Understanding the World Economy Master in Economics and Business Business cycle fluctuations Part I Lecture 6 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr
Lecture 6 : Business cycle fluctuations Part I 1. Definitions 2. Business cycle facts 3.Whatisdrivingthecycle?
Whatisthe business cycle? Two slightly different views: A) Conventional view is that the business cycle describes medium term fluctuations in the level of economic activity (GDP) around a long term trend. B) An alternative view is that the business cycle refers to the way in which activity is bunched over time, whereby the economy oscillates between periods of high and low production. The second definition is more general as it does not define business cycles as relative to a trend.
18000 16000 14000 12000 10000 8000 6000 4000 2000 0 US Real GDP level: do you see the business cycle? Real GDP(Billions of 2009 dollars) Potential Real GDP 2011 2013 Source: BEA 1947 1948 1950 1952 1954 1956 1958 1959 1961 1963 1965 1967 1969 1970 1972 1974 1976 1978 1980 1981 1983 1985 1987 1989 1991 1992 1994 1996 1998 2000 2002 2003 2005 2007 2009
Output gap The output gap is the difference between the trend level of output and actual output: Some problems: GDP level = GDP trend + (GDP level GDP trend) (GDP level GDP trend) = Output Gap 1. get your definition of the trend wrong then also get business cycle wrong. 2. timing of booms and recessions sensitive to exact choice of trend. 3. trend output itself may fluctuate(technology).
Output gap and trend output How to compute the trend? (GDP level GDP trend) = Output Gap Parametric trend Linear trend or linear + quadratic trend, eventually with breaks. Filtering For instance, keep medium(and high) frequencies for business cycle fluctuations. Low frequencies for trend fluctuations. Issue: what if the business cycle is the trend? Long-run fluctuations with highly persistent shocks.
US business cycle fluctuations (% deviations from trend) Source: Federal Reserve Economic Data
US business cycle fluctuations (Annual% Change Real GDP) Source: Federal Reserve Economic Data
2014 Output gaps across countries (1990-2014) deviation of actual GDP from potential GDP (% of potential GDP) 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 6 4 2 0-2 -4-6 France Japan United Kingdom United States Source: OECD
Business cycle vocabulary
Business cycle vocabulary Pro/counter cyclical (a): pro-cyclical variable x = positive correlation between x and y (output gap) along the business cycle (a): counter-cyclical variable x = negative correlation between x and y (output gap) along the business cycle
Datingbusiness cycles Classical approach (Burns and Mitchell, 1946, adopted by NBER and CEPR) Identify local max and min of selected series and then use judgement to determine peaks and troughs of unobserved ``state of the economy. Duration: number of quarter from peak to trough in a recession or fromtroughtothenextpeakinanexpansion. Amplitude: the % change in real GDP from peak to trough in a recession,orfromtroughtothenextpeakinanexpansion.
Datingbusiness cycles GDP measured with error and large revisions. Other variables co-move with GDP (see later): joint analysis should give accurate estimate of state of the economy. NBER uses monthly variables beside GDP: industrial production, sales, income, employment. CEPR does the same, but more emphasis on quarterly variables. NBER and CEPR do not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 US recession EU recession Recession in both US GDP EU GDP 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Datingrecessions CEPR and NBER dating (1970-2010)
Lecture 6 : Business cycle fluctuations Part I 1. Definitions 2. Business cycle facts 3.Whatisdrivingthecycle?
Comovements The business cycle is an aggregate phenomena. Key thing about the business cycle is comovement. The business cycle is reflected in all of the major macroeconomic variables i.e GDP, consumption, investment, unemployment, etc. The majority of sectors are doing well/badly simultaneously. Comovements across regions in a given country (and across countries as shown in the next lecture) of main aggregate variables.
Business cycle and employment Employment co-move positively with the business cycle. US correlation of employment(hours) and output gap 0.9 In demand driven expansions, labour demand increases and so does employment. What about wages? In supply driven (think productivity) expansions, if wages increase, so does labour supply (if upward sloping). Employment should increase. What happens if wages and prices do not adjust immediately?
Real Wage w/p Employment and business cycles (short run) Employment If labour supply upward sloping in the short-run, increase in labour demand triggers an increase in employment.
10 8 6 4 2 0-2 -4-6 U.S. Output Gap and unemployment (1948-2010) 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 % Unemployment Rate Output Gap
Output gap and unemployment: Okun slaw Unemploymentrate=c-d*(outputgap)withc>0andd>0 Unemployment when output gap > 0 (i.e when output potential > actual output) Ifoutputgap=0,unemploymentrate=c=naturalrate Or: %changeunemployment=c-d*%changeoutput US1961-2011:c=1.30,d=0.39
Okun s Law in the U.S. (1949Q1-2009Q4) Cyclical unemployment(%) If output gap = 0, unemployment at its natural rate. When output gap increases, unemployment falls.
Annual percentage change in employment across selected sectors during the last U.S. recessions 10 July 1990 - March 1991 March 2001 - Nov. 2001 Dec. 2007 - June 2009 5 0-5 -10-15 Construction Manufacturing Retail trade Professional & business services Financial activities Education and health services Source: BLS
US Annual% Change of GDP (Expenditure Components) 40 30 % Gross domestic product Personal consumption expenditures Gross private domestic investment Government consumption expenditures and gross investment 20 10 0-10 -20 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Fluctuations in real consumption and real GDP in the U.S. (2000-2015) 6% 4% Real annual growth rate of consumption 2% 0% -2% -4% -6% Real annual growth rate ofgdp 2015q1 2014q1 2013q1 2012q1 2011q1 2010q1 2009q1 2008q1 2007q1 2006q1 2005q1 2004q1 2003q1 2002q1 2001q1 2000q1 6% 4% 2% Real annual growth rate of consumption 20% 15% 10% 5% 0% 0% -2% -4% -6% Real growth rate of non-durable consumption Real growth rate of consumption of services Real growth rate of durable consumption [right-scale] -5% -10% -15% Source: BEA -20%
Business cycle moments U.S. business cycle moments. Quarterly data 1948Q1-2010Q4. HP filtered series Source: Eric Sims, 2011
1,0 0,8 0,6 0,4 0,2 0,0 Output correlation across U.S States 1980-2000 Alabama Alaska Arizona California Colorada Connecticut Delaware District of Colombia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisana Maine Maryland Massachussets Michigan Minneapolis Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhodes Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming
Business cycle factsi Describe what typically happens but every recession/expansion tend to be slightly different. 1.Consumption varies less than GDP. High in expansions and low in recessions. Durable consumption often very volatile while non-durable and service goods consumption (which dominate) are smooth. Why? Savings and dis-savings allow to smooth consumption. 2. Investment is very volatile (2/3 times more volatile than output) and highly procyclical. Why? If consumption less volatile than GDP, investment must be more volatile! Savings are procyclical (and so is investment) 3. Total input of labour almost as volatile as output and very procyclical. High in expansion and low in recessions as explained previously. Note that fluctuations in hours are due more to fluctuations in (un)employment than to fluctuations in average hours/person.
Business cycle factsii 4. Real wages typically much smoother than output (and employment). Wage rigidities? Or strong response of labour supply? 5. All domestic expenditures variables very procyclical except government spendings (especially so if government runs contracyclical policies). In the data G is nearly acyclical. 6. Sectors differ in their exposure to the business cycle. The construction industry is heavily exposed to the investment cycle. Manufacturing industry is exposed to fluctuations in trade, investment and productivity. Services are more stable than manufacturing and construction with public services the least cyclical as they are not exposed to the market.
The business cycle in real time Identifying business cycles is important information for the public. However, high quality data become available only with a delay nobody knows exactly what current GDP is due both to revisions and to delay in data collection. For that reason leading and co-incident indicators are valuable: Leading indicators: Indicators that have predictive power for business cycle turning points and phases. Co-incident indicators: Indicators that have predictive power for current state of the economy.
What are the U.S. Leading Indicators? Labor market Production Investment Monetary conditions 1. Average weekly hours, manufacturing 2. Average weekly initial claims for unemployment insurance 3. Manufacturers' new orders, cons goods and materials 4. Vendor performance, slower deliveries diffusion index 5. Manufacturers' new orders, nondefense capital goods 6. Building permits, new private housing units 7. Stock prices, 500 common stocks 8. Money supply, M2 9. Interest rate spread, 10-year Treasury bonds less federal funds Expectations 10. Index of consumer expectations
Leading Economic Index (1962-2015) Source: Conference-Board
Lecture 6 : Business cycle fluctuations Part I 1. Definitions 2. Business cycle facts 3.Whatisdrivingthecycle?
Understanding the business cycle Acoremacroeconomicmodelisthatofaggregatesupplyand demand with dynamically optimizing agents and firms. Here offersa simplistic&static view of the businesscycle in terms of fluctuations in supply and demand. Health warning : this is a very simple model which immediately provides some analytical insights into the business cycle. Treat with care - In reality supply and demand very interconnected and business cycle crucially driven not just by current prices but expectations of future events. Here, for simplicity, we keep the future as given, in particular future prices.
Whatisaggregatedemand? Aggregate demand is the expenditure on goods and services produced in an economy Itismadeupof(remindlecture1): - Consumers expenditure - Investment(business, government and housing) - Government consumption of goods and services - Exports less imports(net trade) Y = C + I + G + X -M
Aggregatedemandshocks Aggregate Demand can therefore increase because: People want to spend more of given income (e.g conspicuous consumption of 1920s and 1980s). Also when they feel wealthier due to booming asset prices. Entrepreneurs feel more buoyant and want to invest more without changes in interest rates( animal spirits ) Government increases expenditure or announces tax cuts. Overseas demand increases for domestically produced goods. Supply of money increases. Why?
Aggregate Demand Price Demand Shock = for a given price consumer can buy more and Aggregate Demand Curve shifts out. Output
Whatisaggregatesupply? In our analysis of output in the growth model, we showed that what mattered for supply was the capital stock (human and physical), the labour force, technology and various socio-cultural factors. Therefore output did not depend on the price level but real factors and so the long run aggregate supply curve is vertical- output does not change with prices. Then, in the long run increases in aggregate demand justproducehigherpricesandnochangeinoutput-not a good business cycle model.
Long-run effect of a shift in aggregate demand Prices Long Run Aggregate Supply Aggregate Demand increases Output
Whatisaggregatesupply? When firms face rise in demand they can either increase output and salesorraiseprices.raisestheissue-howdofirmssetprices? Standard theory says that prices are set as a mark up over marginal costs(cost of producing extra unit of output). Economists propose two sets of arguments over why prices may not rise in response to stronger demand (or at least only partially such that output fluctuates) - Real rigidities - the idea here is that marginal costs do not change much over the business cycle and nor does the mark up firms wish to charge - Nominal rigidities - firms have to pay costs (reprinting menus, catalogues, etc)
Price Constant marginal cost and mark up mean price does not change over cycle. Price Rising costs (overtime, etc) or means upward sloping supply curve. Output Price Output No scope for higher output. Prices adjust fully. Only prices change. Output
Frequency of Price Changes per Year 40 35 30 25 20 15 10 5 0 More than 125-12 3-4 2 1 0 Source: Survey of U.K. firms
Initial Response to demand increase Overtime More Workers Increase Prices Increase Capacity Increase Sub-contractors Increase delivery lags Other 0 10 20 30 40 50 60 70 Source: Survey of U.K. firms
Theshortrunequilibrium Prices Aggregate Demand Curve Short Run Supply Curve Output
Demanddrivencycles Prices Aggregate Demand Curve Expansion Short Run Supply Curve Recession Output
Fromshorttolongrunequilibrium Prices Long Run Supply Curve Long run equilibrium Short Run Supply Curve Short run equilibrium Dynamics after a permanent shock to aggregate demand [eg. permanent increase in the money supply] Aggregate Demand Curve Output
Demanddrivencycles Changes in demand lead to higher output as firms change output rather than prices to meet demand. In the very short run the increase in demand is met by lowering inventories rather than increasing output. However in the short run firms start to hire more workers/overtime to meet demand. Employment and output increase. Eventually the firm cannot expand output further - capacity constraints, rising overtime/wages, etc and so raises prices to restrain demand. Demand begins to fall and eventually prices rises sufficiently for output to return to level determined by long run aggregate supply curve. Note if the demand shock is only transitory, output goes back to long run equilibrium without further rise in prices.
Aggregatesupplyshocks Have focused on aggregate demand as a cause of business cycles but business cycles maybe generated by aggregate supply changes. Supply may not increase smoothly, because the process of capital accumulation is uneven or because technological progress is subject to shocks. Supply can also vary due to other changes in marginal costs of producing (pressure on wags by unions, costs of intermediary inputs such as energy ). A typical example is an increase in oil prices. Note that there may be shocks to the short-term aggregate supply curve as well as to aggregate demand(e.g pressure on wages, tax increases).
Supplydrivencycles Prices Aggregate Demand Curve Recession Short Run Supply Curve Expansion Output
Oilshockandaggregatesupply Aggregate Demand Curve Prices Recession Rising oil prices Short Run Supply Curve Output An increase in the price of oil means firm is making less profit per unit of output and so will wish to supply less (rising marginal costs). In other words an increase in oil prices shifts the aggregate supply curve to the left.
Oilandthebusinesscycle
Oilandthebusinesscycle Jim Hamilton, Univ. Of California: Beforelastrecession,evidenceisthatnineoutoftenofpostWWIIrecessionsin theushavebeenprecededbyincreaseinoilprices Butbecareful!priceofoilisnot exogenous/drivenbyglobaldemand difficult to identify an exogenous oil shock Need to look at exogenous disruption of supply to identify the impact of the shock.
The business cycle and oil
Oilandthe(last) Greatrecession Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007-08 was caused by strong demand confronting stagnating world production. Hamilton: although the causes were different, the consequences for the economy appear to have been very similar to those observed in earlier episodes, with significant effects on overall consumption spending and purchases of domestic automobiles in particular. In the absence of those declines, it is unlikely that we would have characterized the period 2007:Q4 to 2008:Q3 as one of economic recession for the U.S. The experience of 2007-08 shouldthusbeaddedto the listofrecessionstowhichoilpricesappeartohave made a material contribution.
Summary Business cycles are medium term fluctuations in the economy between expansions and recessions. Business cycles last around 6-10 years. Business cycle characterised by co-movements across sectors and aggregate variables. Employment and investment and investment are very exposed to the business cycle. Business cycle fluctuations in output can be caused by demand and supply shocks. Shocks to aggregate demand affect output due to sticky prices and a non-vertical short-run supply curve.