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Keynesian macroeconomics - Essay Example

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The theory of Real Business Cycles (RBC) hypothesises that all prices are flexible, even in the short run which leads to the implications that money is neutral in the short run and that classical dichotomy holds at all times. RBC theory further proposes that fluctuations in output, employment, and other variables are the optimal to exogenous changes in the economic environment, i.e…
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Keynesian macroeconomics
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Download file to see previous pages However, large changes in available technology, especially regression is very difficult to support (Summers, 1986).
Second, RBC theory assumes that fluctuations in employment reflect changes in the amount people want to work. Because employment fluctuates substantially while the determinants of labour supply - real wage and the real interest rate - vary only slightly, these models require that leisure be highly substitutable over time. This assumption conflicts with many studies (for example, Altonji, 1986); it also conflicts with the belief that high unemployment in recessions is largely involuntary.
Third, real business cycle theory assumes that monetary policy is irrelevant for economic fluctuations, this challenges the Keynesian argument that any correlation of money with output arises because the money supply is endogenous (King and Plosser, 1984). Very little evidence supports this theory.
A different approach to the business cycle is the sectoral shift theory, which emphasizes the costly adjustment of labour among sectors (Lilien 1982, Black 1987). According to this theory movement of labour from one sector to another occurs in response to market fluctuations and recessions are periods during which there are more sectoral shocks and thus a greater need for sectoral adjustment. If this were to be true we would observe high unemployment accompanied by high job vacancies during a recession - this is not correct (Abraham & Katz, 1986). In fact the measured movement of workers is opposite i.e. very low during recession (Murphy & Topel, 1987).
Advocates of the sectoral shift theory argue that it is possible that since the process of sectoral adjustment requires a period of high unemployment and low income, it lowers the demand for the products of all sectors. Thus, we might observe low vacancies and low movement during recessions, even if recessions are initially caused by the need to reallocate labour among sectors.
In this form, it is not clear how to distinguish empirically the sectoral shift theory from real business cycle theories that emphasize economy-wide fluctuations in technology or Keynesian theories that emphasize fluctuations in aggregate demand.
The debate over the RBC theory boils down to four issues:
1. Do changes in employment reflect voluntary changes in labour supply
2. Does the economy experience large exogenous productivity shocks in the short run
3. Is money really neutral in the short run
4. Are wages and prices flexible in the short run Do they adjust quickly to keep supply and demand in balance in all markets
Satisfactory answers have not been found to these questions within the framework of the RBC theory.
New Keynesian Macroeconomics
The single theme that identifies Keynesian economics is the belief that economic fluctuations do not reflect the optimal response of the economy to changes in tastes and technology, but some sort of market failure on a large scale. The market imperfection that recurs most frequently in Keynesian theories is the failure of wages and prices to adjust instantly to equilibrate supply and demand. The short-run ...Download file to see next pagesRead More
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