Studying seriously and earning money at the same time is difficult. So the choice is between either working in the summer and studying in winter or working in the winter and studying in summer. If the student works in winter, then at the end of winter he will have W w rupees. The higher this quantity, it is more likely that the student will choose summer rather the winter work. Thus the incentive to work hard how—accept lots of overtime, say—depends on three factors: the current wage, the expected future wage, and the real interest rate.
Increases in the first and the third tend to lead people to postpone recreation and other non-work uses of time to the future. Increases in the second tend to lead people to work less. If people are strongly desirous of shifting their hours of work from season to season or from year to year, then one would expect substantial fluctuations in employment.
RBC theory uses this concept to explain why employment and output fluctuate. The converse is also true. The RBC theory assumes that economy experiences fluctuations in technology and these fluctuations cause fluctuations in output and employment. Due to inter-temporal substitution of labour, the improved technology also creates more employment. This leads to further rise in output.
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RBC theory assumes that wages and prices adjust quickly to clear markets. It is felt that the assumption of flexible prices is superior methodology to the assumption of sticky prices, because it ties in macroeconomic theory more closely to microeconomic theory. Critics of RBI theory believe that short-run fluctuations in output and employment represent deviations from the natural levels of the variables. This stickness makes the short-run aggregate surplus curve upward sloping rather than vertical. Consequently, fluctuation in the aggregate demand causes short-run fluctuations in capital and output.
New Keynesian economics has attempted to explain price stick-ness by examining the microeconomics behind short-run price adjustment. By doing so, it attempts to put the conventional theories of short-run fluctuations on a much stronger foundation. One reason for price stick-ness or sluggish price adjustment is the existence of menu costs, or the costs of changing prices.
Such costs lead firms to adjust prices at discrete time periods and not every now and then. No doubt menu costs are very small but they are not inconsequential. Even though such costs are small for the individual firm, they can have large effects on the economy as a whole. A typical large manufacturing firm sells differentiated products and employs different types of labour. Changing prices and wages in response to every minor fluctuation in demand is a costly and time-consuming activity. Hence it may be optimal for firms to react to small changes in demand by holding prices constant and responding with changes in output and employment.
If many firms behave in this way, output and employment will respond to changes in aggregate demand. One reason for slow adjusting of prices in the short run is that there are externalities to price adjustment. A price cut by one firm benefits other firms in the economy. The increase in real money balances expands aggregate demand by shifting the LM curve to the right.
The economic expansion in turn raises the demand for the products of all firms. Due to lack of synchronization of the activities of different unions and firms staggering occurs, i. The reason is that every firm prefers to wait and watch the actions of others. No firm wishes to take the lead, i. There is staggering in labour market, too. This affects wage determination. If, for instance, the money supply falls, aggregate demand will fall.
Market equilibrium and changes in equilibrium
This, in turn, requires a proportionate fall in the nominal wages to ensure full employment. If all wage rates fall, proportionally, each worker would willingly accept a lower nominal wage. But each worker is reluctant to be the first to accept a wage cut because this means a temporary fall in his real wage. The staggered setting of individual wages makes the overall level of wages sticky.
Coordination failure occurs in the setting of wage and prices because those who set them must anticipate the actions of other wage and price setters. Firms setting prices are watchful of the prices other firms will charge. A simple example will explain how a recession could arise from coordination failure. Suppose there are just two firms in an economy.
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After a fall in money supply, each firm has to decide whether to cut its price, if its objective is profit maximisation. The choice in terms of a simple duopoly game problem faced by each firm is shown in Table 1, which shows how the profits of the two firms depend on their actions. If each firm changes its current price, real money balances remain low, a recession starts and each firm makes a profit of Rs If both firms cut their prices, real money balances are high, a recession is avoided, and each firm makes a profit of Rs No doubt, both firms prefer to avoid a recession.
But none can do it by its own action. The firm making the price cut earns Rs 50 while the other earns Rs The situation described above is typical of duopoly. When one firm cuts its price, it improves the position of the other firm since money supply goes up. So the other firm can then act to avoid a recession. Two opposite outcomes are possible in this economy. On the one hand, if each firm expects the other to cut its price, both will cut prices, resulting in the best possible outcome in which each earns Rs On the other hand, if each firm expects its only rival to maintain its current price, both will maintain their prices, in which case each makes Rs Each outcome is possible.
So there is multiple equilibria problem.
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If the two firms could coordinate their pricing decision they would both cut their price and reach the preferred outcome. In the real world, in which there are a large number of firms, coordination is really difficult.
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Thus the main message of this example is that prices can be sticky simple because people expect them to be sticky, although stickiness is not in the interest of anyone. Economists in the New Keynesian NK tradition believe that wages and prices are sticky. Therefore, monetary and fiscal policies should be used to stabilise the economy.
Price stickiness at the micro-level is a type of market imperfection, and it leaves open the possibility that government policies can raise social welfare.
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According to this theory, the ups and downs of the business cycle are the natural and efficient response of the economy to changing technological possibilities. The standard RBC model does not include any type of market imperfection. It is essentially a model of equilibrium business cycle in the sense that the invisible hand of the market guides the economy in such a fashion that there is an optimal allocation of resources.
Another important recent development, fusing elements of both new classical and new Keynesian economics, is called efficiency Wage theory.
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This approach developed by Edmund Phelps and J. As firms raise their wages to increase productivity, job seekers may be willing to stand in line for these high-paying jobs, thereby producing involuntary wait unemployment. In the short run, an economy-wide negative supply shock will shift the aggregate supply curve leftward, decreasing the output and increasing the price level. A supply shock can cause stagflation due to a combination of rising prices and falling output.
In the short run, an economy-wide positive supply shock will shift the aggregate supply curve rightward, increasing output and decreasing the price level. The diagram to the right demonstrates a negative supply shock; The initial position is at point A, producing output quantity Y 1 at price level P 1. When there is a supply shock, this has an adverse effect on aggregate supply: the supply curve shifts left from AS 1 to AS 2 , while the demand curve stays in the same position.
The intersection of the supply and demand curves has now moved and the equilibrium is now point B; quantity has been reduced to Y 2 , while the price level has been increased to P 2. The slope of the demand curve determines how much the price level and output respond to the shock, with more inelastic demand and hence a steeper demand curve causing there to be a larger effect on the price level and a smaller effect on quantity.
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