Real Business Cycle (RBC) Model PDF

Real Business Cycle (RBC) Model EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 1 1. Central Features of RBC model 2. The Effect Of A Positive Shock (technology shocks) 3. The Effect Of A Negative Shock 4. Monetary Policy & Fiscal Policy...

Real Business Cycle (RBC) Model EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 1 1. Central Features of RBC model 2. The Effect Of A Positive Shock (technology shocks) 3. The Effect Of A Negative Shock 4. Monetary Policy & Fiscal Policy EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 2 RBC model – is the second generation of New Classical Economics. 1. Money supply (Ms) cannot influence output (O/P) & employment (N) – instead O/P & N are influenced by fiscal policy & technological change. 2. Economic agents optimize – individuals’ optimizing decision. 3. Markets clear – the business cycle is an equilibrium phenomenon. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 3 5. Individual’s goal is to maximize his utility in each period of his life. - He gets utility from 2 sources i.e consumption & leisure. - There will be a trade-off between working & leisure. - There will be a trade-off between consumption & savings. 6. Supply of labour depends on economic incentives – when real wage or benefits increase – supply of labour (SL) will increase. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 4 7. 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. - 7. Output or production function is given by – (zt): - Yt = zt F(Kt, Nt) – where (zt) representing element of shocks in the economy. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 5 EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 6 1. Assuming that the positive shock is only temporary: - This will shift the production function upward [from yt = z0t F(Kt, Nt) to yt= z1t F(Kt, Nt)] - With the same input that is N0, output increase from y0 to y1 – due to increase in productivity – laed to increase in Y. - If workers realise about this increase in productivity – they will increase their working hours (in order to inc income) – hence SL will increase. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 7 - Therefore employment increase from N0 to N1 & O/P increase from Y1 to Y2. - Increase in income will increase saving – hence increase investment in the economy – increase capital stock & output in the next period. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 8 2. If technology shock lasted for several periods or been permanent then a) An individual responses would have been somewhat different. b) He would know that O/P would be high for a longer period i) His incentive to save would be reduced ii) His incentive to consume would be increased iii) He would increase his work effort in each period by less (example: his normal working hours = 8 hours, in the beginning add extra 4 hours of work; later add only 2 hours of work). EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 9 § Negative shock in RBC model is referred to as a sudden increase in oil price. § Diagram 5.2(a) – initial point at B. § Increase in oil price – will decrease the demand for oil increase cost of production – firms will reduce the production and demand for labour. - therefore the production function curve will shift downward to [y = y1(N)]. § Point B shifts to point Z or O/P, y0 decrease to y’0 whil maintaining employment at N0. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 10 EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 11 § Definition for a strong labour union (LU) – that can defend the real wage that being p the workers. § Initial equilibrium in labour market is at p with employment = N0 & real wage = w0/P § A sudden increase in oil price – will lead to decrease in demand for labour – therefore for labour curve DL0 shifts to the left to DL } 3 possibilities for demand for labour in th market: EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 12 EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 13 i) X – sticky real wage (strongest LU) - employment dec the largest from N0 t - real wage maintain/unchange at w0/P ii) V – real wage change by a relatively sm amount (relatively strong to medium st LU) - employment dec from N0 to N1. - real wage dec from w0/P0 to w0/P1. iii) Z – real wage dec the most (indicating t weakest LU) - employment maintain at N0. - real wage dec the most from w0/P0 to w0/P2. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 14 EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 15 § Initial point at point B at short run AS (ASSR0). § A sudden inc in oil price – firms reduce production - - therefore ASSR0 curve shift to the left to ASSR1 § 3 possibilities of AS in the goods market: EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 16 i) X – sticky real wage (strongest LU) - O/P dec the most from yN0 to yN2. - price at P0 ii) V – real wage change by a relatively small amount (relatively strong to medium strength LU) - O/P dec from yN0 to yN1. - price at P1. iii) Z – real wage dec the most (indicating the weakest LU) - O/P dec from yN0 to y’N0 - price at P2 EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 17 1. MP – is neutral – cannot affect O/P & employment. - the role of MP in RBC model is to determine the price level. - a good MP is the one that involve a slow and steady growth of money supply in order to maintain a stable price & low inflation. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 18 2. Fiscal policy – affect O/P & employment – by supply side effects. E.G in Keynesian model – if there is an inc in govt expenditure – AD inc – DD side effects. - Example a tax cut – incentive to the workers – hence inc the supply of labour (SL) – inc the AS – lead to inc in O/P. - However this tax cut – lead to distortion – less resources for government spending on development projects. - This model suggest – create/print new money (money creation) which is also known as seigniorage. EPPE2024 - MAKROEKONOMI II (Norlaila Abu Bakar) 19