Session 2: Business Cycle Theory

Session 2: Business Cycle Theory Michael McMahon University of Warwick McMahon (University of Warwick) Business Cycles 1 / 53

To Cover 1 Measuring business cycles using data 2 Introducing the business cycle theory 3 Discussing the costs of business cycles and the argument for stabilisation policy 4 Understanding and interpreting macroeconomic indicators. McMahon (University of Warwick) Business Cycles 2 / 53

Business Cycles De nition Cycle is made of an expansion (boom) and a contraction (recession). During the expansion all good things (GDP, employment, productivity,... ) tend to go up, or grow faster than normal, and bad things (unemployment) tend to fall. During the contraction good things go down and bad things go up. To be contrasted with economic growth. McMahon (University of Warwick) Business Cycles 3 / 53

The Cycle? expansion peak contraction Business cycle trough trough McMahon (University of Warwick) Business Cycles 4 / 53

Features of Business Cycles I 1 Business cycles are NOT regular: They do not behave anything like sine waves. This is important because it tells us that they are not due to some regular underlying component. 2 Expansions tend to be long and mild. They are measured in years. The 1990 s expansion and the most recent expansion = the longest ever (my PhD). 3 Recessions tend to be short but more dramatic. They are measured in months. 4 However, in recessions the decline per period is relatively large. McMahon (University of Warwick) Business Cycles 11 / 53

Features of Business Cycles II Series St. Dev Rel. Dev Autocorrelation Corr. with GDP Y 1.49 1.00 0.58 1.00 C 1.59 1.06 0.73 0.68 I 6.69 4.48 0.68 0.74 G 1.50 1.00 0.63 0.15 NX 0.90 0.60 0.51 0.16 Hours 1.60 1.07 0.70 0.58 Employ 1.05 0.70 0.77 0.39 Y E 1.43 0.95 0.34 0.40 P 2.1 1.45 0.88 0.57 M1 3.11 2.05 0.74 0.33 McMahon (University of Warwick) Business Cycles 12 / 53

Business Cycle Dating Game Problem Answer the following: 1 How would you identify periods of recession in the US economy since 1940? 2 What criteria would you use to de ne the periods? 3 Apply this criteria to the data on US GDP and US GDP growth (and other important variables) using Excel. McMahon (University of Warwick) Business Cycles 5 / 53

Should We Care About Business Cycles? McMahon (University of Warwick) Business Cycles 13 / 53

Should We Care About Business Cycles? Picture suggests that business cycles are minor blips and not worth much attention. However: 1 What would level of GDP be without business cycles? Some average of what we observe now? Or by eliminating recessions something that is on average higher? 2 Although GDP doesn t do much in a recession, this doesn t mean some rms and individuals are not hurt (e.g. bankruptcies are very cyclical) 3 Business cycles could a ect growth rates McMahon (University of Warwick) Business Cycles 14 / 53

Business Cycle v. Output Gaps De nition Output gap - A measure of the di erence between actual activity and potential activity. Is the economy under-performing or over-performing? The two concepts are related but conceptually distinct. The economy could be in a statistical recession without this corresponding to an output gap - e.g. natural disaster. Likewise, the economy could be in a boom but still be under-performing. Output gap may be more useful as a concept but it is much harder to measure - one way is the production function technique: Y t = A t L α t K 1 t α McMahon (University of Warwick) Business Cycles 15 / 53

Growth Accounting Framework Using the production function: Y t = A t L α t K 1 t α Combined with data on inputs and income shares... we can decompose GDP growth into its driving forces: Contributions to Aggregate Growth Y TFP K L 1970s 1.55 0.56 0.89 0.11 1980s 2.58 1.77 0.76 0.07 1990s 2.39 1.56 0.74 0.09 2000s 2.41 1.42 0.84 0.15 McMahon (University of Warwick) Business Cycles 16 / 53

A Basic Business Cycle Theory AS-AD Model A simple diagrammatic exposition to examine the behaviour of output and in ation. Contains 2 elements: 1 Aggregate demand curve - captures the national income identity: AD = C + I + G + X M 2 Aggregate supply curve - captures the total quantity supplied at every price level. The aim is to examine the interaction of these two relationships and to develop a framework to think about the causes of business cycles. McMahon (University of Warwick) Business Cycles 17 / 53

A Basic Business Cycle Theory II AD Curve I Aggregate demand curve - captures the national income identity: AD = C + I + G + X M Shows the level of aggregate demand at every price level. Slopes down in Y-P space: Real money balances e ect - As P#, the real value of money balances held " )purchasing power of consumers ". Prices and interest rates - CB cuts nominal interest rates as the price level falls ) Lower nominal interest rates increases in consumer demand and planned investment. International competitiveness - Lower UK prices makes the UK more competitive (for a given exchange rate) ) competitiveness " and X ". Shifts in AD: the government may increase its own expenditure ( scal policy) the monetary authority may change interest rates consumer sentiment may change. McMahon (University of Warwick) Business Cycles 18 / 53

A Basic Business Cycle Theory III AD Curve II P AD Y McMahon (University of Warwick) Business Cycles 19 / 53

A Basic Business Cycle Theory IV AS Curve I Aggregate supply is the total quantity of goods and services produced (supplied) at every price level. It re ects productivity capacity of the economy and production costs. The curve shows the level of aggregate supply at every price level. In Y-P space, the AS curve is : vertical in the long-run. The economy operates at its potential level in the long-run and prices will adjust to ensure slopes up in the short-run. As prices increase, rms are willing to increase the amount that is supplied. This may be achieved by employing overtime sta or increasing utilization of machines. Shifts in AS curve: changes in size & quality of the labour force or capital stock technological progress and the impact of innovation changes in unit wage costs (incl. taxes and subsidies) changes in in ation expectations McMahon (University of Warwick) Business Cycles 20 / 53

A Basic Business Cycle Theory IV AS Curve II P LRAS SRAS flex SRAS SRAS fixed equilibrium level of income McMahon (University of Warwick) Business Cycles 21 / 53 Y* Y

Price Adjustment is Key Why don t rms adjust prices immediately - the Classical School (AS curve is vertical): 1 Most rms seem to revise prices only occasionally (perhaps as rarely as once a year). This means that some rms will delay price revision by as long as one year. 2 Firms are concerned with their market share: even those whose turn is to revise prices will do so slowly if they know many others are not revising any time soon. 3 May be uncertain about nature of shock (is it only me or is it everyone?) and reactions of competitors. 4 Wages are often xed for long periods (annual contracts). So marginal cost fairly stable. In competitive markets price cannot move too far from marginal cost. McMahon (University of Warwick) Business Cycles 22 / 53

Frequency of Price Reviews 40 35 30 25 20 15 10 5 0 More than 12 5 12 3 4 2 1 0 McMahon (University of Warwick) Business Cycles 23 / 53

How React to Initial Changes in Demand Overtime More Workers Increase Prices Increase Capacity Increase Sub contractors Increase delivery lags Other 0 10 20 30 40 50 60 70 McMahon (University of Warwick) Business Cycles 24 / 53

Price Adjustment is Key But eventually: More and more rms get chance to revise prices, meaning that aggregate prices creep up Workers get a chance to renegotiate wages, meaning that costs start increasing, and rms need to increase prices Also, start running out of unemployed workers, which also pushes wages and hence prices upwards McMahon (University of Warwick) Business Cycles 25 / 53

A Basic Business Cycle Theory V Equilibrium P LRAS SRAS equilibrium level of income McMahon (University of Warwick) Business Cycles 26 / 53 Y* AD Y

What causes business cycles? Economy humming along its long-run growth path but constantly bu eted by: Demand Shocks: changes in demand for good and services; Supply Shocks: essentially changes in rms costs of production; Both demand and supply shocks can generate uctuations. McMahon (University of Warwick) Business Cycles 27 / 53

Demand Shock I Shifts in the AD curve: Consumption Investment Government spending Exports Changes in desired amounts of all these a ect the demand faced by rms 1 Say initial shock pushes demand up; 2 Firms initial response is to leave prices unchanged, and accommodate the surge in demand by producing more (GDP, investment, employment go up). This is the boom. 3 In a second stage rms begin to increase prices and reduce output. GDP etc. return to their long-run trend. And a recession is the same thing in reverse. McMahon (University of Warwick) Business Cycles 28 / 53

Demand Shock II P LRAS SRAS equilibrium level of income Y* AD Y McMahon (University of Warwick) Business Cycles 29 / 53

Demand Shock II P LRAS SRAS AD equilibrium level of income Y* Y 1 Y McMahon (University of Warwick) Business Cycles 29 / 53

Demand Shock II P LRAS SRAS AD equilibrium level of income Y* Y 1 Y McMahon (University of Warwick) Business Cycles 29 / 53

Supply Shock I Accelerations or decelerations in technical change Changes in commodity prices Changes in regulation Any other changes to the cost structure The cycle? But: Positive supply shock: because of lower costs, rms can produce more, hire more, and lower prices Negative supply shock: because of higher costs, rms reduce production, hire less, and increase prices Often observe recessions with no clear supply side culprit ; Booms seem to be accompanied by increasing - not falling - prices; Technological regress is implausible. McMahon (University of Warwick) Business Cycles 30 / 53

Supply Shock II - Temporary P LRAS SRAS equilibrium level of income Y* AD Y McMahon (University of Warwick) Business Cycles 31 / 53

Supply Shock II - Temporary P LRAS SRAS equilibrium level of income Y 1 Y* AD Y McMahon (University of Warwick) Business Cycles 31 / 53

Supply Shock III - Permanent P LRAS SRAS equilibrium level of income Y* AD Y McMahon (University of Warwick) Business Cycles 32 / 53

Supply Shock III - Permanent P LRAS SRAS equilibrium level of income Y 1 Y* AD Y McMahon (University of Warwick) Business Cycles 32 / 53

Propagation of Shocks - I Above we have thought about business cycles in terms of demand and supply shocks. This is informative but does not answer following question: How do shocks to the economy become transmitted over time? Remember that business cycles have a duration of 4-10 years, so the fact that the uctuations are persistent is a key feature. To think about this, it is useful to consider a distinction between the initial shock to the economy the impulse and the mechanism that transmits shocks over time the propagation mechanism. McMahon (University of Warwick) Business Cycles 33 / 53

Propagation of Shocks - II Impulse Propagation Mechanism Business Cycles If there was no propagation mechanism, impulses would quickly die out unless the impulses are repeated over time. Propagation mechanisms are aspects that gives rise to persistent e ects. McMahon (University of Warwick) Business Cycles 34 / 53

Propagation of Shocks - III Propagation mechanisms: investment and capital accumulation. e.g. credit markets; intertemporal substitution in consumption and labor supply nominal rigidities Neoclassical economists stress the rst two. Keynesian economists stress the last. McMahon (University of Warwick) Business Cycles 35 / 53

Propagation of Shocks - IV Impulse Response Functions Suppose that we are in equilibrium Allow there to be a once-occurring shock (e.g. technology shock) Impulse-response functions tell you how the variables of the model adjust over time. McMahon (University of Warwick) Business Cycles 36 / 53

Propagation of Shocks - V 101.5 Response of TFP (% of SS) 104 Response of GDP (% of SS) 101 102 100.5 100 100 2 0 2 4 6 8 10 12 14 16 18 101 Response of Consumption (% of SS) 98 2 0 2 4 6 8 10 12 14 16 18 110 Response of Investment (% of SS) 100 100 99 2 0 2 4 6 8 10 12 14 16 18 101 Response of Capital (% of SS) 90 2 0 2 4 6 8 10 12 14 16 18 102 Response of Hours (% of SS) 100 100 99 2 0 2 4 6 8 10 12 14 16 18 1 Response of Inventory Investment ( from SS (% of GDP)) 98 2 0 2 4 6 8 10 12 14 16 18 105 Response of Inventories (% of SS) 0 100 1 2 0 2 4 6 8 10 12 14 16 18 120 Response of ι (% of SS) 95 2 0 2 4 6 8 10 12 14 16 18 1 Response of Storage (% of SS) 100 0 80 2 0 2 4 6 8 10 12 14 16 18 1 2 0 2 4 6 8 10 12 14 16 18 Model 0 (RBC) Model 2 (Baseline) McMahon (University of Warwick) Business Cycles 37 / 53

The Timeline of Modern Macroeconomic Theory The basic framework we have examined is useful as a framework to think about macroeconomics, but modern macroeconomics is more complex. It is also an ever evolving eld: Traditional Keynesian models (60 s) RBC models (early 80 s onwards) New-Keynesian Economics (mid/late 80 s onwards) DSGE models (mid 90 s onwards) McMahon (University of Warwick) Business Cycles 38 / 53

The DSGE Model I The RBC model was the rst of a class of models now known as DSGE: D Dynamic - we look at variables over time S Stochastic - the model is subject to random shocks GE General Equilibrium - everything e ects everything else (if households work more, the wage rate is driven down) The RBC model assumes: Perfect competition no market imperfection fully exible nominal prices Saving determines capital accumulation Technology shocks and their propagation create uctuations around the equilibrium of all macro variables The model is fully microfounded Fluctuations re ect optimal reactions to shocks McMahon (University of Warwick) Business Cycles 39 / 53

The DSGE Model II Contributions of the basic RBC model: Combines growth and business cycles Uses a relatively simple model and can capture the key features of business cycles Hugely important methodological contribution Objections to the RBC model: Ignores demand shocks which are known to contribute to output uctuations Needs very persistent exogenous shocks to generate reasonable output uctuation persistence Cannot generate the highly variable employment numbers, unless we assume very high elasticity of labour supply (not true) Weak propagation mechanism McMahon (University of Warwick) Business Cycles 40 / 53

The DSGE Model III Basic Equilibrium Equilibrium in DSGE models is given by rational expectations. Need to combine: Optimality conditions for equilibrium consumption, savings and labour supply from household s maximisation problem Optimality conditions for equilibrium prices of production factors (rental and wage rate) from rm s maximisation problem Market clearing conditions (GE) Households derive utility from consumption and from leisure and so it faces a trade-o : Need to work (provide labour) to earn labour income for current and future consumption Need to have some leisure Will have a set of equilibrium conditions which will determine the evolution of all variables over time McMahon (University of Warwick) Business Cycles 41 / 53

The DSGE Model IV From RBC to alternative DSGE models I 1 Capital market imperfections / Credit Frictions 2 Externalities, multiple equilibria and self-ful lling expectations (Farmer) 3 Sticky information (Mankiw-Reis, Maćkowiak-Wiederholt) 4 Bounded rationality McMahon (University of Warwick) Business Cycles 42 / 53

The DSGE Model IV From RBC to alternative DSGE models II Capital market imperfections / Credit Frictions RBC models assume perfect capital markets But borrowers are better informed than lenders about the risk and returns on their projects (information asymmetries) Lenders guard themselves against this extra risk by: requiring an external nance premium that is negatively related to the value of the borrowers collateral (Bernanke-Gertler-Gilchrist) limiting the amount of lending to a fraction of the value of the collateral (Kiyotaki-Moore) Both lead to a nancial accelerator. McMahon (University of Warwick) Business Cycles 43 / 53

The DSGE Model IV From RBC to alternative DSGE models III Bounded rationality =) expectations are not always and completely rational Agents need to nd out what is going on by learning (Evans & Honkapohja) While learning, bounded rationality may amplify business cycle and generate asymmetric e ects (Giannitsarou) While a reasonable assumption, non-rationality could be anything - too many ways to model bounded rationality McMahon (University of Warwick) Business Cycles 44 / 53

The DSGE Model VI The future? Good modelling idea in principle But these models get very complicated and di cult to solve Must resort to approximate solutions which are often computationally complicated Assumption of rational expectations and representative agent is often criticised (see recent Economist article). My View: Existing approaches are not perfect, and are certainly not de nitive theories of business cycles However, we have gone a long way in explaining lots of things and shown that the methodology is exible enough to deal with a lot of the current challenges: though they will be hard from a computational point of view A very exciting and challenging area of current research! McMahon (University of Warwick) Business Cycles 45 / 53

Macroeconomic Indicators Di erent countries have a large (and varied) range of macroeconomic indicators apart from GDP statistics: Industrial Production Indexes Prices series Money Aggregates Interest Rates Financial Variables Demand Indicators (such as retail sales, auto sales, etc) Surveys (Industrial, Construction, Consumer) Trade Variables Labour Market Series Daily stock markets series McMahon (University of Warwick) Business Cycles 46 / 53

Leading and Co-incident Indicators Identifying business cycles is important information for the public. But: 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. The spread between the yield on short and long bonds; New private housing starts; Un lled orders in manufacturing; Number of people on part-time work. Co-incident indicators: Indicators that have predictive power for current state of the economy. Industrial production; Real personal sector income; Real manufacturing trade and sales; Total non-agricultural payroll and hours McMahon (University of Warwick) Business Cycles 47 / 53

Leading and Co-incident Indicators Annual GDP growth or Yield Curve 8 6 % Real annual GDP growth 4 2 0 Recession 2 Correct 4 Recession Correct 6 Mar 69 Mar 71 Mar 73 2 Recessions Correct Mar 75 Mar 77 Mar 79 Mar 81 Mar 83 Yield curve Recession Correct Mar 85 Mar 87 Mar 89 Mar 91 Mar 93 Yield curve accurate in recent forecast Data though 3/5/03 Mar 95 Mar 97 Mar 99 Mar 01 Mar 03 McMahon (University of Warwick) Business Cycles 48 / 53

Surveys I Many bodies (o cial and uno cial) conduct surveys in order to gather information on the economy: They are very timely - often can get them within the period of interest Expectations of agents matter But: there is an issue of how to interpret them we need to be careful they can be volatile and may not be representative sample size is important McMahon (University of Warwick) Business Cycles 49 / 53

Surveys II European Surveys All EU countries conduct a common survey of manufacturers, service companies, construction rms, retailers and consumer: survey has both backward-looking and forward-looking components; most questions asked monthly (some quarterly); respondents choose from a menu of qualitative answers:, + + (most positive answer) + (positive answer) = (neutral answer) - (negative answer) - - (most negative answer) Don t know". Some surveys are combined to give "Economic Sentiment Indicator" McMahon (University of Warwick) Business Cycles 50 / 53

Surveys III European Surveys Example from consumer survey: 1 How do you expect the general economic situation in this country to develop over the next 12 months? It will... + + get a lot better + get a little better = stay the same - get a little worse - - get a lot worse N don t know. Answer is reported as a balance between positives and negatives where ++ is worth double +. Don t knows are discarded. Often compare to long-term average. McMahon (University of Warwick) Business Cycles 51 / 53

Final Comments on Indicators When looking at macroeconomic indicators, two additional issues need to be considered: 1 Seasonal adjustment 2 Revisions to statistics McMahon (University of Warwick) Business Cycles 52 / 53

END McMahon (University of Warwick) Business Cycles 53 / 53