SHOCKS CHAPTER 9 2BASICS Introduction Shock/shifter Definition: Some unexpected event that affects economic fundamentals and hence decisions. Will consider (for now) two types of shocks Total Factor Productivity (TFP) Shocks – unexpected changes in At in the production function Atf(kt, nt) kt nt Atf(kt,nt)Atf(kt,nt) rise in A fall in A rise in A fall in A 3BASICS Introduction Shock/shifter Definition: Some unexpected event that affects economic fundamentals and hence decisions, but which is unexplained or unexplainable Introducing shocks into our frameworks (consumption-leisure, consumption-savings, infinite-period) will “get them moving” Will consider (for now) two types of shocks Total Factor Productivity (TFP) Shocks – unexpected changes in At in the production function Atf(kt, nt) Preference Shocks – unexpected changes in representative consumer’s utility function; causes rotations of indifference curves kt nt Atf(kt,nt)Atf(kt,nt) rise in A fall in A rise in A fall in A “SUPPLY SHOCK” “DEMAND SHOCK” 4BASICS Introduction Shock/shifter Definition: Some unexpected event that affects economic fundamentals and hence decisions, but which is unexplained or unexplainable Introducing shocks into our frameworks (consumption-leisure, consumption-savings, infinite-period) will “get them moving” Will consider (for now) two types of shocks Total Factor Productivity (TFP) Shocks – unexpected changes in At in the production function Atf(kt, nt) Preference Shocks – unexpected changes in representative consumer’s utility function; causes rotations of indifference curves kt nt Atf(kt,nt)Atf(kt,nt) rise in A fall in A rise in A fall in A Later: Monetary policy shocks Fiscal policy shocks Financial shocks 5TFP IN COBB-DOUGLAS PRODUCTION FUNCTION TFP Shocks Revisit the commonly-used functional form in modern quantitative macroeconomics Describes the empirical relationship between aggregate output, aggregate capital, aggregate labor, and level of sophistication of technology (TFP) Cobb-Douglas form useful for illustrating effects of TFP shocks Unexpected change (i.e., a shock) in At Causes change in marginal product of labor Causes change in marginal product of capital 1output ( , )t t t t t t tA f k n Ak n output ( , ) (1 )t t t n t t t t t tmpn f k n k n n A A 1 1output ( , )t t t t k t t t t t mpk f k n k nA A k 6TFP SHOCKS AND LABOR DEMAND TFP Shocks Firm-level demand for labor defined by the relation IMPORTANT: TFP shocks shift the labor demand curve (1 ) ( )t t t ttw k n mpnA (1 ) tt t t k n Aw Because exponent (-α) is a negative number, can move to denominator labor real wage D rise in A fall in A Firm-level labor demand function Aggregate-level labor demand function labor real wage D rise in A fall in A Sum over all firms FOR GIVEN rt and wt, rise (fall) in At raises (lowers) nt 7TFP SHOCKS AND CAPITAL/INVESTMENT DEMAND TFP Shocks Firm-level demand for capital defined by the relation (see Chapter 6) IMPORTANT: Future TFP shocks shift capital demand (and hence investment demand recall invt = kt+1 – kt) curve k r capital demand function rise in A fall in A Sum over all firms Firm-level capital demand function Aggregate-level capital demand function k r capital demand function rise in A fall in A FOR GIVEN rt and wt+1, rise (fall) in At+1 raises (lowers) kt+1 rt=At+1kt α-1nt+1 1-α 8PREFERENCE SHOCKS Preference Shocks Illustrate idea using consumption-leisure framework Utility function (modified from Chapter 2): u(Bc, l) c: consumption l: leisure B: preference shifter, with B > 0 Recall Chapter 2: there we had set B = 1 Mechanics of B Makes each unit of c more (high B) desirable… …or less (low B) desirable 9PREFERENCE SHOCKS Preference Shocks MRS between consumption and leisure Definition is same as always But now need chain rule of calculus to compute Because first argument of u(.) is now the composite Bc, not simply c Chain rule: (grab the B term inside the first argument) MU of leisure same as always: MRS between consumption and leisure B affects MRS in “two” ways , / / c l u l u M S c R /u c 1/ ( , )u c u Bc l B 2/ ( , )u l u Bc l 2 , 1 ( , )/ 1 / ( , ) c l u c lu l MRS u c u c B BB l The effects of B here cancel out (affects numerator and denominator in same way) The effects of B here affect indifference curves 10 PREFERENCE SHOCKS AND INDIFFERENCE MAPS Preference Shocks 2 , 1 ( , )/ 1 / ( , ) c l u Bc lu l MRS u c u BcB l leisure c Increase in B flattens all indifference curves (i.e., lowers MRS at any point in c-l space). Interpretation: each unit of c MORE valuable, so decreased willingness to trade c for one more unit of l POST-SHOCK optimal choice – FEATURES HIGHER OPTIMAL CONSUMPTION AND LOWER OPTIMAL LEISURE PRE-SHOCK optimal choice POSITIVE SHOCK TO B 11 PREFERENCE SHOCKS AND INDIFFERENCE MAPS Preference Shocks 2 , 1 ( , )/ 1 / ( , ) c l u Bc lu l MRS u c u BcB l leisure c Rise in B flattens all indifference curves (i.e., lowers MRS at any point in c-l space). Interpretation: each unit of c more valuable, so decreased willingness to trade c for one more unit of l leisure c Fall in B steepens all indifference curves (i.e., raises MRS at any point in c-l space). Interpretation: each unit of c less valuable, so increased willingness to trade c for one more unit of l IF B RISES IF B FALLS Superimpose a budget line: optimal choice of c and l clearly affected by shock to B 12 PREVIEW OF BUSINESS CYCLE THEORY Where Things Are Going Modern macro view: periodic ups and downs of macroeconomic activity driven fundamentally by (various and many) shocks Supply shocks: TFP shocks, others Demand shocks: preference shocks, monetary policy shocks, others Shocks over time lead to changes over time in Consumers’ incentives to work, save, and consume Firms’ incentives to hire, invest, and produce time Actual GDP (or virtually any real economic series…) Long-run GDP aka steady-state GDP aka potential GDP Economy’s response(s) to shocks mediated through labor markets, capital markets, and goods markets
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