Macroeconomics
Lecture 9
Misperception theories of the
business cycle
Outline
• Models of Aggregate Supply
• The misperception model
We are here DAD-SAS
(r,,Y)
Labour market
(AS)
Goods market
AD-AS
Keynesian
(r,P,Y)
Cross (IS)
IS-LM
(r, Y)
AD
Financial
markets (LM)
Foreign
AD*
exchange
(r*,Y,e, NX)
markets
Models of Aggregate supply
Markets with imperfection
labor Goods
Imperfect-
Misperception
Yes information model
model
(Lucas Island)
Markets clear?
Sticky-wage Sticky-price
No model model
The natural rate hypothesis: A link
between the long-run and the short-run
P
AS 0
Short-run
equilibrium
Long-run AD1
equilibrium
AD0
Y
Y
The natural level of output (potential output).
Monetarist New Classical New Keynesian
Phillips Friedman Lucas Taylor
1960 1968 1973 1977
time
The The mis- The imperfect The sticky wage model
Phillips perception information model (or the New Keynesian
curve model (or the (or the Lucas supply supply curve)
expectations curve)
Sticky augmented Phillips
wage curve)
Ignore expectations Rational expectations
Stable relationship Natural rate hypothesis
Adaptive expectations Rational expectations
Natural rate hypothesis Natural rate hypothesis
The misperception model
Workers make
mistakes when
they try to predict the
state of the economy
Business cycle
fluctuations, i.e.,
Upwards
sloping deviations from the
AS natural level
of output
Main assumptions
A1: Perfect competition and market clearing.
A2: Firms observe the price level
A3:Workers misperceive the price level
Why is the AS upwards sloping?
P W W/Pe W/P
increases increases increases decreases
W P0e f ( Ls )
LS Ld
B increases increases
P
W A
P g ( Ld )
1
P0 g ( Ld )
_ L
Y
L increases
The misperception theory of
the cycle
_
Y Y (P P ) e
Unanticipated
Natural change in the
level of price level
output
Underestimation of Boom
the price level
Overestimation of Recession
the price level
What causes misperception?
Adaptive expectations
Rational expectations and imperfect
information
Adaptive expectations
Workers base their expectation of economic variables (prices)
on information about past observations of that variable (only).
Workers use a mechanic rule to process the information
they got about past observations.
Adjustment speed
P
t 1 t
e
P a ( Pt 1
e
t 2 t 1 P ), 0 a 1.
e
t 2 t 1
Expectation at time
t-1 of what the Last period’s expectation
price level will be Previous period’s error
at time t expectation
t 1 tP e
P a ( Pt 1
e
t 2 t 1 P ) e
t 2 t 1
(1 a ) t 2 Pt e 1 aPt 1
Backwards looking a (1 a) Pt 1i
i
i 0
Minimum consistency requirements: if prices are constant for ever,
then price expectations should be correct.
Pt P for all t
aP
t 1 P aP (1 a )
e i
P
t
i 0 1 (1 a)
Problems with adaptive
expectations
• Limited information
• Backwards looking
• Unrelated to the economic model
(exogenous).
• Adjustment speed unexplained.
• Systematic errors likely.
Rational expectations
Workers base their expectation of economic
variables on all available information.
Workers use the economic model which determines
the variable of interest to process the information.
P E[ P t 1 ]
t 1 t
e
t
Rational Information
expectation set
In other words…
• Rational expectations require that the
expectations to a variable (prices) should be
consistent with the economic model that
explain the variable.
• Expectations become an endogenous variable
and depend on all the determining (exogenous)
variables (such a government spending and
monetary policy) of the model.
• Expectations become forward looking.
Misperception and rational
expectations
Under RE workers do not make systematical
expectation errors but still they DO make mistakes!
Misperceptions related to imperfect information and
confusion about random shocks.
The imperfect-information model
The Lucas supply curve
New classical supply curve
Two types
of shocks P qP (1 q ) P
e
0
e
1
e
_
Y Y (P P ) e
e
LR Real wage
Productivity P 0 increased and q
shocks labor supply
increases
W
LR Real wage
Nominal unchanged and 1-q
price shocks e labor supply
P1 unchanged
Sources of misperceptions
_
Y Y (P P ) e
• Adaptive expectations (AE) lead to systematic
misperceptions and a gradual adjustment of
price expectations to facts
– original formulation in Friedman’s natural rate
model.
• Rational expectations (RE) do not allow any
systematic misperceptions and imply a very
fast and immediate response to facts.
– However, there may be confusion about how the
facts should be interpreted (imperfect information).
AS ( P e )
1
P
LAS
AS ( P0e )
P1
Unanticipated RE = immediate
increase in
adjustment.
price level
P0 AE = gradual
adjustment.
Y
Y
Where are we going next?
• The sticky wage model
Aggregate demand
Combinations of P and Y at which the market for goods
and the money market are in equilibrium.
r P Aggregate
IS(P1) LM(P0)
IS(P0) Demand (AD)
A
LM(P1) P0
A C
r0
P1 C
r1 B B
Y Y
Y0 Y1 Y2 Y0 Y1 Y2
Why is the AD curve
downwards sloping?
P M/P r
ESM
decreases increases falls
The AD curve does Keynes
V/P I
Pigou increases NOT slope downwards effect
increases
because consumers
effect demand less at higher
prices Y
C
increases increases
Extra slides. Not covered in the
lectures
• These slides sets out the details of how the
misperceptions model works. This material
is covered in older versions of Mankiw’s
textbook but not in the latest edition.
• I do not expect you to learn the details of
this, but the interested student may
nonetheless want to run through the
material.
The behaviour of firms
d
W Pg( L )
Price up =>
labour demand
shifts out
Nominal
wage
W The value of the
marginal product
of labour
P g ( Ld )
1
d
Labour P0 g ( L )
Ld
demand for
given P
Worker behaviour
e S
Labour supply: W P f (L )
Labour supply
Expected
e S
W P f (L )
1 shifts up when value of the
the expected price MRS of
increases. consumption for
leisure
e
P0 f ( LS )
LS
Long-run equilibrium at the
labour market
Market clearing: Demand = supply.
Expectations are fulfilled.
e
W d
Pg( L )
e S
P f (L ) P P
Natural level
of unemployment
W*
Natural level of
employment
_ L
LF
_ _ _
L
Y F ( L, K ) Natural level of output
Short-run equilibrium at the
labour market
Market clearing: Demand = supply.
Misperceptions about
the price level
W P0e f ( Ls )
Unanticipated
B increase
P in the price
W A
P g ( Ld )
1
P0 g ( Ld )
_ L LAS
Y L P
AS ( P0e )
P1 B
Y1
_
Y B
A
P0 A
_
Y F ( L, K )
L _ Y
Y Y1
P1e f ( Ls )
W From the short-run to the
P0e f ( Ls )
long run:
C
B
P W Pe W
A
P e W P
P g ( Ld )
1
P0 g ( Ld ) AS ( P e )
1
_ L LAS
Y L P
AS ( P0e )
P1 C
Y1
_ B
Y B
A
P0 A
_
Y F ( L, K )
L _ Y
Y Y1