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Unformatted text preview: Macroeconomic Policy Class Notes Business Cycles II: Theories Revised: December 5, 2011 Latest version available at www.fperri.net/teaching/macropolicy.f11htm In class we have explored at length the main features of the fluctuations in economic activity known as business cycles. However the most interesting questions in busi- ness cycles research is what drives business cycles fluctuations and what are their consequences for welfare. These questions will also be answered partly into the next classes in which we will also explicitly consider the role of fiscal policy, money and monetary policy. Causes of Business Cycles To start it is convenient to rewrite once again the basic national income accounting equation Y = AF ( K,L ) = C + I + G + NX This equation highlights two possible (non mutually exclusive) determinants of busi- ness cycles. Supply Shocks These are shocks either to A, L or K. By definition they affect Y and so they cause fluctuations in GDP. Example of this shocks are productivity increases (the US Econ- omy in the late 1990s), large investment plans that increase K (The Marshall plan in Europe after the war), increases in employment (the increase in female labor mar- ket participation). Neoclassical economists (among which Finn Kydland and Edward Prescott which were awarded the 2004 Nobel Prize in Economics) believe that the shocks to supply are the key drivers of business cycle fluctuations. In particular they Business Cycles 2 argue that aggregate demand (i.e. C I , G and NX ) will simply respond to aggregate supply. Their key idea is that the business cycle of a nation is not very different from the business cycle of farmer Joe. Suppose that farmer Joe expects a few years of high productivity (say because he expects good weather). In order to take advantage of the high productivity hes going to work hard (high L) and invest in a new tractor. But now farmer Joe is also richer and he will want to buy new clothes and eat well (high C ). If Joe is counting on a lot of future good harvests, consumption and invest- ment expenditures will probably exceed current income but Joe will not hesitate to borrow (negative NX ). Note that demand of farmer Joe moves exactly like aggregate demand over the cycle but obviously the key driver is not demand. His consumption and investment and are high because of the good harvest and it is not that he has a good harvest because he consumes and invest a lot. Kydland and Prescott argue that the modern market economies can be described as a collection of farmer Joes all hit by shocks to their productivity and these shocks generate business cycles. Their con- clusion is that understanding business cycles is not very different from understanding growth, i.e. everything boils down to understanding TFP. In growth we were inter- ested in understanding the long run movement of TFP, in business cycles we are more interested in understanding its short run fluctuations. For example Prescott argues that if you want to understand the 90s in Japan (the so called lost decade) you need...
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