Understanding the World Economy Master in Economics and Business Business cycle fluctuations Part II Lecture 7 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr
Lecture 7: Business cycle fluctuations Part II 1. Real Business Cycles vs Keynesians 2. Asset markets and business cycles 3. International Business Cycles
RealBusinessCycleversusKeynesians Macroeconomists mostly agree on what business cycles look like. Also a reasonable agreement on the likely candidates for the shocks which cause business cycles Disagreement over (a) The relative importance of different shocks. (b) The propagation mechanisms which cause business cycles.
Real Business Cycles (RBC) Real Business Cycle models emphasize change in technology (understand TFP) as the source of economic fluctuations. Solow model emphasized TFP as source of growth. Now emphasize (random) variations in TFP as source of business cycles. Propagation mechanisms: intertemporal labor substitution and capital accumulation. Intertemporal labor substitution. When productivity is high, wanttoworkmore,producemore.whenitislow,thereverse. Capital accumulation: when productivity is high, invest and produce more. Opposite when low.
Real Business Cycles (RBC) Empirical implications: (1) TFP fluctuations must be correlated with GDP fluctuations. (2) When a positive technology shock happens firms increase labour demand which leads to higher employment and output. They also invest more due to raising marginal productivity of capital if the shock is persistent. Thus positive co-movements between employment, investment, productivity and output. Exactly what we see in the data.
Source: Basu et al. (2006)
Business cycle moments U.S. business cycle moments. Quarterly data 1948Q1-2010Q4. HP filtered series Source: Eric Sims, 2011
RBC controversies At least three controversial implications of RBC a) business cycles caused by supply and not demand shocks b) need to assume flat labour supply curve - if supply curve not flat then wages rather than employment rises in a boom which is counterfactual. However, in reality need large changes in wages to increase employment - labour supply curve steep. c) business cycles are an optimal market response to supply shocks and so government stabilisation policy is misconceived.
Real Wage Productivity improvement leads to increase in labour demand Labour Supply Employment If (short run) labour supply curve is very flat then increases in labour demand due to technology improvements bring forth big increase in employment but smallincreaseinwages-asseenindata.
Keynesians(and Neo-Keynesians) Underlying these models is the idea that business cycles are inefficient and it is welfare improving to remove them. In its most general form Keynesian macroeconomics is based on the idea that market prices either will not adjust or will not adjust by enough to ensure full employment/full capacity output. Price/wage rigidities are of various forms and lead to socially inefficient output.
Remember from lecture 4. Wage rigidity : short-run equilibrium Real Wage w/p Long run Rigid Real Wage (short-run) short-run Employment With rigid wages (short run), labour is demand determined. A positive demand shock lowers unemployment (increase hours). The opposite for a negative demand shock.
Keynesians(and Neo-Keynesians) In the previous example, a recession is inefficient. Driven by wage rigidity which lowers employment below its potential level (as determined by the long-run supply curve). The simple remedy to this problem is for the government to increase demand in the economy - either by increasing expenditure, the money supply or lowering taxes. Provides a role for public intervention to stabilize output. Big issue is the efficiency of such stabilization policies. We will discuss this in later lectures.
Whatiscausingthe business cycle? Still great dispute over the propagation mechanism. Debate also marked over the causes of business cycles Consensus view is that while Real Business Cycle has forced us to re-evaluate importance of supply shocks it is incorrect in arguing that technology shocks are the main driving force behind the business cycle or that business cycle fluctuations are optimal. Technology shocks usually found to explain about 30% of business cycle.
Demandorsupplyshocks? Large number of studies trying to identify the respective contribution of supply (technology) and demand shocks. Basu et al. (2006) among others compute the of % of variance of output due to technology shocks in the US at different horizons Horizon (years) % of variance of output due to technology shocks 1 17 3 40 10 48 Consensus leads towards demand shocks most important cause of business cycles even though at longer horizons productivity shocks much more important.
Demandorsupplyshocks? Business cycles comoves a lot with consumer sentiment Source: Angeletos et al. (2013)
Lecture 7: Business cycle fluctuations Part II 1. Real Business Cycles vs Keynesians 2. Asset markets and business cycles 3. International Business Cycles
Assets and liabilities Assets: forms in which wealth is held = mean to transfer consumption across periods (and states of the world). Assets: stocks, bonds, houses, money & deposits, derivatives, currencies Assets differ by their degree of liquidity and riskiness. Liabilities are also means to transfer consumption across time but implies higher consumption today than tomorrow. Note that liabilities of an agent (bank, household, ) are assets of an another
Asset markets and business cycles Want to show how financial markets can propagate shocks and amplify economic fluctuations. Basic message: increasing asset prices tend to increase consumption and investment if those assets are used as collateral for borrowing by consumers and firms. Illustrate this theoretically in a two period model of consumption with collateral constraints.
Limited commitment and collateral Borrowers need incentives not to default on their debts. These incentives typically provided by collateral requirements. This is due to limited commitment: borrowers cannot commit to repay loans. Even if they can afford repayment in future, may choose not to repay. Strategic default. Examples: House is collateral for a mortgage loan, car is collateral for a car loan. Collateral can also support borrowing for other purposes, such as home equity lines for consumption purchases. A fall in the value of the collateral can lead to a large reduction in borrowing and consumption.
A simple two period model of consumption The consumer s first period budget constraint: + = = consumption; = output; = taxes; = wealth (positive or negative). Second period(denoted with ): = + (1 + ) Start without financial frictions(no collateral constraint). Intertemporal budget constraint with free borrowing and lending: + /(1 + ) = ( ) + ( )/(1 + ) = Y Net present value of expenditures = net present value of income (Y).
A simple two period model of consumption Utility to be maximized: U = log(c) +β log( )with 0 < β < 1 Budget constraint: + /(1 + ) = ( ) + ( )/(1 + ) = This implies: / = β(1+r) For simplicity, assume β(1+r) = 1 Thus: = /(1 + β) = Agents consume a constant fraction of lifetime income (permanent income hypothesis).
A simple two period model of consumption = = /(1 + β) Using first period budget constraint: + = = /(1 + β) = " #$% [ ( )] Lend if future income (net of taxes) lower than today s income and borrow otherwise. From now on, we consider the borrowing case: < ( ) < 0 Financial frictions in the form of borrowing constraint would limit the possibility of borrowing.
Financial frictions (collateral constraint) Supposenowconsumershaveahouse & ofprice '. Housing is illiquid: cannot be sold but possible to borrow against housing wealth, with a collateral constraint: ) '& 1 + Borrowing in first period restricted by the value of collateral. Where ) is negatively related to the tightness of the constraint. ) = 0: no borrowing at all ) large enough : constraint does not matter
Financial frictions (collateral constraint) Assume optimal debt ( ) larger than what households can borrow: > ) +, #$-. This implies that consumers are constrained: = ) '& 1 + Using first period budget constraint: + = = ( ) + ) +, #$- Higher collateral value of housing allows more borrowing and thus higher consumption.
Financial frictions (collateral constraint) = ( ) + ) +, #$- For constrained consumers, fall in value of collateral will lead to one-for-one reduction in consumption. So reduction in price of housing p can lead to fall in consumption through a fall in collateral value for loans. Here we take p as exogenous, but fall in p can have an amplifier effect in equilibrium. Initial fall leads to less consumption, less borrowing. Reduces demand for housing, which can further drive down house prices and consumption. The fall in consumption is thus associated to a fall in aggregate demand and output.
Realeffectofafallinhousingwealth Prices (of consumption) Short Run Supply Curve Fall in housing wealth Output Aggregate demand falls through falling consumption when housing wealth falls.
1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1954 1955 1956 1957 1959 1960 1961 1962 1964 1965 1966 1967 1969 1970 1971 1972 1974 1975 1976 1977 1979 1980 1981 1982 1984 1985 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2001 2002 2004 2005 2006 2007 2009 2010 2011 2012 2013 190 170 150 130 110 90 70 50 U.S. Real Home Price Index (1890-2013) Source: Shiller website
Financial frictions (collateral constraint) This amplification mechanism through collateral constraint illustrates how changes in the value of assets (here housing) can triggers economic fluctuations. The mechanism can be extended to banks and firms. Value of collateral of firms fall, which reduces their ability to borrow and triggers further fall in their value. Value of bank assets fall, which makes it hard for them to borrow. Need to sell assets, value banking assets drop further. Bank need to deleverage further. More fire sales of assets, etc... = Vicious spiral of deleveraging. Reminds the last financial crisis/recession. Opposite occurs in period of asset prices booms.
Bank balance sheets expand in good times
Deleveraging during the financial crisis
Financial accelerator The financial accelerator is a related concept. Small shocks to the economy get amplified by the financial accelerator. Decline in output and asset prices reduce the net worth of firms willing to borrow (the sum of his internal funds [liquid assets] and the collateral value of his illiquid assets) Financial distress increases risk for lenders Cost of external finance up and this reduces investment [Bernanke on the Great Depression and mechanism to understand current crisis]
Lecture 7: Business cycle fluctuations Part II 1. Real Business Cycles vs Keynesians 2. Asset markets and business cycles 3. International business cycles
International business cycles (IBC) In a globalized world, shocks (demand and supply) are transmitted across borders (through trade in goods and financial assets). International business cycles is about understanding the international propagation of shocks. A key feature of international business cycle is co-movements of the main aggregate variables across countries (consumption, investment, employment, output). Another important dimension is the understanding of international relative prices (think exchange rates) but we abstract fromitfornowandfocusonquantities.
Comovements Quarterlydata over 1970-2000 Source: Ambler et al. (2004)
International business cycle facts Positive international propagation of shocks. Consumption, investment, employment and output positively correlated across countries. Why positive comovements of aggregate variables? Various hypothesis: - Positive spillovers of supply (think technology) shocks. To the opposite, country-specific technology shocks tend to predict negative comovements of output as inputs (labor and capital) are allocated towards their more productive use. - Positive spillovers of demand shocks through trade in particular (potentially also through financial markets).
Business cycle synchronization Crucial issue are the sources of business cycle synchronization. Obvious candidates: - Technological transfers. - Similar sectoral specialization. - Trade globalization(trade in goods). - Financial globalization(trade in financial assets).
Business cycle synchronization Typically run the following regression for country pairs (., 0): 1 23,4 = 5 2 + 5 3 + 6 " 7 8 23,4 + 9 23,4 7;# 1 23,4 =measureofsynchronizationbetweencountry. and (0)atdate () 5 2 and 5 3 arecountryspecificfactors 8 23,4 are determinants of synchronization between country. and 0 at date (distance,tradeingoodsbetween. and 0.). Ideally, control for country bilateral fixed factors and estimate effects in the time-dimension: : 1 23,4 = 5 23 + 6 " 7 8 23,4 + 9 23,4 7;# :
1 Trade intensity and business cycle synchronization (France vis-à-vis OECD countries) Business cycle synchronization with France 0,8 0,6 0,4 0,2 0-2,5 USA GER BEL PER NOR -0,2 Indicator of Trade Intensity with France controlling for size of trading partner Health warning: correlation is not causality
Empiricalfindings Identification of causality difficult but quite a consensus that: - Trade globalization (trade in goods) between countries increase their synchronization. - So does the similarity in sectoral specialization. - Geographical distance is also a strong predictor: countries further apart exhibit less synchronization. Holds controlling for trade and specialization similarity. Technological transfers? - The impact of financial integration between countries is found to be more ambiguous. Why?
Trade, Finance, Specialization and Synchronization Trade Integration + Financial Integration + + (but small)? Business cycle synchronization + Sectoral Specialization - This figure from Imbs (2004) summarizes the effects of variable x on y (with x and y being trade integration, financial integration, specialization and cycle synchronization). Source: Imbs (2004)
Financial integration and the transmission of shocks On going debate regarding the impact of financial integration between countries on business cycle synchronization and international transmission of last financial crisis. Kalemli-Ozcan, Papaioannou and Peydro (2011) revisits the question. 1. Identifytheeffectinthetimeseries. 2. Use legal harmonization of financial harmonization within the EU to identify properly the causality. Countries within the EU adopted European directives at different dates. Find that financial integration within EU lowers business cycle synchronization in normal times. But opposite in times of financial crisis.
Banking Integration and Synchronization Source: Kalemli-Ozcan, Papaioannou and Peydro(2011)
Banking Integration and Synchronization Source: Kalemli-Ozcan, Papaioannou and Peydro(2011)
Financial crisis, recessions and recoveries Recessions Output loss (percent from peak) Duration (quarters) All recessions Recoveries Time until recovery to previous peak (quarters) Output gain after four quarters (percent from trough) All recessions Financial crises Financial crises Highly synchronized recessions Financial crises which are highly synchronized Highly synchronized recessions Financial crises which are highly synchronized 0 2 4 6 8 0 2 4 6 8 Source: IMF WEO April 2009
Financial integration and the transmission of the financial crisis Application: emerging markets lending during the 2007-2009 crisis Emerging markets are prone to sudden stop in capital flows. Large fall of capital inflows towards these markets during the last financial crisis. True across all asset classes but especially relevant for international bank lending. = The international lending channel See Goldberg and Cetorelli(2009)
Source: Goldberg and Cetorelli (2009)
Financial integration and the transmission of shocks Application: emerging markets lending during the 2007-2009 crisis Goldberg and Cetorelli(2009) emphasize how global banks played a significant role in the transmission of the 2007 to 2009 crisis to emerging market economies. Loan supply in emerging markets was significantly reduced through three different channels (i) a contraction in direct, cross-border lending by foreign banks (ii) a contraction in local lending by foreign banks affiliates in emerging markets (iii) a contraction in loan supply by domestic banks resulting from the funding shock to their balance sheet induced by the decline in lending through interbank markets Banks relying on distressed global banks for funding were more heavily hit.
International Lending Channel Large Global Bank (in the US) Asset Liabilities Liquid assets Deposit Foreign Loans Internal borrowing Domestic Loans Foreign Affiliate (in Argentina) Asset Liabilities Liquid assets Deposit Internal Lending Loans Small stand-alone bank (in Argentina) Asset Liquid assets Loans Liabilities Deposit Foreign borrowing
Summary Two views of the business cycle: 1) driven by demand shocks that are propagated through price rigidities; 2) driven by supply shocks (technology) propagated through investment and employment. Consensus that demand shocks tend to dominate at least at shorter horizons. Financial frictions (collateral or borrowing constraints) amplify business cycles. Shocks propagate internationally, generating international comovements. Trade globalization amplify such international comovements while the role of financial globalization is more ambiguous. During the last financial crisis though, financial globalization spread the crisis globally.