Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 11 Market-Clearing Models of the Business Cycle.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 11

Market-Clearing Models of the Business Cycle

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 11-2

Study Three Market-Clearing Business Cycle Models

• Real Business Cycle Model

• Segmented Markets Model

• Keynesian Coordination Failure Model


Real Business Cycle Model

• Business cycles are caused by fluctuations in total factor productivity.

• There is no role for the government in smoothing business cycles – cycles are just optimal responses to the technology shocks.

• Model fits the data well.


Figure 11.1 Solow Residuals and GDP


Figure 11.2 Effects of a Persistent Increase in Total Factor Productivity in the Real Business Cycle Model


Figure 11.3 Average Labor Productivity with Total Factor Productivity Shocks


Table 11.1 Data Versus Predictions of the Real Business Cycle Model with Productivity Shocks


Figure 11.4 Procyclical Money Supply in the Real Business Cycle Model with Endogenous Money


Equation 11.1

Cobb-Douglas production function, with labor share of output of 64%:


Segmented Markets Model

• Business cycles can be caused in this model by unanticipated shocks to the money supply.

• Model exhibits a liquidity effect – the interest rate falls in the short run when the money supply increases.

• Monetary policy can only improve the functioning of the economy if the central bank has an informational advantage over the private sector.

• Fit to the data is not as good as with the real business cycle model.


Figure 11.5 Effects of an Unanticipated Increase in the Money Supply in the Segmented Markets Model


Table 11.2 Data Versus Predictions of the Segmented Markets Model with Monetary Shocks


Figure 11.6 A Welfare-Improving Role for Active Monetary Policy


Figure 11.7 Percentage Deviations from Trend in Money Supply and GDP


Figure 11.8 Real and Nominal Interest Rates


Figure 11.9 Relative Price of Energy


Keynesian Coordination Failure Model

• Strategic complementarities imply that the aggregate production function has increasing returns to scale, and the labor demand function can be upward sloping.

• There can be multiple equilibria.• In an example, the model fits the data as well as the real

business cycle model.• GDP fluctuates in the model because of self-fulfilling

waves of optimism and pessimism.


Figure 11.10 A Production Function with Increasing Returns to Scale


Figure 11.11 Aggregate Labor Demand with Sufficient Increasing Returns to Scale


Figure 11.12 The Labor Market in the Coordination Failure Model


Figure 11.13 The Output Supply Curve in the Coordination Failure Model


Figure 11.14 Multiple Equilibria in the Coordination Failure Model


Table 11.3 Data Versus Predictions of the Coordination Failure Model


Figure 11.15 Average Labor Productivity in the Keynesian Coordination Failure Model


Figure 11.16 Procyclical Money Supply in the Coordination Failure Model


Figure 11.17 Stabilizing Fiscal Policy in the Coordination Failure Model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 11 Market-Clearing Models of the Business Cycle.

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business cycle slide

segmented markets model

scale slide

gdp slide

endogenous money slide

active monetary policy

relative price of energy