GDP is expected to remain below the trend for a considerable period. This supports the Real Business Cycle Theory. One part of this theory states that the Solow residual has persistence (Williamson 2008:406). By this it is meant that the Solow Residual remains above or below trend for an extended length of time. This is because a decrease in z will result in a further decrease in z’. As a result of this the RBC theory suggests that firms will demand less labour, thus shifting the labour demand curve to the left. However the report states that this has not occurred in this recession. One reason the report proposes is “One reason why some companies may have maintained employment is because the costs associated with firing and then rehiring staff are substantial” (BOE Report). This therefore shows a critique of the RBC Model. The critique is that the RBC does not capture capacity utilization, which may result in situations such as labour hoarding (as proposed by the BOE report). Additionally as the RBC theory has historically not matched previous data and with the problems of using the Solow Residual as a measure of total factor of productivity it therefore limits the real business cycle model and its interpretations within the report.
The Keynesian Coordination Failure Model suggests that the reason for business cycles is a lack of coordination within the economy, in particular with aggregate supply (Williamson 2008:425). This is because a producers willingness to supply is based on what other producers are simultaneously producing. This can lead to multiple equilibria for the aggregate economy, which are driven by waves of optimism and pessimism. Therefore it is beneficial for governments to aim to reduce the waves of optimism and pessimism. This can be achieved through the government promoting optimism within the economy (Williamson 2008:433). This is shown the BOE report as in many circumstances the report is positive in the outlook for the future of the economy. One example of this optimism is “After falling substantially, output in the United Kingdom stabilised in the second half of 2009 and a period of gradual expansion is in prospect” (BOE Report). Through promoting optimism the economy, according to the Keynesian Coordination Failure Model, the economy should reach good equilibria. However a critique of this model is that the model uses underlying shocks as the cause of business cycles, but these are themselves expectations. As expectations are essentially unobservable it makes it difficult to use the theory in the model to explain previous recessions and booms (Williamson 2008:436).
In the Keynesian business cycle theory, the sticky wage model is the most important principle. The sticky wage model suggests that not all markets are flexible because some prices or wages are sticky, meaning they cannot move in the short term (Williamson 2008:441). In particular in the labour market it is the nominal wage ‘W’, in the short term that is imperfectly flexible. This can be attributed to institutional rigidities in how nominal wages are set. One example of this is that it is “costly to get workers and firms together frequently to negotiate wage agreements, so that wages are typically set at a given firm for a year or more (Williamson 2008:442)”. This institutional rigidity is shown in the BOE report as “Nominal wage growth remained at a very low level during 2009 H2” (BOE Report). The inflexibility of the nominal wage is shown in the report by “In the short term, there is a tendency for increases in the unemployment rate to be associated with weakness in earnings growth, as a growing pool of available labour discourages employees from bidding up pay” (BOE Report). This suggests that due to the increased unemployment, nominal wages are being kept constant and are therefore not flexible as have not adapted in the short term to reach labour market equilibrium.
The Friedman-Lucas model advocates that it is monetary shocks that cause business cycle fluctuations. The basis of this model is that households do not have perfect knowledge. Therefore they are unable to determine what shocks to either money supply or total factor of productivity. In the report the BOE states that “The MPC has maintained Bank Rate at 0.5%, and has continued its programme of asset purchases to a total of £200 billion” (BOE Report). This shows that the central bank has attempted to maintain the same level of Money Supply. This may be attributed to the Friedman Lucas Model. This is because the model emphasises that the central bank should adopt a constant money growth rule. This should help prevent households from misinterpreting monetary shocks. This transparency helping households anticipate shocks is shown in the report by “Measures of households’ medium-term inflation expectations have been broadly stable” (BOE Report). However the Friedman Lucas model also advocates the Friedman Rule. In the Friedman rule it suggests that the nominal interest rate should equal zero (Williamson 2008:589), but in this circumstance the Bank Rate is set at 0.5% (BOE Report).
As the money supply has been kept constant (BOE Report) it means that there will be no shift in the LM curve. The LM curve stands for ‘Liquidity of Money’ and shows the relationship between Real Output ‘Y’ and the real interest rate ‘r’. The IS curve is identical to the output demand curve Yd. It represents the equilibria where total private investment is equal to total savings. In the report the government has not altered spending (BOE Report) so the IS curve should remain constant. Where the IS and LM curve intersect is the real interest rate ‘r’. Due to the IS and LM curves not shifting either direction, the real interest rate ‘r’ should remain constant. This is shown in the report by the “(CPI -Consumer Price Index) Inflation is likely to remain significantly above the 2% target in the near term” (BOE Report). This therefore supports the Keynesian Business Cycle Theory.
Throughout the report it is apparent that it shows, supports and counteracts various models. This is because all the models, in their own context, help explain occurrences in the economy. However not one model is absolute in explaining the business cycle and price and wage fluctuations. This is because all the models have limitations, and because of this struggle to match the data shown in the BOE Report. Additionally due to the two main contrasting schools of Economics (Classical and Keynesian) having different base points, but still similar ending points, it may explain why there is such a mix of support and negatives of the models in the BOE report.
References
Williamson, S.D. (2008) Macroeconomics. Pearson.
Bank of England Quarterly Report February 2010. Accessed on 10/05/2010, http://www.bankofengland.co.uk/publications/inflationreport/2010.htm
