Grasping Reality on TypePad, by Brad DeLong

September 19: Lecture: Building Up the Flexible-Price Full-Employment Business-Cycle Model

For the past couple of weeks we have been looking at long-run growth. Now we turn to looking at much shorter-run phenomena: business cycles. For the next couple of weeks we are going to be in a halfway house: looking at the economy over a period short enough that we can take its productive capacity to be fixed, but long enough that we can take wages and prices to be sufficiently flexible that supply and demand in the labor market balance and that the economy is as a result at "full" or "normal" employment.

Potential Output

• In this model, actual output is equal to the economy's productive potential (as discussed in the long-run economic growth section).
  • And by the circular flow principle output == national income == aggregate demand
  • Why? Because wages and prices are flexible so that unused and idle resources are few
    • A mystery: why is the average--the "natural"--rate of unemployment so high? Why is it 5% or so rather than 1%?
• The production function (go back to your "economic growth" notes and to chapter 4)
• Supply and demand in the labor market
  • Labor demand: firms with fixed capital stocks and diminishing returns to labor...
  • Labor supply: fixed (we may relax this assumption later)
  • Labor market equilibrium: supply equals demand
    • With our Cobb-Douglas production function, the economy-wide equilibrium real wage is (1 - [alpha])(Y/L)

Domestic Spending

• Consumption spending

  • Household decisions
    • Taxes
    • Saving
    • Spending
  • Our consumption function: C = C₀ + C_y(1-t)Y
    • Note our notation convention for parameters like C₀ + C_y...
  • Baseline consumption and consumer confidence
  • The marginal propensity to consume
  • What's left out
    • Consumption depending on wealth...
      • Using your house as an ATM: how much does consumption depend on the interest rate?
    • Consumption depending on ability to borrow
    • Financial sophistication, the relaxation of liquidity constraints, and the falling MPC C_y

• Investment spending

  • Firm decisions
    • Expected profits
    • Interest rates
      • Real, long-term, risky interest rates (not the short-term nominal safe interest rates the Federal Reserve directly controls)
  • Our investment function: I = I₀ - I_rr
  • Types of investment
    • Residential construction
    • Non-residential construction
    • Business equipment
    • Inventories
    • Government capital
  • Baseline investment and animal spirits
  • The interest sensitivity of investmen
  • Tax credits and investment
  • How much does investment depend on cash flow--and thus on the level of output Y?

• In this our model, we say that consumption depends on Y (but not on r) and that investment depends on r (but not on Y). If we have time we may relax this assumption and allow both to depend on both)

• Government purchases G we leave to the political scientists

  • Note: government purchases, not government spending

The International Sector

• Imports depend on Y alone: IM = IM_yY
• Exports depend on foreign incomes and on the exchange rate:
  • Our exports equation: X = X_fY^f + X_ee
    • Note: the peculiar sign of our exchange rate convention...
• The exchange rate
  • Greed and fear--speculators fear capital losses but want current income
  • Our exchange rate equation: e = e₀ + e_r(r^f-r)

Today we have done nothing but build up the behavioral relationships that are the building blocks of our flexible-price full-employment business-cycle model. Putting the pieces of this model together we will do on Wednesday.

Even after Wednesday, we will still be far from having a complete picture of business cyles. We won't have integrated cycles with growth; we won't have even started to think about demand-driven fluctuations in output and unemployment; and we won't have thought about the price level and the inflation rate.