Business Cycles. (c) Copyright 1998 by Douglas H. Joines 1

Business Cycles (c) Copyright 1998 by Douglas H. Joines 1

Module Objectives Know the causes of business cycles Know how interest rates are determined Know how various economic indicators behave over the business cycle Understand the benefits and limitations of countercyclical fiscal policies (c) Copyright 1998 by Douglas H. Joines 2

What Are Business Cycles? Business cycles are short-run deviations of the economy from its long-run trend Cycles are irregular rather than fixed in duration Typically, a complete cycle lasts 5 to 7 years The expansion phase of the cycle typically lasts longer than the contraction phase (c) Copyright 1998 by Douglas H. Joines 3

Cyclical Behavior of Indicators Many macroeconomic indicators exhibit cyclical behavior Procyclical variables move up during the expansion phase of the cycle and down during the contraction phase Countercyclical variables move down during the expansion phase of the cycle and up during the contraction phase The degree of procyclicality or countercyclicality can be measured by the correlation with GDP. Because many economic indicators contain trends, it is common to perform some transformation to make them stationary before computing these correlations (see the discussion in the module on Economic Indicators). Common transformations are: computing the growth rate (or difference of the natural logarithm) if the variable is always positive taking the ratio of the variable to GDP if the variable is sometimes negative (e.g., net exports, change in inventories, etc.) using the Hodrick-Prescott filter to extract the cyclical component of the variable In addition, one can examine lead or lag behavior by computing the correlation with future or past GDP (after performing the appropriate transformation). Finally, one can examine stability or volatility over the cycle by computing the standard deviation (again, after performing the appropriate transformation to make the variable stationary). (c) Copyright 1998 by Douglas H. Joines 4

What Causes Cycles? Y t = A t K t α L t 1-α Assess the importance of short-run movements of L, K, and A. From the production function, short-run movements in output imply short-run movements in L, K, or A. (c) Copyright 1998 by Douglas H. Joines 5

14000 12000 10000 8000 6000 Capital is Too Smooth Capital Stock and GDP Capital 4000 GDP 2000 50 55 60 65 70 75 80 85 90 Billions of 1987 dollars. Looking at annual data show some decline in K during the Great Depression, but K normally increases even in recessions. This ignores questions of capacity utilization, which may vary over the cycle. A drop in capacity utilization during a recession implies a drop in the demand for capital services rather than a drop in the supply, since the available capital has not declined. (c) Copyright 1998 by Douglas H. Joines 6

Labor is Very Procyclical Labor and GDP 5000000 6000 5000 4000000 4000 3000 Labor GDP 3000000 2000 1000 50 55 60 65 70 75 80 85 90 GDP in billions of 1987 dollars per year, left scale Labor in thousands of hours per week, right scale 2000000 Variation in labor input seems to account for much of the short-term variation in output. The drop in labor input during recessions seems to be due to a decline in demand rather than in supply. Labor demand curve = MPL curve. For a given MPL curve, lower labor supply implies higher MPL. MPL is proportional to APL. If recessions are caused by declines in labor supply, then APL should be high during recessions. This is not the case. (c) Copyright 1998 by Douglas H. Joines 7

Technology Shocks are Important Total Factor Productivity and GDP 6000 5000 4000 TFP 3000 GDP 2000 1000 50 55 60 65 70 75 80 85 90 GDP in billions of 1987 dollars, left scale. What is the source of decline in labor demand during recessions? Adverse technology (productivity) shocks could be an explanation: Lower TFP implies lower MPL, thus lower labor demand (also implies lower MPK, thus lower demand for capital services) (c) Copyright 1998 by Douglas H. Joines 8

Simple Keynesian Model Consumption function marginal propensity to consume (MPC) Multiplier depends on MPC Recessions could be caused by deficient aggregate demand Suggests countercyclical fiscal policy tax cut spending increase Consumption plays a central role. Consumption function: C = C* + θ(y T*) = C* θt* + θy T is net taxes (i.e., net of transfers). * means independent of income Equilibrium condition: Y = AD = C + I + G = C* θt* + θy + I* + G* = X* + θy Solve for output to get: Y = X*/(1 θ) 1/(1 θ) is the multiplier, which depends on θ, which is known as the marginal propensity to consume. What causes recessions? A decline in autonomous demand, X* No mention of aggregate supply. Equilibrium output may be less than full-employment output. (c) Copyright 1998 by Douglas H. Joines 9

Permanent Income Hypothesis Consumption depends on permanent income current income future income interest rate age (in Life-Cycle Hypothesis) Motivated by empirical difficulties of Keynesian model of consumption. conflicting evidence on size of MPC estimates are high in time series data estimates are low in cross-sectional data Both PIH and LCH predict consumption smoothing, i.e., consumption varies less than income. Consumption demand is negatively related to interest rates, and saving is positively related to interest rates. (c) Copyright 1998 by Douglas H. Joines 10

Implications Marginal Propensity to Consume is not well defined is close to one for permanent changes in income is close to zero for transitory changes in income increases with age (in Life-Cycle Hypothesis) Low MPC out of transitory changes in income means that consumption is relatively smooth over the business cycle. Other categories of expenditure must absorb more of the variation in output. Smoothness of consumption also implies that saving is highly procyclical. (c) Copyright 1998 by Douglas H. Joines 11

Capital and Investment K is an input in the production function Investment is a component of aggregate demand K t+1 = K t + I t δk t Net Investment = I t δk t Net Investment is about 2-3% of K Large fluctuations in net investment cause only small changes in K K is very smooth (c) Copyright 1998 by Douglas H. Joines 12

Investment Demand Net marginal rate of return on capital MPK t+1 - δ Market rate of interest is r Compare the two returns Investment demand depends on expecations about the future MPK This is just the NPV rule from corporate finance. In this simple setup, NPV rule is equivalent to IRR rule. In effect, firms rank projects by IRR and take all projects with IRR>r This is equivalent to taking all projects with NPV>0 (c) Copyright 1998 by Douglas H. Joines 13

r Investment Demand Curve r 0 δ I 0 MPK t+1 δ MPK t+1 I (c) Copyright 1998 by Douglas H. Joines 14

Shifts in Investment Demand MPK = αa(k/l) α 1 Changes in capital-labor ratio cross-country comparisons ongoing population growth baby boom Technology shocks ongoing technological improvement temporary productivity shocks The normal level of MPK depends on the normal levels of A and L. If A and L are growing, the MPK curve shifts rightward over time, leading to a larger capital stock. If A increases slowly or not at all in some period, then the rightward shift in the MPK curve is small or nonexistent. This leads to a below-normal increase in the capital stock. Notice that a decline in investment demand does not require a decline in A. It merely requires a slowdown in the rate of increase of A. Thus, investment spending may decline during periods of slow technological improvement. This decline in investment may trigger a recession. (c) Copyright 1998 by Douglas H. Joines 15

r Closed Economy S r 0 I S 0 =I 0 S,I The real interest rate adjusts in a closed economy so that, in equilibrium, planned saving equals planned investment. How do saving, investment, and interest rates behave during a recession? Interest rate changes depend on shifts in the two curves, which we will consider in more detail below. What would happen if the saving curve shifted to the left? The interest rate would increase. The actual quantity of investment spending would decline, even with no shift in the investment demand curve. If the saving curve is relatively steep and the investment demand curve is relatively flat, a shift in the saving curve would translate into an almost equal change in investment spending. Thus, it is possible for investment spending to vary a lot over the business cycle even if the investment demand curve does not shift much. (c) Copyright 1998 by Douglas H. Joines 16

Small Open Economy r S r w I Net Imports S 0 I 0 S,I For a small open economy, the real interest rate is given by the world market. Any imbalance between saving and domestic investment shows up as a trade surplus or deficit. How does the trade balance behave over the cycle? Consumption and saving behavior, and thus shifts in the saving curve, are governed by the Permanent Income theory of consumption. Shifts in the investment demand curve are determined by the theory of investment described above. Whether interest rates and/or the trade balance rise or fall depends on which of these two curves shifts, and by how much. This leads to two polar cases: a temporary decline in productivity, which is expected to last for only one period an decline in expected future productivity (or in expected future productivity growth), with no change in today s productivity. We will now examine these two polar cases in both a closed economy and a small open economy. (c) Copyright 1998 by Douglas H. Joines 17

r Temporary Productivity Shock Closed Economy S 1 S 0 r 1 r 0 I I 1 I 0 S,I Suppose that a temporary, adverse productivity shock hits a closed economy, and that this shock lasts only for the current period. (The adverse productivity shock takes the form of a decline in total factor productivity, represented by A in the Cobb-Douglas production function.) Productivity is expected to return to normal next period. output and income temporarily fall (a recession) investment demand is unaffected because it depends on the expected future productivity of capital saving shifts left (consumption smoothing) the interest rate increases this shock tends to generate a countercyclical interest rate The leftward shift in the saving curve is an implication of the Permanent Income Hypothesis and the fact that consumers experience only a temporary loss of income. (c) Copyright 1998 by Douglas H. Joines 18

r Temporary Productivity Shock Open Economy S 1 S 0 r w I 0 S 1 S 0 I 0 S,I Now suppose that the same temporary, adverse productivity shock hits a small open economy. The real interest rate is given by the world market, and sny imbalance between saving and domestic investment shows up as a trade surplus or deficit. output and income temporarily fall (a recession) investment demand is unaffected because it depends on the expected future productivity of capital saving shifts left (consumption smoothing) the trade balance declines (smaller surplus or larger deficit) this shock tends to generate a procyclical trade balance (c) Copyright 1998 by Douglas H. Joines 19

r Future Productivity Shock Closed Economy S r 0 r 1 I 1 I 0 I 1 I 0 S,I Now suppose that people expect an adverse productivity shock in the near future, but that today s productivity is unaffected. In a closed economy: the investment demand curve shifts leftward because the expected future productivity of capital has declined this decline in investment spending may cause a recession the saving curve may shift in either direction any loss of current income tends to shift the saving curve leftward any anticipated loss of future income tends to shift the curve rightward under the reasonable assumption that the investment curve shifts further to the left than the saving curve, the interest rate declines this shock tends to generate a procyclical interest rate Empirical evidence seems to indicate that interest rates are somewhat procyclical, suggesting that shifts in the investment demand curve are larger than shifts in the saving curve over the business cycle. (c) Copyright 1998 by Douglas H. Joines 20

r Future Productivity Shock Open Economy S r w I 0 I 1 I 1 S 0 I 0 S,I Finally, suppose that the decline in expected future productivity occurs in a small open economy. In that case: the investment demand curve shifts leftward because the expected future productivity of capital has declined this decline in investment spending may cause a recession the saving curve may shift in either direction any loss of current income tends to shift the saving curve leftward any anticipated loss of future income tends to shift the curve rightward under the reasonable assumption that the investment curve shifts further to the left than the saving curve, the trade balance increases (larger surplus or smaller deficit) this shock tends to generate a countercyclical trade balance Empirical evidence seems to indicate that the trade balance is somewhat countercyclical, suggesting that shifts in the investment demand curve are larger than shifts in the saving curve over the business cycle. (c) Copyright 1998 by Douglas H. Joines 21

Stock Prices and Interest Rates Leftward shift of saving curve higher interest rates (lower bond prices) constant or lower profits lower stock prices Rightward shift of investment curve higher interest rates (lower bond prices) higher profits probably higher stock prices (c) Copyright 1998 by Douglas H. Joines 22

Countercyclical Fiscal Policies Temporary tax cuts raise private disposable income how much does private consumption increase? Temporary government spending In the Keynesian model, the size of the tax cut required to hit any GDP target depends on the size of the multiplier, which depends on the MPC. The PIH and LCH say that the MPC out of temporary increases in income is small, so a temporary tax cut would not be very effective. (c) Copyright 1998 by Douglas H. Joines 23

Difficulties with Countercyclical Government Purchases Lags inside lag recognition implementation outside lag Forecasting Ignorance of parameters (e.g., MPC) Changing parameters expectations (c) Copyright 1998 by Douglas H. Joines 24

Cyclical Unemployment Recessions temporarily raise the job separation rate, s, and lower the job finding rate, f Countercyclical unemployment rate Unemployment rate is a lagging indicator f returns to normal only after output begins growing Unemployment remains above the natural rate even after s and f return to normal (c) Copyright 1998 by Douglas H. Joines 25