A. The Real Business Cycle Theory

1. Real shocks to the economy are the primary cause of business cycles

a. Examples: Shocks to the production function, the size of the labor force, the real quantity of government purchases, the spending and saving decisions (All examples affect the IS of FE curve.)

b. Nominal shocks include shocks to the money supply (affect LM curve)

2. The largest role is played by productivity shocks (supply shocks)

a. Examples: Development of new products or production techniques, changes in quality control, changes in government regulations

b. Often beneficial supply shocks cause expansions and adverse supply shocks cause recessions.

c. The recessionary impact of adverse supply shocks

3. Are productivity shocks the only source of recession?

a. Critics cite only the oil price shocks as examples of shocks which are easily identified as causing recessions.

b. RBC’s proponents argue it could be a cumulation of many shocks.

A. Wages are slow to adjust in the Keynesian model. This allows for unemployment to persists, without adjusting to full employment equilibrium as in the classical case.

B. Reason’s for real wage rigidity:

1. Unemployment exist when the real wage is greater than the market clearing wage.

2. Why would firms not reduce wages?

a. Minimum wage might keep wage from decreasing.

b. Higher wage produces a more stable labor force.

c. Unions

3. Want to avoid high turnover rate.

4. Productivity might depend on wage.

A. Tendency of prices to adjust slowly to changes in the economy explains why money is not neutral.

B. Sources of price stickiness

1. Monopolistic Competition-allows firms to not respond to the market determined price. Since they have some monopoly power they are capable of setting prices and changing output to meet demand at those prices.

2. Menu Costs-prices only change when warranted by changes in demand or productivity

3. When prices don’t’ change firms are able to produce amounts which are not on the FE line. The firm has an additional markup on its goods since it can set prices above the market determined price. Firm is paying efficiency wage so it can hire more workers at t he same wage to cover an increase in output.