3. Survey of Business Cycle Theories

7/31/2019 3. Survey of Business Cycle Theories

1/23

WS 2006/07

3. Business Cycle Theories (Survey)

History: pre-Keynesian vs. modern theories

Principal: real vs. monetary theories

Stability: endogenous instability vs. exogenous shocks

(rocking chair)

Price flexibility: new Keynesian vs. new classicalMacroeconomics

KuB 4 1

U van Suntum, Vorlesung KuB 1


2/23

WS 2006/07

monetary real

endogenous Ralph Hawtrey

(1879-1975):

Instability of v

Knut Wicksell(1851-1926):

interest rate spread

F.A. von Hayek

(1899-1922):

excess investment

M. Woodford: dynamicstochastic general

equilibrium model

(DSGE)

E. Lederer, R. Malthus, K. Marx: underconsumption

Albert Aftalion (1874-1956), Artur Spiethoff (1873-

1957), Gustav Cassel (1866-1945):

Excess investment, accelerator

J.R. Hicks, P.A. Samuelson: multiplier/accelerator

Goodwin/Pohjola:

distribution battle, chaos theory

E. Prescott: New classical Macroeconomics

Technological shocks, real business cycle (RBC)

G.Akerlof, P. Romer: New KeynesianMacroeconomics

Sticky prices

exogenous Milton Friedman:

monetary policy

Robert Lucas, B.T.

McCallum (1980):

Price expectations

William St. Jevons (1835-1882):

sunspot-theory

W.D. Nordhaus (1975):

political cycles

KuB 3.1 2

KuB 4 2



3/23

WS 2006/07

Interdependency of Macroeconomics

M

*V

:

P

=

=

Lnet

+

Gnet

+

T

= C + I + E + EX - IMC + S = Y

underconsumption

theoriesKeynesian theories

monetary/monetaristic theories

distribution theories

KuB 3.1 3

KuB 4 3



4/23

WS 2006/07

Basic idea of monetary theories

HP = Mv = MB * m * v (quantity equation)

v dependent on i and dP/dt)/P => instability m dependent on behavior of banks and households => instability

KuB 3.1 4

KuB 4 4



5/23

WS 2006/07

Central bank balance(simplified)

Assets Liabilities

credit claims

bonds foreign currency

other

currency in circulation

reserves

monetary base MB

KuB 3.1 5

KuB 4 5

monetary base MB



6/23

WS 2006/07

Velocity of circulation v in Euro-Zone (19802000)

source: ECB

ln [GDPnom/M3]

KuB 3.1 6

KuB 4 6



7/23

WS 2006/07

Pure monetary theory by Ralph Hawtrey (1928) (I)

inventories are sensible to interest rate

Inventory bought at 1000.-

leveraged 900.-

equity: 100.-

inventory sold at 1100.-

=> Profit before interest 100.-

Rate of return ( i = 10%): 10%

Rate of return (i = 11%): 1%

KuB 3.1 7KuB 4 7U van Suntum, Vorlesung KuB 7


8/23

WS 2006/07

Pure monetary theory by Ralph Hawtrey (1928) (II)

KuB 3.1 8KuB 4 8

inventories are also sensible to inflation

Interest rates decline

inventory and commoditydemand increase

Inflation

rising velocity of

money circulation

(Hawtrey effect)

Inflation

Interest rates rise



9/23

WS 2006/07

Criticism on Hawtrey`s theory

Inventory less important today

Explanation of cycle is one-sided

Stimulus of initial interest rate decline unclear

However: leverage effect was relevant in recent financialcrisis



10/23

WS 2006/07

Monetary over-investment theory (Knut Wicksell 1922,

F.A. von Hayek 1934 )

upswing downswing

inat

imon

imon

S

I

S + d(M/P)

S + d(M/P)

S

I

KuB 3.1 10KuB 4 10

Interest rate spread causal for disparity between investment

and consumption goods



11/23

WS 2006/07

Criticism on Wicksell`s theory

Stimulus of initial interest rate spread unclear

Neglect of real effects (e.g. accelerator)

However: interest rate spread was also relevant in recent

crisis



12/23

WS 2006/07

Critisicm:

real wage increase by technical is progress neglected

turning points are not sufficiently explained one sided theory, no formal exposition

export demand neglected

Theories of under-consumption

(Lauderdale, Malthus, Lederer)

KuB 3.1 12KuB 4 12

technical progress and capital accumulation

pressure on wages and rising unemployment

sales crisis and depression



13/23

WS 2006/07

Criticism:

cause of initial rise in aggregate demand?

no formal exposition

one sided

Accelerator effect:

K/GDP = 300/100

d = 10%

=> D = 30

suppose demand rises at 10% in t1

=> I1 = 60 + 100% I2 = 33 -45%

=> extreme instability

Non-monetary theory of excess investment (Aftalion u.a.)

Aggregate Demand

Investment



14/23

WS 2006/07

Accelerator effect in East German Housing Market

Housing

stock

./.

outs

(99)

adds

(1)

Demand

(100)

Housing

stock

./.

outs

(99)

adds

(11)

Demand(110)

increase in aggregate demand by 10% => rise in investment by 1100% !

after completed construction of new houses drop in investment

Demand(110)

Housing

stock./.

outs

(108,9)

adds

(1,1)

previous

After unification today



15/23

WS 2006/07

Auftragseingang / Werte / Bauhauptgewerbe Ost/ arbeitstglich bereinigt

0

50

100

150

200

250

Jan91

Jul9

1

Jan92

Jul9

2

Jan93

Jul9

3

Jan94

Jul9

4

Jan95

Jul9

5

Jan96

Jul9

6

Jan97

Jul9

7

Jan98

Jul9

8

Jan99

Jul9

9

Jan00

Jul0

0

Jan01

Jul0

1

Jan02

Jul0

2

Jan03

Jul0

3

Jan04

Monatswerte

12 Per. Gleitender Durchschnitt (Monatswerte)

KuB 3.1 15KuB 4 15

Orders in East-German Construction Industry



16/23

WS 2006/07

Dynamics of the business cycle

GDP

Investment

GDP

Investment



17/23

WS 2006/07

Demand Supply

)(11

1

)1(

1

t

N

N

N

NN

IIs

Is

Y

IsY

IYs

IcYY

1

t

A

A

AA

A

IxY

KxY

dK

dY

K

Yx

KxY

Is there an equilibrium of aggregate demand and investment?

(Harrod-Domar 1939):

KuB 3.1 17

xswI



18/23

WS 2006/07

Dynamics in Harrod/Domar-model:

t

SYln

lnI

lnY

DYln

Y* = 1/(1-c)Iaut



19/23

WS 2006/07

a) equlibrium: gI = g* = 0,1

Numerical example I: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1

Period: 0 1 2

K 200 220 242

=> YS = xK 100 110 121

I = I t-1 (1 + gI) 20 22 24,2

=> YD = I/s 100 110 121

ALG = YD/YS 100% 100% 100%

Steady-state: all variables grow at the same rate

t

SDYY lnln

lnI

lnY

I = sY = 0,2*100 = 20



20/23


21/23

WS 2006/07

c) disequilibrium: gI = 0,05 < g*

Numerical example III: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1

Period: 0 1 2

K 200 220 241

=> YS = xK 100 110 120,5

I = I t-1 (1 + gI) 20 21 22,05

=> YD = I/s 100 105 110,25

ALG = YD/YS 100% 95% 91%

Lack of investmentleads to excess capacity!

t

DYln

lnY

SYln



22/23

WS 2006/07

Criticism of Harrod/Domar

model does not reflect reality

s, x bzw. v need not be constant

no cycles

model is far too simple (no consumption, no public sector, no

money, no labor market)



23/23

WS 2006/07

Learning goals/Questions

How do we classify business cycle theories?

Which pre-Keynesian theories do we know?

To what extent are they still relevant today?

Explain why we cannot forecast GDP for more than two yearsat best!

Explain the Harrod-Domar condition for a balanced growth!


3. Survey of Business Cycle Theories

Documents