Chapter 8 This Hard Reconcile With The Data Labor

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Chapter 8: An Equilibrium Business Cycle Model

Chapter Summary:

This chapter provides a “real” business cycle model that will serve as the basis for

constructing each of the alternative theories described in subsequent chapters. The key

assumption here is one of flexible prices so that all markets clear. Fluctuations in GDP and

employment are caused by temporary technological shocks which change the marginal

product of resources. This sets in motion a series of adjustments which matches closely the

real world data on business cycles. A temporary technological improvement leads to

increased marginal productivity of resources, and cause the demand for labor and capital

Chapter Outline:

I. Cyclical Behavior of Real GDP-Recessions and Booms

A. Conceptual Issues

B. The Model

i. The marginal product of labor and the real wage rate

II. Temporary Changes in the Technology Level

III. Variation in Labor Input

A. Labor Supply

i. The Substitution effect for leisure and consumption

ii. Income effects on labor supply

Teaching Tips:

1. Review the patterns reviewed by business cycle data with students. Make them aware

that the efforts of economists to develop a model capable of explaining and predicting these

2. One of the interesting aspects of this model is the ability to generate a business cycle

3. A historical perspective would be helpful to students see the logic of the equilibrium

business cycle theory. A discussion of figure 8.4 is useful, but some context for students

4. Students understand positive technological shocks, but find negative shocks difficult to

envision. Emphasize that these “shocks” could have other sources beyond technological

change. The recent example of Hurricane Katrina and its impact on the capital stock of the

5. Real business cycle theory is dynamic- the modeling techniques used are somewhat

beyond the range of students enrolled in the course. But instructors should note that it may

Answers to review questions, pg. 199

1. This year’s labor supplied depends on the leisure consumed. We would expect that

market events would have at least one of 3 potential effects: income effects, substitution

effects, or intertemporal substitution effects.

a. Higher interest rates primarily cause an intertemporal substitution effect: the

b. A permanent increase in the real wage rate will have both an income and

substitution effect. On the one hand, people can afford more leisure (income effect) which

B. Problems for discussion, pg. 199-200

2. a. Labor force participation rates should respond to changes in the real wage rate just as

the quantity of labor supplied does. In this case, the real wage was increasing throughout the

period, so we should see an increase in labor supply due to the substitution effect. However,

b. The fact that the average work week did not change implies that the labor supply of

working individuals is inelastic with respect to the real wage. This hard to reconcile with the

data on labor force participation, which indicates a strong substitution effect. However, if we

consider labor supplied by households rather than individuals, the results are more

consistent. In this case, the average two-earner household is supplying more labor in

response to the higher real wage rate.

c. We see that when we consider the labor supply decision of households, rather than

individuals, that we can reconcile the data found in parts a and b. However, this does not

3. A reduction in the labor force:

A decrease in population shifts the labor supply curve to the left.

This causes an increase in equilibrium real wages and a decrease in

equilibrium real output. (These effects on the wage may be offset somewhat

3b..

A reduction in labor per unit of capital reduces the marginal product of

capital and causes the MPK curve to shift left from MPK(L*) to MPK(L’).

The real rental rate of capital falls from (R/P)* to (R/P)’.

3c. If we continue to assume constant returns to scale in the production function, then it can

be shown that output per worker (y) increases as the capital per worker (k) increases. Since

the population reduction is permanent, both current and future incomes are affected, so that

4. A reduction in the capital stock:

4a.

4b.

4c. In this case, we have the opposite effects found in part 3c; income per worker falls, and

consumption per worker will fall for two reasons: the decrease in income as well as the

intertemporal substitution effect. The net effect is a decrease in aggregate consumption

which is greater than the decrease in current income: the capital stock will increase over

time.

5. A Reduction in Desired Saving

5a. Since the reduction in the desired savings rate has no effect on labor productivity, the

demand for labor will not change. There will be no direct effects on labor supply.

5b. A decrease in savings rates would cause an excess supply of bonds in the market, which

would raise interest rates. In the graph for capital services, In we will assume that the

6. A willingness to work more.

6a. The direct effect of this change would be to shift the supply curve of labor to the right;

real wages fall and labor input increases.