Instructions: Please show all work or points will be taken off. Good luck!
1. (30 points) As we can see from the graphic below, the simulated real business cycle (RBC) model fits real world data quite well with the exception of average labor productivity (the bars on the far right hand side of the graphic). In particular, the real world data suggests that average labor productivity is weakly pro-cyclical with the correlation between average labor productivity and output between 0.3 and 0.4. The simulated correlation from the RBC model over 0.8, clearly not consistent with the facts. Given these results, we say that the simulated RBC model implies that average labor productivity is more pro-cyclical than it actually is.
We then argued that when we add fiscal (Government spending) shocks to the RBC model, this ” average labor productivity is too pro-cyclical” problem is lessoned since the theory implies that in a fiscal shock world, all else constant, average labor productivity tends to be slightly counter-cyclical. In the space below, explain in detail how average labor productivity is slightly counter-cyclical in a “fiscal shock” world. Be sure to support your arguments with a labor market diagram and a production function labeling the initial equilibrium (before the fiscal shock) as point A and the subsequent equilibrium (after the fiscal shock) as point B. Be sure to explain exactly why workers and firms change their behavior given the fiscal shock. Finish your essay by commenting on how the RBC theorists felt about discretionary counter-cyclical fiscal policy and why (i.e., “hands off” or “hands on?”).
Write your essay here – be sure to refer to your graphs in your discussion.
2. (40 points total) When Milton Friedman and Anna Schwartz in a book titled: A Monetary History of the United States, 1867-1960 uncovered the empirical reality that money is ‘pro-cyclical’ and ‘leading,’ the classical economists “went to the drawing board.” We discussed how the RBC theorists explained this phenomenon through reverse causation. We also discussed how the New Classical school explained this phenomenon via the Lucas Island Model.
(20 points) In the space below, provide the RBC explanation as to why money is leading and pro-cyclical. Be sure to include a money market diagram, an IS-LM diagram, and an AS/AD diagram in your answer being sure to refer to your graphs in your essay. Finish your essay by discussing whether or not money is neutral in the RBC model and why.
b) (20 points) In the space below, use the “Lucas Island Model” to provide an explanation as to why money is leading and pro-cyclical according to the New Classical Economists. Be sure to include a completely labeled AS/AD diagram and an explanation of what we mean exactly by a Lucas Aggregate supply curve (along with the intuition underlying it). Finish your essay by discussing whether or not money is neutral in this New Classical model and why.