FIN 30220: Macroeconomics The Business Cycle. Billions of 2000 Dollars $12,129B 2014Q1 $1,938B (1947Q1) Looking at real GDP over the last 67 years, we.

FIN 30220: Macroeconomics

The Business Cycle

1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 20120

2000

4000

6000

8000

10000

12000

14000Bi

llion

s of

200

0 D

olla

rs

$12,129B2014Q1

$1,938B(1947Q1)

Looking at real GDP over the last 67 years, we should see two basic features in the data

1) The US economy grows over time

2) The US doesn’t grow at a constant rate

GDP

Time

Trend (Average growth)

“Business Cycle” (deviations from average growth)

Here’s an exaggerated view of what we are talking about

GDP

Time

Trend (Average growth)

The business cycle is a repeated pattern of recessions followed by recoveries

Recession (Below Trend Growth)

Recovery (Above Trend Growth)

Peak

Trough

Peak

Once we have identified the trend, we can subtract it out to leave the cycle component all by itself.

GDP

Time

Trend (Average growth)

Actual GDP

Trend GDP

*100Actual Trend

DeviationTrend

We end up with a series that looks like this

% Deviation From Trend

Time

0

Trough

Peak Peak

Recession Recovery

1/1/1919 1/1/1939 1/1/1959 1/1/1979 1/1/1999

-40

-30

-20

-10

0

10

20

30

Great Depression WWII

We have had 22 full cycles since 1900.%

Dev

iatio

n fr

om tr

end

Indu

stria

l Pro

ducti

on

2007-01-01 2009-01-01 2011-01-01 2013-01-0112500.0

12700.0

12900.0

13100.0

13300.0

13500.0

13700.0

13900.0

Jan. 2013

$13,326B

$12,746B

$13,750B

Real GDP: -4.5% Real GDP: 7.5%

Dec. 2007 June 2009

The most recent cycle began in Dec. of 2007

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-4

-3

-2

-1

0

1

2

3

Recession Recovery

% D

evia

tion

from

tren

d G

DP

Dec. 2007“Peak”

June 2009“Trough”

2.5%

-2.8%

The most recent cycle in terms of deviation from trend

Arthur Burns(1904 – 1987)

Wesley Mitchell(1874 – 1948)

Robert Hodrick(1950 -)

Edward Prescott(1940 - )

Business Cycles all look alike!

In the 1930’s, Burns and Mitchell began document a set of remarkably consistent business cycle regularities…

This was reconfirmed by Hodrick/Prescott in the 1980’s…

This tells us that the nature of these fluctuation in the economy are independent of institutional factors or country specific issues!!

Nobel Prize 2004

By “regularities”, we are referring to statistical relationships….

Time

GDP

Time

GDP

X

X

Time

GDP

X

Procyclical variables move in the same direction as GDP

Countercyclical variables move in the opposite direction as GDP

Acyclical variables have no obvious relationship to GDP

CORR(GDP, X) >0

CORR(GDP, X) <0

CORR(GDP, X) =0

Peak

Trough

Indu

stria

l Pro

ducti

on (%

Dev

iatio

n fr

om T

rend

)

Correlation = .77

1/1/2007 1/1/2009 1/1/2011 1/1/2013

-12

-10

-8

-6

-4

-2

0

2

4

6

8

-4

-3

-2

-1

0

1

2

3

Employment Industrial Production

Empl

oym

ent

(% D

evia

tion

from

Tre

nd)

Total Employment is highly procyclical…

1/1/2007 1/1/2009 1/1/2011 1/1/2013

-12

-10

-8

-6

-4

-2

0

2

4

6

8

4

5

6

7

8

9

10

11

Unemployment Rate Industrial Production

Indu

stria

l Pro

ducti

on (%

Dev

iatio

n fr

om T

rend

)

Une

mpl

oym

ent R

ate

Peak

Trough

5%

9.5%

Correlation = -.54

Therefore, the unemployment rate will be countercyclical!

The statistical relationship between employment and GDP should be too surprising given that labor is a major input into production. In most economic models, we assume that production is related to three basic inputs:

, ,GDP F A K L

Real GDP “Is a function of”

Total hours worked

Total Physical Capital Stock“Productivity”

Pro-cyclicalCORR(GDP, A) = .78

Pro-cyclicalCORR(GDP, L) = .77

AcyclicalCORR(GDP, K) = 0

Every good or service that is produced is purchased by somebody. This leads to the following accounting identity…

GDP C I G NX Consumer Expenditures

• Durables• Non-Durables• Services Business Investment

Expenditures• Structures• Equipment• Inventories• Residential

Investment

Government Purchases Net Exports = Exports - Imports

The correlation between expenditures and GDP has to be 1 (by definition), but what about the components?

7/1/2007 7/1/2009 7/1/2011

-12

-10

-8

-6

-4

-2

0

2

4

6

8

Retail Sales Industrial Production

% D

evia

tion

from

Tre

nd

Peak

Trough Correlation = .82

Retail sales is essentially the goods portion of consumer expenditures (durables and non-durables)

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-4

-3

-2

-1

0

1

2

3

4

Consumption GDP

GD

P (D

evia

tion

from

Tre

nd)

Correlation = .83Trough

Peak

Here’s the whole consumer…

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-25

-20

-15

-10

-5

0

5

10

15

Gross Investment GDP

% D

evia

tion

from

Tre

nd Peak

Trough

Correlation = .78

Note that business investment is much more volatile that GDP (i.e. fluctuates more)

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-6

-4

-2

0

2

4

6

Government Expenditures GDP

% D

evia

tion

from

Tre

nd

Peak

Trough

Correlation = -.007

Government purchases are acyclical, but tax revenues are very highly procyclical.

2006-07-01 2008-07-01 2010-07-01 2012-07-01

-4

-3

-2

-1

0

1

2

3

4

-150

-100

-50

0

50

100

150

200

250

300

Trade Balance GDP

GD

P (D

evia

tion

from

Tre

nd)

Trad

e Ba

lanc

e (D

iffer

ence

from

Tre

nd B

illio

ns o

f Dol

lars

)

Peak

Trough Correlation = -.34

During recessions, we buy less from abroad and they buy more from us…hence a countercyclical trade balance

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-4

-3

-2

-1

0

1

2

3

Real Wages Real GDP

Trough

Peak

Dev

iatio

n fr

om T

rend

Correlation = .12

Real wages are procyclical….barely!

The fact that wages are procyclical makes sense as well…

, ,GDP F A K L

Productivity is procyclical, so with higher productivity, we are producing more output with any given level of inputs

GDP Total Income

Labor Income + Capital Income

If inputs are producing more output, they should be compensated at higher levels!

Further, more production means more income…in particular, more labor income (however, be careful, employment is higher as well)

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-4

-3

-2

-1

0

1

2

3

Price Real GDP

% D

evia

tion

from

tren

d G

DP

% D

evia

tion

from

tren

d Pr

ice

Correlation = -.18

The price level is countercyclical (barely), but….

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-4

-3

-2

-1

0

1

2

3

4

5

Inflation Real GDP

Annu

al In

flatio

n Ra

te

Real

GD

P (D

evia

tion

from

Tre

nd)

Correlation = .18

The growth in prices (the inflation rate) is procyclical

1/1/2007 1/1/2009 1/1/2011 1/1/2013

-12

-10

-8

-6

-4

-2

0

2

4

6

8

0

1

2

3

4

5

6

1 Year Treasury Rate Industrial Production

Peak

Trough

Indu

stria

l Pro

ducti

on (%

Dev

iatio

n fr

om T

rend

)

1 Ye

ar T

reas

ury

Rate

Correlation = .20

The nominal interest rate is procyclical….but we need to be careful here…

Suppose that you pay $95 today for a bond that will pay out $100 in one year. Your nominal return would be

$100 $95*100 5.3%

$95i

Per yearHowever, if inflation over the course of the year is 3%, your gain in terms of purchasing power is 5.3% - 3% = 2.3% right?

r i Real (inflation adjusted) interest rateCountercyclicalCORR(r, GDP) = -.35

Nominal interest rateProcyclicalCORR(i, GDP) = .20

InflationProcyclicalCORR(INF, GDP) = .18

So, we have a set of facts to explain…how do we go about doing this?

Ideology: How do you believe the world works?

Methodology: How do you go about modelling the economy?

Say's law states that the production of goods creates its own demand. In 1803, John Baptiste Say explained his theory. This view suggests that the key to economic growth is not increasing demand, but increasing production.

Jean-Baptiste Say (1767 -1832)

Classical Economics

Adam Smith (1723 – 1790) David Ricardo (1772 – 1823) Thomas Malthus (1766 – 1834) John Stuart Mill (1806 – 1873)

It should be noted that while classical economists were aware of what was called at the time the “Boom Bust cycle”, they weren’t overly concerned about it and focused primarily on microeconomic issues.

John Maynard Keynes (1883 – 1946)

"I believe myself to be writing a book on economic theory which will largely revolutionize—not I suppose, at once but in the course of the next ten years—the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say,--in my own mind, I'm quite sure."

The General Theory of Employment, Interest and Money (1936) 

Keynesian Economics is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

*Note: The Nobel prize in economics was first awarded in 1969. The statutes of the Nobel Foundation stipulate that the prize cannot be awarded posthumously.

Consider, for simplicity, an economy with no government that does not trade with the rest of the world…

t tGDP C I

Suppose that, investment in this economy increases by $100

t tGDP C I

The $100 investment generates $100 increase in GDP

+$100+$100

So, what happens next?

Because any production should translate into income, our national income should increase by $100.

t tGDP NI

But, an increase in income should effect consumption expenditures…

1 0t tC C NI

Autonomous consumption

Marginal Propensity to ConsumeThe fraction of each additional dollar earned that we spend

+$100+$100

Word of caution….don’t confuse marginal propensity to consume with average propensity to consume

1 500 .6t tC NI Suppose we have

C

NI

500

500 .6C NI

Slope = .6 = MPC

2,000

1,700

1,700.85

2,000APC

1 0t tC C NI

So, if national income increases by $100M, consumption should increase …

$100 $100

But consumption will add to GDP ….

1tC I

$100 $100

1tGDP

But the increase in GDP should increase national income again which further increases consumption….

1t t tGDP NI $100 $100

0 1tC NI $100

2tC

2 $100

This continues on and on and on and on…

So, what’s the end result….

2 3$100 $100 $100 $100 ...GDP

2 3$100 1 ...GDP

$100

1GDP

A little mathematical magic here!

So, GDP increases by a multiple of the initial increase in investment spending!

In our example,

100$250

1 .6GDP

100I

1 500 .6t tC NI

Putting it together….

t tGDP C I

0 1t tC C NI

0 1t tGDP C NI I

1 1t tGDP NI

0 1t tGDP C GDP I

In the steady State,

0

1

C IGDP

,C GDP

NI

0C NI I

GDP NI

0C I

0

1

C I

0

1

C I

The Keynesian Expenditure Model

1t tGDP GDP GDP

,C GDP

NI

0C NI I

GDP NI

600

1,500

1,500

The Keynesian Expenditure Model

In our example,

500 100$1500

1 .6GDP

100I

1 500 .6t tC NI 500 .6 1500 $1400C

,C GDP

NI

0C NI I

GDP NI

600

1,500

1,500

The Keynesian Expenditure Model

Suppose that GDP is currently $200

200

200

100I 1 500 .6t tC NI

500 .6 200 100 720

720

500 .6 720 100 1,032

1032

500 .6 1,032 100 1,219

1

2

3

500 .6 1,500 100 1,500

Steady State

Time 1 2 3 4 5 6 7 8 9 10 110

200

400

600

800

1000

1200

1400

1600

YC

I

We end up with a time series that looks like this….

720

1032

1219

13311398

Suppose that this kid broke the neighbor’s window….the window costs $50 to replace. Should he be punished?

Absolutely not! The $50 spent by the neighbor will generate a multiplied effect on income/output in the community….

Keynesian Economics and the Case of the Broken Window

$50$125

1 .6GDP

In our example, MPC is .6

While the neighbor might be out $50, the net benefit to the overall community is $125!!!

,C GDP

NI

0GDP C NI I

GDP NI

0C I

*GDP

*NI

So, if investment expenditures rise by $50…

$50

$50$50

$1251 .6

GDP

$50$125

1 .6NI

Time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 151400

1450

1500

1550

1600

1650

Time 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15100

125

150

Y

C

I

$125

$50

Here’s how the transition looks over time…

$75

The paradox of thrift is a paradox of economics, popularized by John Maynard Keynes, though it had been stated as early as 1714 in The Fable of the Bees. The paradox states that if everyone tries to save more money during times of economic recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth.

,C GDP

NI

0GDP C NI I

GDP NI

*GDP

*NI

Now, let’s try something a little more complicated…

1 0t tC C NI

Autonomous consumption

Marginal Propensity to ConsumeThe fraction of each additional dollar earned that we spend

We will leave consumption the same…

Let’s assume that businesses base investment decisions on past production increases

1 2( )t t tI GDP GDP

“Accelerator Parameter”Change in Capital

Change in GDP

1948 1963 1978 19931.6

1.8

2

2.2

2.4

2.6

2.8

2.2

Recall the (relatively) constant ratio of capital to GDP of around 2.2

Capi

tal S

tock

/GD

P

1 2( )t t tI GDP GDP

2.2 in the Data

This says that a average business must invest $2.20 in capital equipment for every $1 in GDP

For example, Nike needs to spend around $190 on plant/equipment for every pair of shoes they produce (average retail = $85)

t t tGDP C I

0t tC C NI

t tGDP NI

0 1 1 2t t t tGDP C GDP GDP GDP

0

1

CGDP

1t tGDP GDP GDP

Putting everything together….

1 2( )t t tI GDP GDP

0 1 2t t tGDP C GDP vGDP

In the Steady State, GDP is constant

In the steady state, GDP is constant (and, hence, investment is zero)

tC tI

500 .6t tC NI

t tGDP NI

1 2( )t t tI GDP GDP

Let’s Suppose the following

Same as before

Let the accelerator parameter equal 1

We need two initial values for GDP to get started….

0 5001250

1 1 .6

CGDP

Time GDP Consumption Investment

0 1000

1 1100 1100

2 1260 1160 100

3 1416 1256 160

4 1505.6 1349.6 156

1500 .6t tC GDP 1 2( )t t tI GDP GDP

1 2500 1.6t t tGDP GDP GDP

Time

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

-500

0

500

1000

1500

2000

YC

I

We end up with a time series that looks like this….

0

1

CGDP

5001250

1 .6

1250

Suppose that we see a decline in consumer spending…

500 .6t tC NI

400

Time

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

-500

0

500

1000

1500

2000

0

1

CGDP

4001000

1 .6

250

Y

C

I

Major problem: Suppose we set the accelerator parameter to a number greater (empirically, it should be around 2) than 1 (empirically, things blow up

500 .6t tC NI

1 21.1( )t t tI GDP GDP

Time 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48

-1000

-500

0

500

1000

1500

2000

2500

3000

3500

4000

Y

1250

Major problem: Suppose we set the accelerator parameter to a number less than 1.

500 .6t tC NI

1 2.9( )t t tI GDP GDP

Time 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48

900

1000

1100

1200

1300

1400

1500

Y

1250

Keynesian Economics

Fundamental belief: The economy is demand driven. The business cycle is a result of random fluctuations is spending behavior (“Animal Spirits”)

GDP C I

Modelling Strategy: Use macroeconomic data and time series analysis to develop relationships between macroeconomic variables

2007-01-01 2009-01-01 2011-01-01 2013-01-01

-25

-20

-15

-10

-5

0

5

10

15

Gross Investment GDP

% D

evia

tion

from

Tre

nd

Peak

Trough

Note that business investment is much more volatile that GDP (i.e. fluctuates more)

Problem: 0

1

C IGDP

If this is true, then GDP should be much more volatile than investment!!

GDP C I

Problem: Keynesian economics suggests that GDP responds to changes in demand. If demand goes up, where does this extra production come from?

If aggregate demand exceeds supply (i.e. we are trying to buy more goods than are available) what happens?

• In an open economy, the trade deficit worsens (we get the extra goods from overseas.

• In a closed economy, the interest rate rises (higher interest rates should discourage spending)

Neither of these effects are mentioned!!!!

Have you ever heard the story about the economist and the NFL?

Typical Economist

0t tC C NI

Where do we get these parameters? They are estimated using regression analysis from past data

The moral of the economist and the NFL

There is no reason to believe that parameters from the past will remain constant in the future are individuals adjust to ever changing “rules of the game”

Robert Lucas Jr. (1937 - )

Nobel Prize 1995

Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory

"...it is the econometric tradition, or more precisely, the 'theory of economic policy' based on this tradition, which is in need of major revision.  More particularly, I shall argue that the features which lead to success in short term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies."   

("Econometric Policy Evaluations: A Critique", 1976)

Friedrich Hayek (1899 - 1992 )

Nobel Prize 1974

Recall, our story about the macro economy as an apple orchard…

At some point in time, you have a fixed number of trees (Capital) and workers

Those workers/capital combine with productivity to produce apples (output)

OR

Those apples are allocated either towards consumption or investment (planting them to grow new trees)

, ,GDP F A K L GDP C I

' 1

' 1 L

K K I

L g L

Investment today determines your capital stock next year. Population grows at a constant rate

At some point in time, you have a fixed number of trees (Capital) and workers

Those workers/capital combine with productivity to produce apples (output)

OR

Those apples are allocated either towards consumption or investment (planting them to grow new trees)

, ,GDP F A K LGDP C I

For the long term, we made some behavioral assumptions

PopPop

LF

LF

LL

Employment rate is constant (equal to one)

Participation rate is constant (equal to one)

1C Y I Y

Investment/Consumption rate is constant

At some point in time, you have a fixed number of trees (Capital) and workers

Those workers/capital combine with productivity to produce apples (output)

OR

Those apples are allocated either towards consumption or investment (planting them to grow new trees)

, ,GDP F A K LGDP C I

L

w

pSL

DL

*L

*w

p

For a given capital stock and productivity level, labor markets determine total employment

,S I

r S

I

* *S I

*r

For a given output, capital markets determine the consumption/investment allocation

For the shorter term, we can’t rely on these constant parameters…markets determine outcomes

' *1K K I

If you only learn one thing from microeconomics, it should be this…

Economic Decisions are Made at the Margin!!!!!

MB MCMarginal Benefit

Marginal Cost

Neoclassical Economics (A.K.A Real Business Cycle Theory)Fundamental belief: The economy is supply driven. The business cycle is a result of random fluctuations to productivity that influence our ability to produce goods and services.

GDP C I

Modelling Strategy: focus on the determination of prices, outputs, and income distributions in markets through supply and demand

1.People have rational preferences between outcomes that can be identified and associated with values.2.Individuals maximize utility and firms maximize profits.3.People act independently on the basis of full and relevant information.

Larry Summers• Director of the National Economic Council (2009-2010)• President of Harvard University (2001-2006)• Secretary of the Treasury (1999 – 2001)• Chief Economist, World Bank (1991-1993)• Professor, Harvard University (1983 -1991)

“The model is not an inconceivable representation of reality. But to claim that its parameters are securely tied down by growth and micro observations seems to me a gross overstatement. The image of a big loose tent flapping in the wind comes to mind …”

“the central driving force behind cyclical fluctuations is technological shocks. The propagation mechanism is intertemporal substitution in employment. As I have argued so far, there is no independent evidence from any source for either of these phenomena …”

“If these theories are correct, they imply that the macroeconomics developed in the wake of the Keynesian Revolution is well confined to the ashbin of history. And they suggest that most of the work of contemporary macroeconomists is worth little more than that of those pursuing astrological science” 

“My view is that business cycle models have nothing to do with the business cycle phenomena observed in The United States or other capitalist economies” 

Some Skeptical Observations on Real Business Cycle Theory

(Fall 1986)

Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the modelling strategy of neoclassical economics

John Hicks (1904 – 1989)

Nobel Prize 1972

Paul Samuelson (1915 – 2009)

Nobel Prize 1970

Robert Solow (1924 –)

Nobel Prize 1987

James Tobin (1918 – 2002)

Nobel Prize 1981

Franco Modigliani (1918 – 2003)

Nobel Prize 1985