Lecture 24: Flexible Prices I

[Music] [Music] welcome back so we will be now starting with the new topic so so far we have discussed with the different types of models in macro but now we will be found formally introducing ourselves into the core area of macroeconomics where we will be not just discussing about the macroeconomic phenomena so maybe the output decline interest rate rise price increase price decrease how it is impacting the monetary policy how monetary policy is impacting the fiscal policy those dimensions we have covered already and i think i hope all of you are aware about how we have at least understood the idea behind the macroeconomic phenomenon that we should be studying but in this particular session we will be looking beyond the conventional macro we will be also trying to see the interaction among different schools of economic thought so i have already mentioned about the macroeconomic schools different types so here you are already aware about the neoclassical and then you have so we started with with classicals which believed in flexible wages and prices then we move to the region school of economic thought in kenyan school of economic thought we have already found that there is a role of the government so canadian school of economic thought emphasized on the short-term characteristics of the economy where they emphasize on the role of fiscal policy how government intervention can bring macroeconomic stabilization or can ensure macroeconomic stabilization and then once you have the macroeconomic stabilization taking place then the interaction of monetary policy interaction of multiples can be introduced into the model now given this background we also looked at that particular school of economic thought which talked about having both kinesian and classical dimension in the shorter and long run context and they tried to look at that how we can incorporate these two schools of economic thought basically the kinesian which i mentioned about the government but i forgot to mention that tunisians also believed in non-flexible wages and prices which also it is called sticky wages and prices according to them in the short term it is very difficult to have a quick adjustment or quick adjustment into the equilibrium wages and the prices and because of that reason they emphasize more on the staggered prices or maybe you can say about the sticky prices where the we do not find a quick flexib or we do not find flexible wages and prices now looking beyond this what new classical economic school of thought recommended that can we have some kind of coherence between these two rigid school of economic thought thought so they focused on understanding the behavior of the the macroeconomic agents in the context of rational expectations or also in the context of microeconomic foundations with we have already examined in the context of one period model to period model so that's the idea and then we had the new classicals and then we have the i have said new kinesians those who believe in that we introduce the idea of what we call it as the we call it as fresh water and salt water belong so so fresh water belongs to the new classicals and then you have the fresh water coming from the kinesian now with this background i hope it is clear that what are we going to talk about so now we will be looking at the neoclassical schools school of macroeconomics where they emphasize that it is not just the government policy there are avenues through which we can understand the stabilization process in the economy so for the first time we have we had under gone through understanding the business cycle dynamics from the supply side perspective if i am saying about venous cycle dynamics from supply side perspective then it implies that how with certain changes in the behavioral pattern of either the top management of the company or maybe the good technology good weather a good i would say or very suitable innovation all these things contribute to the productivity i would say productivity of capital becomes critical so in this particular session we will try to understand that and for those people who are not aware about the business cycle so business cycle phenomena business cycle is a phenomenon under which we try to study different phases of business different phases of the macroeconomy wherein we say that when economy is achieving high growth rate so we say that economy is an expansion phase when economy is going or having the or its it is exhibiting some kind of downward trend in its gdp then we say that economy is on downward trend so that we qualify the contraction so expansion and contraction and then you have the you have the slow down and recovery phases that we call it a peak so normally expansion and contraction it is also in the language of venous cycle it is called peak and trough but recovery and slowdowns are also the phases through which we try to understand the macroeconomic phenomena so so far what conventional business access school of economic thought believes that the business cycle dynamics are more linked with the demand side factor so what we have already understood y is equal to c plus i plus g plus n minus x but for the first time the new school of economic thought try to add dimension into the binary cycle theory by introducing the concept what we what we call it with the supply side factors how demand and supply of labor how equilibrium in the labour market can play instrumental role in understanding the macroeconomic picture when it is aligned with the productivity shock so when we have a shock into the system either it is positive or negative normally it is considered that when you have productivity shock it is bound to be positive which means that it is creating avenues for the researchers it is avenues for the consumers to have better income better wealth consumption in the current and future the role of anticipation the role of expectation so we will be talking about that so lets start so i hope this background will help you understand the the particular chapter in a in a better way so ah we are following the same here we have the stephanie williamson here the book remains same the macroeconomics and here we we try to understand the key learning objective that i mentioned that it tries to explain you about the real business cycle model and it also tries to explain that how we can analyze the real business cycle dynamics when we try to bring changes so maybe you can say comparative aesthetics that how we can deal with how the real business cycle model could be consistent with the observed government of money and output discuss criticism of the real business cycle model will be talking about certain i would say drawbacks or shortcomings so let us start so first we are going to talk about the monetarist and kinesians so once i talk about monetarist and kinesians then you must be having an idea that once i talk about monetarist and he talks about the dominant role of monetary policy in the economy and they believe that monetary policy brings stability uh in the economy and though in the in the very short term it may not be very impactful but yes it creates stability in the economy and one of the major roles of the monetary policy is about the price stabilization so that they mentioned then here you have the monetaries argued that it is the monetary policy that can stabilize the economy kinesian argued in favor of the fiscal policy which they believe that the role of the government is important so this was the 1960s era when monetarists and kinesians were having good interaction on the dominance of their schools of economic thought policies so that was the clear case here by 1970s when we had the invention or i would say introduction of rational expectations so once the individuals or the economists started talking about the role of rational expectation in macroeconomic formulation with what we have mentioned about the policy ineffectiveness proposition that is directly linked with the lucas critic so at that time the economist that where lead the the economist those who were leading this particular argument or new dimension where robert lucas then you have the thomas sergeant then you had the nail wireless and then you have the robert varro barrow so these economists had so here you have a team missing and here also you have the team missing so robert lucas thomas sergeant they were more in favor of macro economic principles of the economy ah what do you mean by microeconomics so this is what this course is trying to understand the new classical perspective that you can introduce the microeconomic dimensions about utility about production function about market about forms and about the endowments technology and then you can try to optimize consumers and form and arrive at the macroeconomic implications of these optimization tools now that that about the area in the field of macroeconomics that we call it as it is linked with the general equilibrium models and with further advancement in ah the tools and techniques now we have something called the dynamic system of general equilibrium so that we call it as the dsg model and if you try to analyze the shock into the general equilibrium model so it becomes dynamic a stochastic genetic barrier model we try to work out with the large set of agents we try to define in the same manner in the new classical way what we call it as the consumer forms endowments technology so all these play very important tool they also emphasized on the microeconomic modeling with classical flame work so new classical they emphasize that in order to understand the long run characteristics of the economy it is always good to talk about the flexible wages and prices and how we can think about the the classical framework so i hope these two lines are important and these two lines are also directly linked with the course that we are we are doing so microeconomic foundation so this is how they try to understand so in recent literature if you go through and read about the macroeconomic dimensions then you will find that the dynamic stochastic general equilibrium based models so dsg based models are quite popular in the literature in recent studies if you read go through or if you browse through the journals or on macroeconomic topics then you find that the theoretical foundations are playing very important role and these theoretical foundations are are critical for the way the i would say not just the understanding of the macroeconomic phenomena but also about the predictions so sometime we also try to see so if you want those of you are interested in understanding further or extending this idea further or looking for new developments you should read journal of monetary economics so there you find lot of these models talking about by 1980s we found that the widespread acceptance of this particular school of economic thought and people started real relying more on these mathematical models and then it became quite evident that even the role of government will be easier to understand in this setup so in order to understand that how the new classical school of economic thought contributed to the real business cycle it starts from here now lets deal with the real business cycle theory during 1980s or i would say early 1980s finn kidland and edward prescott they had given this idea that the venus cycle theory can be understood not only from the perspective of of demand side but there should be a supply side perspective also to explain this phenomenon so they added this dimension so their basic question was that whether or not a standard model of economic growth subjected to random productivity shock so when i say about random productivity shock then normally we in in the in the long run growth theories that we have what we call it this solo residuals which means that it is just the total output our aggregate output divided by the inputs with the given elasticities how much you are getting and how much is the residual output that you have so this productivity shock comes from there and it becomes really important to see how we can analyze so can a random productivity shock replicate qualitatively and quantitatively understanding about and and can it help understand the venus cycle so that was the idea behind kidland and prescott and these two gentlemen are known for at this particular contribution and if you want to go through about the the further dynamics of the real venus i kill more mathematical treatment you can refer their paper that appeared in 1980s and then you can also have a look at their basic foundations i have tried to simplify and i have followed the book of williamson to give you the basic framework how we can understand this in a better way so here they explain that the venous cycle the total factor probability shock plays very important role in determining the venous cycle phases so what are the factors that play that explains the or i would say what are the factors that explain the total factor productivity it includes good weather then you have a technological innovation so maybe you have the startup culture you have a new forms coming collaborating innovating you have a lot of emphasis on innovations government government is is putting effort to bring new innovations into mainstream easing of government regulation regulation so maybe you are not allowing the technology import but if government goes for revision of those policies then it helps the firms to import more decreases in the relative i would say price of energy so anything that benefits the production process so maybe you can think about earlier ah laborers where doing the manual jobs for creating outputs that they might be producing 100 units of output but now because of this productivity shock they are able to produce 1000 units of output so that could be that there is new machinery new technology some major productivity of capital has also gone up right so once you have the productivity increase so if you remember your one period model in that we had discussed about this comparative aesthetics where we mention about that if a productivity shock increasing it is good for the labor also because labor also sees increase in income and there is a further uh increase in consumption right so that's what and and this also creates opportunity for the labor for mark to work for more number of hours demand for labor also increases because once you have the major product of labor getting higher firms are inclined to hire more now in this setup when they define about the venus cycle explanation they do not explain or they do not go for any kind of government intervention so that is the idea behind that here they focus only on the monetary policy that if you have monetary policy with the same assumption that the money supply is neutral so that argument they take it forward and then they walk out with certain data sets and they find that whatever prediction they had it fits well with the data so that's what so whether the when you have productivity shock so whether the investment consumption so y is equal to c plus i plus z wages prices all these are pro cyclical or counter cyclical pro cyclical in the sense that if a money supply increase one or two variables are increasing showing the increasing trade trend or direct relationship but rates of the variables are showing inverse relationship so that we call it the pro cyclical control cyclical so this is how we try and understand counter cyclical it is also linked with the ah with the physical policy when you have or monetary policy when you have slow down in the economy you pump up more so that also shows the inverse that your gdp is going down you are augmenting the expenditure you are augmenting the money supply so once you have augmentation of these two variables then it creates a scenario of what we call it as the the the pro cyclical or the counter cyclical so those arguments are also added here so here you have the simple descriptions of solo residual and this is the gdp so you can see that since this is this was the main motivation of these real business accolades school of economic thought how they had gone for so what they mentioned that you will find some kind of coherence or as a very small deviation between gdp which is output and the solar residual because solar residual which means that with the change of capital and labor or whatever input technology that you are using you are able to at least decide about how much output you can have so this shows about so the movement that we have here with regard to solar residual and the gdp it reflects the same you can also see the period that we have the the y axis and it it speaks in volume about the role of inputs in driving the output so this is the idea behind this now lets explain the bina cycle model first and in business cycle model it becomes really important to see that how the model works in real life so the idea is simple that when we see increase in productivity when total productivity increases what do we see immediately immediately we will see that there will be demand for labor shifting rightward because you firms are quite enthusiast about the production process about the outlook they are optimistic and given that the because of the employment capital the productivity of labour has gone up so they do not mind hiring more labor so this is how it looks like what typically happens that because of this shift that we have rightward this shift leads to a rise in wages because if your demand for labor increasing you have a supply of labor will also increase because labor will be looking for employment right from such theory also you can say the labor market tightness will increase which means that you have more matching taking place so if you have that kind of situation then here you have a w t w 2 rising so once you have w 2 going up so which means that wage rate increases and these are wage rate increase accompanied by the labor supply increase so this part is clear okay so let's focus on only n1d and n2d now we are talking about here so once you have the production process increasing right you have more implement of labor labor is producing output so which also means that your output supply will increase so this is how it is leading so here you have a y1 s and y2s so rightward shift of the the output supply it is leading to what it is leading to earlier we were at r1 now we are at r2 and this creates a scenario where in the rate of interest is lower your output is increasing now this rate of interest lower is also having two types of multiplication so one implication that we have to understand with regard to wage and labor i am saying that demand is shifting up it means that the labor is also having some anticipation anticipation in the sense that they are thinking in terms of the inter temporal aspects that if the productivity is going up it is bound to increase the current income higher and in the future income is also going to be higher because wage rate is going to increase so once productivity is going high it is creating a some kind of favorable scenario for the labor because labour expects that now they will have better standard of living right this we had also seen in case of one period model in this case once you have the the rate of interest lower then and since the productivity has gone up so form a form also does not bother about how much they have to invest so even when you have the rate of interest lower this incentivizes the form to go for more investments which means that investment also become pro cyclical here we are saying about the consumption consumption also become pros cyclical because the labor is expecting that the current and future income will go up so as a result the consumption will also go up so that we have made now we have also made about the investment now one of the reasons that you have to understand that if the rate of growth of productivity if it is not same so in this period here you have the increase in productivity right so if you have increase in productivity and if the increase in productivity suppose in this period it has increased by 100 in next period it is increasing by just 50 so you have to have decreasing so if the rate of growth is not same then the anticipation about the future will also be compromised so what will happen that the labor will also think about that whether they have to go for more of consumption in the current period or in the future period so there will be confusion but since rate of interest is lower this this representative consumer will think about the current consumption or maybe maybe he will be thinking about the future consumption so current and future consumption scenarios may not be as smooth as we are seeing so because of that there will be a leftward shift of the labour supply and this is directly linked with the interest rate that you have so once you have the interest rate lower then you tend to tend to think about that yes you have to you have to you have to think about the labour supply so labor supply is moving left and this is how it is linked with the how the anticipation plays very important also in the beginning i mentioned about rational expectation rational expectation plays very important role here so here we have one two clear now about three once we have the money supply fixed and once you have the low interest rate this will further create the scenarios but since the role of the central bank is to maintain the price stability so they will be simply going for increasing the money supply which further will increase the the the demand for money so more or less price will not be the same price will decrease so once we have the demand for money shifting so p l y one r one so it is coming from the previous lecture where we drive the demand for money there we are seeing that with given money supply it is fixed and it is reducing so which means that with the productivity shock the role of anticipation becomes very important so in the beginning when the labour was quite enthusiast about these things consumption became poro cyclical investment became pro cyclical because you have the rate of interest lower the demand for money supply also increase and this money supply increase has ah impact on the on the prices also because then you have the role of anticipation playing important role now this anticipation role is critical to understand the real business cycle dynamics but overall the understanding is that with the productivity shock the labor market reacts in the same way output reaction the same way the rate of interest also react in the same way so all have the pro cyclical characteristics and this is what we try to derive now overall with regard to to productivity i would say production function here we are at a to b and here you will find that once we have the productivity shock so this leads to better output production right once your better output production you will find that slope of a to b it become more steeper which means that here this is leading to more of increase in output but given the proportion of increasing output we are not seeing that much increase in input but it is increasing which means that productivity shock it is bound to increase the employment in the economy it is bound to have the better scenario of wages and that is what we try to understand with the labor market or total factor productivity or real business cycle school of economic thought so overall what came out so they also emphasize with the data that if they can predict with the data that whether it is working or not what they found that consumption became pro cyclical investment became pro cyclical employment became pro cyclical real wage became pro cyclical and average labor productivity became pro cyclical but there are certain dimensions that are worth understanding in case of real business cycle school and which are also some of the shortcomings of this model so i hope it has made you understand that how the productivity shock can create a favorable scenario in the economy without thinking about the role of government government is not playing any role here it is all about flexible wages and prices with the change in productivity shock how much you have adjustment in wages and prices and how much it is leading to in all other macroeconomic variables whether it is consumption whether it is a investment and whether it is employment if in increasing all it is good for the economy and it will stabilize the output it will also create favorable scenarios and moreover here the money supply increase it is more or less has to deal with the the price adjustment so here it is becoming a really important to look at that how money supply it is getting translated into the into the current and future consumption of the household and how the expectation is playing a dedicated role so i will stop here and we will start from here the next session so thank you thank you so much [Music] [Music] [Music] you