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Questions and Answers
What is the effect of a Z-real wage decrement on the labor union?
What is the role of monetary policy in the RBC model?
What is the characteristic of a good monetary policy?
What is the effect of fiscal policy on output and employment?
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What is the effect of a tax cut on the labor market?
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What is the drawback of a tax cut?
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What is the alternative to fiscal policy in the Keynesian model?
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What is the effect of an increase in government expenditure on aggregate demand?
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What is the effect of an increase in aggregate demand on output?
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What is the effect of a Z-real wage decrement on output and price?
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Study Notes
Central Features of RBC Model
- RBC model is the second generation of New Classical Economics
- Money supply (Ms) cannot influence output (O/P) and employment (N), instead O/P and N are influenced by fiscal policy and technological change
- Economic agents optimize, individuals' optimizing decision
- Markets clear, the business cycle is an equilibrium phenomenon
Goals and Preferences
- Individual's goal is to maximize his utility in each period of his life
- He gets utility from two sources: consumption and leisure
- There will be a trade-off between working and leisure
- There will be a trade-off between consumption and savings
Labour Supply
- Supply of labour depends on economic incentives, when real wage or benefits increase, supply of labour (SL) will increase
- Intertemporal substitution of labour refers to the willingness of workers to choose working or reduce working hours or not to work depending on economic incentives
Production Function
- Output or production function is given by: Yt = zt F(Kt, Nt)
- Where zt represents the element of shocks in the economy
The Effect of a Positive Shock
- Assuming the positive shock is only temporary, it will shift the production function upward
- With the same input, output will increase due to an increase in productivity, leading to an increase in Y
- If workers realize about this increase in productivity, they will increase their working hours, hence SL will increase
- Therefore, employment will increase, and O/P will increase
- Increase in income will increase saving, hence increase investment in the economy, increase capital stock, and output in the next period
The Effect of a Negative Shock
- A negative shock in the RBC model is referred to as a sudden increase in oil price
- Increase in oil price will decrease the demand for oil, increase the cost of production, and firms will reduce production and demand for labour
- Therefore, the production function curve will shift downward
- Point B shifts to point Z or O/P, y0 decrease to y’0 while maintaining employment at N0
Labour Market
- A sudden increase in oil price will lead to a decrease in demand for labour, therefore, the labour curve DL0 shifts to the left to DL
- 3 possibilities for demand for labour in the market:
- X – sticky real wage (strongest LU), employment decreases the largest from N0 to N
- V – real wage changes by a relatively small amount (relatively strong to medium strength LU), employment decreases from N0 to N1
- Z – real wage decreases the most (indicating the weakest LU), employment maintains at N0
Aggregate Supply
- A sudden increase in oil price – firms reduce production, therefore, the ASSR0 curve shifts to the left to ASSR1
- 3 possibilities of AS in the goods market:
- X – sticky real wage (strongest LU), O/P decreases the most from yN0 to yN2
- V – real wage changes by a relatively small amount (relatively strong to medium strength LU), O/P decreases from yN0 to yN1
- Z – real wage decreases the most (indicating the weakest LU), O/P decreases from yN0 to y’N0
Monetary and Fiscal Policy
- Monetary Policy (MP) is neutral and cannot affect O/P and employment
- The role of MP in the RBC model is to determine the price level
- A good MP is the one that involves a slow and steady growth of money supply in order to maintain a stable price and low inflation
- Fiscal policy affects O/P and employment by supply-side effects
- Fiscal policy can influence AS by changing incentives for workers
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Description
This quiz covers the central features of the Real Business Cycle (RBC) model, including its response to positive and negative shocks, as well as the role of monetary and fiscal policies in macroeconomics.
