Question from Past Macroeconomics Qualifying Exam (Fall, 2005 - Question two) at George Mason University[]

2) ‘Equilibrium business cycle theory since the early 1970s has followed two distinct paths. One path emphasizes the role of money in aggregate fluctuations. The second path emphasizes the role of real shocks’.

a) Clearly describe versions of these two types of models and be specific about how the fluctuations arise in each of them.

b) What are the analytical strengths and weaknesses of these alternative paths?

c) How well does each model stand up to empirical testing in the US?


a) Equilibrium business cycle involving money fluctuations (i.e. New Classical) involves individual actors making decisions based on erroneous perceptions of wage levels by individuals. When workers perceive their wages to be higher than they actually are, a boom results. When they perceive the wages to be lower, a recession occurs. These effects are driven by higher/lower consumption than workers would have made if they perceived their wages to be at the correct real level.

The equilibrium business cycle emphasizing real shocks (i.e. RBC) depends on shocks due to sudden changes in costs (such as the sudden jump in oil prices in the 1970s) or technology changes (productivity shocks) that enhance/decrease productivity. These shocks in turn drive up or down productivity as goods become cheaper/more expensive in real terms due to the shock.

b) The analytical strengths of the money misperceptions include simultaneously explaining the apparent effectiveness of monetary policy in short-run equilibrium and giving a potential explanation for booms and recessions. The weakness of this model include the lack of a mechanism to coordinate massive misperceptions throughout the economy by a majority of workers or a mechanism to cause persistent booms and recessions. It depends on workers confusing nominal and real prices in the economy.

The analytical strengths of the real shocks model includes the convincing explanation for explaining booms as a result of productivity gains from technology and cost-induced recessions. The weaknesses include the inability to explain negative technology shocks leading to a decrease in productivity. (Is technological knowledge suddenly lost in an economy?)

c) The money misperceptions model has weakly stood up in empirical testing in the US. There does appear to be some degree of money illusion on the part of workers. Empirically, the real shock model has held up extremely well to empirical testing, being able to parallel the historic performance of the US economy. Unfortunately, this model does not yield a high degree of predictive power and has been criticized as using the methodology of running many regressions until one turns up that fits the data.

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