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