Question

In the real business cycle model, suppose that firms become infected with pessimism (for example, due to COVID-19 outbreak) and they expect that total factor productivity will be much lower in the future.

a. Determine the equilibrium effects of this.
b. If waves of optimism and pessimism of this sort cause GDP to fluctuate, does the model explain the key business cycle facts?
c. Suppose that the monetary authority wants to stabilize the price level in the face of a wave of pessimism. Determine what it should do, and explain.

Answer 1

a.If the firms are infected with pessimism of lower productivity,then they will reduce investments,which will negatively impact production,prices of products will highly fluctuate,they will reduce and which will impact wages of labour,then labour supply will reduce,hence overall negative impact on GDP.Consumers will demand less goods as they will be left with lower income.This will more lead to negatively impact production and investment.This will be the equilibrium effect.

b.Real business cycle model explains that the shocks in technology and productivty can lead to various business cycles in the economy.Like the wave of pessimism about the lower of productivity can lead to a wave of recession in the economy.

c.If the monetary authority wants to stablilize the prices,then real business cycle model focuses on supply side economy which suggests that it should reduce taxes and regulations in the economy which will lead to increase in disposable income of consumers which will increase demand from their side.As explained by laffer curve,like reduction in tax rate upto certain level leads to increase in economic growth and can help the economy to revive from the recession.