and in implementing it
a. So choosing the right policy today depends on where you think the economy will be in
5. It’s also not clear how much to change fiscal policy to get the desired effect on employment
and output
III. Unemployment in the Classical Model (Sec. 10.3)
A. In the classical model there is no unemployment; people who aren’t working are voluntarily
1. Workers and jobs have different requirements, so there is a matching problem
2. It takes time to match workers to jobs, so there is always some unemployment
3. Unemployment rises in recessions because productivity shocks cause increased mismatches
between workers and jobs
4. A shock that increases mismatching raises frictional unemployment and may also cause
structural unemployment if the types of skills needed by employers change
5. So the shock causes the natural rate of unemployment to rise; there’s still no cyclical
unemployment in the classical model
Theoretical Application
A nice discussion of the classical view of unemployment is by Robert E. Lucas, Jr., Models of
Business Cycles, Chapter V, New York: Basil Blackwell, 1987.
1. Many workers are laid off temporarily; there’s no mismatch, just a change in the timing of
work
2. If recessions were times of increased mismatch, there should be a rise in help-wanted ads in
recessions, but in fact they fall
Data Application
Classical economists believe that unemployment is often affected by institutional factors that
encourage unemployment. Many unemployed workers find jobs once their unemployment
2010. However, the rise of long-term unemployment can be explained by a sharp decline in the
rate of transition from unemployment to employment, with a small portion explained by
1. Doing so doesn’t improve the mismatch problem
2. 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
1. After each of the last three recessions, employment continued to decline during the recovery,
so the recoveries have come to be known as “jobless recoveries”
2. The previous 5 recessions (before 1990) all featured a sharp rebound in employment as soon
as the recession ended (text Fig. 10.6)
3. For the recoveries that followed the 1990-1991 and 2001 recessions, one theory was that the
recessions were so mild that the recovery was weak because employment didn’t fall very
4. It appears that productivity growth has been strong in the jobless recoveries, so GDP has
grown even as employment declined; but this explanation doesn’t explain why the same
thing didn’t happen previously
Theoretical Application
Data Application