Business Cycles

1
Business Cycles
2
What is the Business Cycle?

• The fluctuation in the economy, commonly observed
  through changes in real GDP and Unemployment.
• Okuns Law
• Recession Real GDP decreases, while U increases
• Expansion Real GDP increases, while U decreases

3
(No Transcript)
4
(No Transcript)
5
(No Transcript)
6
(No Transcript)
7
Why is it upward sloping?
8
(No Transcript)
9
Why Does the Business Cycle Occur?

• Over 200 years of Theories
• Famous early example Malthus (1789)
• No longer accepted

10
Why Does the Business Cycle Occur?

• Theories Divide into Five Schools
• Classical Smith (1776), Ricardo (1817), and Say
  (1803)
• Keynesian Keynes (1937), Hicks (1937), and
  Phillips (1958)
• Monetarism Friedman and Swartz (1968)
• New Classical Lucas (1972)
• New Keynesian Mankiw

11
Why Does the Business Cycle Occur?

• All schools seek to explain
• Production fluctuations
• Supply and output
• Demand and output
• Supply and Demand
• Employment fluctuations
• Flexibility or non-flexibility of the real wage
  (W/P)

12
Classical Economics

• Goal Show that exchanges between households and
  firms are self adjusting and self equalizing
  (invisible hand)
• Core Equation Y f(L,K)

13
Classical Economics

• Supply creates its own demand (Says Law)
• Wages and prices are flexible, so economy adjusts
  very quickly.
• Excess supply leads to fall in price. Real Wage
  rises, causing unemployment. Firms lower nominal
  wage so as to reduce unemployment and return
  market instantly to equilibrium
• No good explanation for Business Cycle (except to
  say that equilibrium must return).

14
Keynesian Economics

• Goal Classical Economists cant explain
  Depression
• Core Equation Y C I G (X-M)

15
Keynesian Economics

• Demand creates Supply
• Wages and Prices are sticky so economy can get
  stuck in a disequilibrium.
• Why Sticky? Not really specified
• Business Cycle Results from Shocks to demand (ex
  decline in consumer confidence, erratic
  expectations, animal spirits)
• If households and firms wont spend, who will?

16
Monetarists

• Goal Keynesians cant explain Stagflation
• Core Equation ?M ?V ?P ?Y
• Where V is constant, P is fixed in short-run, and
  ?Y is fixed in the long-run (around 3).

17
Monetarists

• Demand determines production in the short-run
• Supply determines production in the long-run
• Wages and Prices are flexible, but expectations
  are adaptive
• Business Cycle results from Changes in Money
  Supply, but inflation is the long run result (see
  figures).

18
(No Transcript)
19
(No Transcript)
20
New Classical Economics

• Goal Reintroduce Classical with
  Micro-foundations
• Core Equation Y A Ka L(1-a)
• Where A is total factor productivity growth in
  production not accounted for by changes in K or
  L. In short, technological change.

21
New Classical Economics

• Supply determines production in long-run and
  short-run (like classical)
• People have rational not adaptive
  expectations regarding wages and prices.
• Business Cycle results from changes in A (also
  called the Solow residual). See Figure

22
The Solow residual and growth in output
Percent per year
10
8
Output growth
6
4
2
0
Solow residual
-2
-4
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
1945
Year
23
New Classical Economics

• Looks good, but
• Solow Residual is not directly measuring
  technology, just what is left over after
  subtracting growth in capital and growth in
  labor!
• So no wonder it follows output growth so closely!

24
New Keynesian Economics

• Goal Give Keynes Micro foundations (to counter
  New Classical)
• Core Equation P f(w, µ, MPL)

25
New Keynesian Economics

• Demand determines production in the Short-run
• Supply determines production in the Long-run
• The presence of rational expectations means wages
  and prices, though still sticky, adjust faster
  than Keynes recognized.

26
New Keynesian Economics

• Why are Wages and Prices Sticky?
• Menu Costs
• Coordination failure (firms wait for each other
  to lower prices/ workers will be unwilling to be
  the first to take pay cut)
• Staggered Price Adjustments (wage and price
  adjustments not done at once, but are staggered
• fairness to customers

27
What Can We Learn From BC Theories?

• Exploring these theories reveals some Principles
  (Laws) of Macroeconomics (along with tips for
  business managers)
• (1)   Expectations, formed either adaptively
  and/or rationally, influence the economy.
• Know your customer and follow Consumer Confidence
  indexes.
• Example includes the University of Michigan
  Consumer Sentiment Survey (see Figure)
• People tend to use adaptive expectations in the
  short-run, rational expectations in the long-run
  (when its easier to have full information to make
  a rational, cost/benefit choice)
• This is why bubbles form

28
(No Transcript)
29
What Can We Learn From BC Theories?

• (2)   Exogenous shocks (war, plague, natural
  disasters, technological innovations, etc)
  can influence the economy.
• Follow world events and have contingency plans
  (inventories or multifunctional workers)
• (3)   The economy is basically stable after a
  shock, it will eventually return to its normal
  trend paths for output and employment.  However,
  because of rigidities in the economy, this return
  could be slow.
• Dont fall into the trap of thinking that the
  condition the economy is currently in is the
  condition it will continually be.
• (4)   Money supply growth influences inflation,
  nominal long-term interest rates, and the
  exchanges of all goods and service.
• Pay attention to the actions of the Federal
  Reserve