Topic13-Business Cycles_AAP_B&W-6

Topic13-Business Cycles_AAP_B&W-6 - Characterizing...

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Unformatted text preview: Characterizing Cycles (cnt.) cnt.) • Quarterly time series of real GDP, investment, time GDP money supply, etc. are used to analyze business cycles • Interested in 2 features of the data: Business Cycles Which variables are most volatile (as measured by the standard deviation around the trend)? standard Characterizing cycles, US business cycle facts, The real business cycle theory, Policy implications Is a variable procyclical procyclical comoves cyclically in the same direction as (real) GDP GDP or countercyclical countercyclical comoves cyclically in the opposite direction as GDP? GDP That is, is the correlation with GDP positive or negative? correlation with GDP Topic 13 (Text: 8.1-8.3 & 10.1; no FE curves) 1 6 Characterizing Cycles Two Features of Cycles • Business Cycles are recurring but irregular fluctuations in real GDP around a trend over short GDP periods of time (several quarters) 1. Volatility (standard deviation): GDP The period of time when real GDP is falling is a GDP contraction or a recession contraction recession The period when real GDP grows is an expansion or a GDP expansion boom. boom A severe recession is a depression depression Trend line x Variable x is less volatile than GDP. 2. Cyclicality (Correlation coefficient with GDP): • The entire sequence, measured from peak to peak or trough to trough is a business cycle business GDP Peaks and troughs are called turning points These points are catalogued by the National Bureau of Economic Research (NBER) Trend line x y X is procyclical (corr. coeff. > 0) Y is countercyclical (corr. coeff. < 0) 4 7 Characterizing Cycles Pro-Cyclical & Lower Volatility Pro2.75 2.50 One business cycle 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0 5 10 20 30 40 50 60 70 80 90 100 8 1 1 Counter-Cyclical Counter- A Leading Indicator 2.75 2.75 2.50 2.50 2.25 2.25 2.00 2.00 1.75 1.75 1.50 1.50 1.25 1.00 1.25 0.75 1.00 0.50 0.75 0 10 20 30 40 50 60 70 80 90 100 0 10 20 30 40 50 60 70 80 90 9 100 12 Timing US Business Cycle Facts Real GDP GDP 1.7% 1.00 0.9% 0.77 6.8% 0.92 Gov Purchases 2.0% 0.05 Worker Hours -- 0.88 Unemployment -- -0.92 M1 -- 0.31 M2 10 Corr. With GDP Investment Leading indicators move before GDP GDP Coincident indicators move with GDP GDP Lagging indicators move after GDP GDP Std Deviation Consumption • Economic variables can move before or after GDP GDP -- 0.46 13 A Lagging Indicator Figure 8.2 Cyclical behavior of the index of industrial production 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0 10 20 30 40 50 60 70 80 90 100 11 15 2 2 Figure 8.3 Cyclical behavior of consumption and investment Figure 8.8 Cyclical behavior of the nominal interest rate 16 Figure 8.4 Cyclical behavior of civilian employment 19 Figure 8.7 Cyclical behavior of nominal money growth and inflation 17 Figure 8.5 Cyclical behavior of the unemployment rate 20 Figure 8.6 Cyclical behavior of average labor productivity and the real wage 18 21 3 3 Figure 8.9 Industrial production indexes in six major countries The Keynesian Business Cycle • Demand initiated Fed reduces Money growth during a boom This means that r & Y Reduces the demand for labor Requires a reduction of W/P to maintain full W/P employment Therefore, a reduction in W But W is rigid or sticky in the short run This means real wage is rigid or sticky Employment & unemployment 22 31 Business Cycles A Historic Perspective on Recessions • Keynes proposed his solution to business cycles in the mid-30s mid• Marx and Engel proposed a solution earlier • Here are some data that shows how many months months per year the U.S. spent in recessions: • In the 1950s and 1960s, business cycles were thought to be caused by monetary fluctuations The Fed blamed for every recession; Milton Friedman recession; • But the 1974-75 recession was clearly not a 1974not monetary recession Enter RBC models • Monetary/Financial markets: Period 1854 –WWI 1900-WWII 1900Post WWII Months/Year 5.54 1971, 1980-2, 2008 1980- • RBC: 1975, 1991 5.53 1.80 25 32 Business Cycle Theories The Real Business Cycle Theory • After the Great Depression the Keynesian theory of fluctuations became the dominant business cycle theory • The new classical “revolution” questioned revolution” the Keynesian conventional wisdom It is based on Demand fluctuations Likely to be generated by the Fed Price rigidities based on micro foundations rational expectations supply shocks market clearing • The implications of the new approach for policymaking are radically different Explains unemployment Short-run non-neutrality of money Shortnon- RBC theory is much more consistent with the principles of economics! Active government intervention indicated 30 33 4 4 The Real Business Cycle Theory Real Business Cycles (cnt.) cnt.) • However, the demand-based recessions demandhaven’t gone away! haven’ Current example The current recession is not a series of bad TFP is shocks! • However, the process the economy goes through is still valid The consequences of a negative shock have to work through the economy and it takes time • Basic idea: temporary, but serially temporary serially correlated technology shocks hit the economy positive shock today positive shock tomorrow with high probability • These shocks spread through the economy, economic actors react, and it takes a while for everything to be made right 34 Real Business Cycles • 37 Real Business Cycles (cnt.) cnt.) (cnt.) cnt.) The cornerstone of the new classical approach is the Real Business Cycle (RBC) model. It is based on four implicit four or explicit assumptions • Households and firms react to these shocks by altering their consumption, investment, and production plans in a particular way 1. Fluctuations in technology (technology shocks or supply shocks) cause fluctuations in supply output and employment 2. The neutrality of money. The money supply, if anything, responds to change in output and responds not the other way around • Recall that the goods market clearing implies capital market clearing The supply shocks are propagated throughout the economy and output, its components, and output components the real interest rate fluctuate real We’ll examine the effect of shocks on the We’ capital market and the labor market i. So, we can study fluctuations in a real model without monetary variables without 35 38 Real Business Cycles (cnt.) cnt.) Real Business Cycles (cnt.) cnt.) The four assumptions of RBC models • 3. People willingly substitute labor from times when wage or real interest rate is low to when they are high a. This intertemporal substitution of labor, explains a. intertemporal why employment and output fluctuate 4. Prices and wages are fully flexible. The economy is always in equilibrium 36 Suppose there is a temporary negative (adverse) technology (productivity or TFP) shock to the economy. That is, the “A” in the production function goes down from A1 to A2< A1 We’ll trace the effects of this on the behavior We’ of firms and households 39 5 5 RBC Model Dynamics RBC Model Dynamics (cnt.) cnt.) Temporary negative productivity shock: A2< A1 Temporary negative productivity shock 7. The effect on the real interest rate is ambiguous. The leftward shift of S tends to real interest rates, but this is offset by a leftward shift of I, due to the in MPK 1. Output Y decreases, • at the current levels of capital (K) and labor (L) 2. But MPL and MPK also decrease, which MPL MPK decreases the firm’s desired amount of labor firm’ desired and capital a. 1. Real interest rate is acyclical in the data • Summary: a negative productivity shock output, employment, saving, investment and leaves the real interest rate virtually unchanged this further decreases output 3. In the labor market the shift in labor demand equilibrium real wages, and the equilibrium labor supplied (& employed) Accords well with most cycle facts a. Hours and employment are procyclical, and procyclical, unemployment is countercyclical 40 43 RBC Model Dynamics (cnt.) cnt.) Real Business Cycles Temporary negative productivity shock • Recessions can thus be explained by negative negative productivity shocks • Expansions by positive productivity shocks positive 4. The in MPK Kd MPK a. Investment demand curve shifts left b. Even if the S curve does not shift, this is enough to decrease equilibrium investment c. Also, the shock is likely to be negative tomorrow. So, this is not the time to expand business! d. Note investment is procyclical Note the role that the various assumptions played in the effects that we traced through • Distinguish between temporary productivity shocks used to study cycles (oil shocks, bad weather, innovations, etc.) and permanent ones used to study long run productivity slowdowns and growth (R & D, inventions.) 41 RBC Model Dynamics 44 (cnt.) cnt.) Shock Transmission In Simple RBC -1 Temporary negative productivity shock 5. How do households react to a temporary loss in income? The permanent income hypothesis says that consumers try to maintain smooth consumption, consumption only a little because they either borrow or reduce savings a. Note consumption is the least volatile. This means that the saving curve S shifts leftward 6. This reinforces the previous effect of in investment. Investment drops even further RBC Mode l 8.0 7.0 k 6.0 A Total duration of AR1 shock Y_Per 5.0 4.0 3.0 2.0 1.0 1. Investment is the most volatile component 1. -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30 35 40 45 50 Periods 42 45 6 6 Shock Transmission In Simple RBC -2 Example #1.B (cnt.) cnt.) • Y = A(100L - 0.5L2); MPL = A(100 – L); the MPL supply of labor is LS = 56 + 0.1w What happens to the equilibrium levels of Y, L, & w if A = 1.1? if RBC Model 86.0% 85.5% 85.0% Participation 84.5% 84.0% 83.5% 83.0% -45 -40 -35 -30 -25 -20 -15 -10 -5 0 5 10 Periods 15 20 25 30 35 40 45 50 46 58 Policies Figure 10.03 Small Shocks and Large Cycles • The presumption that government should actively counter business cycle downturns is a cornerstone of Keynesian macroeconomics. Recall The Phillips curve and countercyclical monetary policy Fiscal policy in recessions Actively subsidizing the unemployed • But in the RBC theory, fluctuations in output, employment, consumption, etc. are responses of individuals to unavoidable shocks unavoidable Employment fluctuation is a rational response to exogenous events Intervention makes everyone worse off 47 62 Example #1.A Policies (cnt.) cnt.) • Y = A(100L - 0.5L2); MPL = A(100 – L); the MPL supply of labor is LS = 56 + 0.1w • If A = 1.0, what are the equilibrium levels of output, labor supplied and the real wage rate? • There are long-term policies that can be longhelpful (under any theory) Work to improve how markets function Information flow Artificial rigidities Infrastructure that promotes labor mobility Beneficial but spare regulation Reduce government subsidies to businesses Break up monopolies Maintain a credible and workable social safety net 54 63 7 7 Glossary Policies (cnt.) cnt.) • New classical economists argue that government cannot have much influence on the economy, and even if it did, its actions cannot be a stabilizing influence Interfering with the RBC cycle is likely to make things worse • The arguments parallel the ones for “rules” rules” regarding the Fed’s monetary policy Fed’ Long lags might mean the stimulus arrives at the wrong time Bureaucratic cost of providing the stimulus is too high Stimulus might be given for political, rather than economic reasons M1 Monetary aggregate M2 Monetary aggregate Y MPK, MPL MPL Real GDP (output, income) GDP Marginal products of capital & labor Desired capital stock Investment Saving Nominal ($) wage rate Real Business Cycle theory (Currency + Demand Deposits) (Currency (M1 + Time Deposits) Kd I S W RBC 64 67 Policies (concl.) concl.) • The Fed has not been entirely won over by the RBC arguments The FOMC doesn’t believe it is doing something doesn’ useless Implement countercyclical policies Recall the Taylor Rule Policymakers have given up the idea that any countercyclical policy can substantially insure full employment all the time THE END At least for now Much more respect of market forces and the role of information Much more transparency at the Fed 65 68 3 Examples of “Market Failures” Failures” Below are three of many examples of phenomena that analysts, the press, and many policymakers have declared to be obvious market failures! But are they? obvious But • The 2000 bubble • The gender difference in pay • The explosion of executive compensation in the U.S., particularly in options compensation 66 8 8 ...
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This note was uploaded on 03/02/2010 for the course BUAD 350 taught by Professor Safarzadeh during the Spring '07 term at USC.

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