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FIN 30220: Macroeconomic Analysis. Real Business Cycles. A Complete Business Cycle consists of an expansion and a contraction. recession. Peak. Trough. Expansion. - PowerPoint PPT Presentation
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Real Business Cycles
FIN 30220: Macroeconomic Analysis
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recession
Expansion
Peak
Trough
A Complete Business Cycle consists of an expansion and a contraction
GDP: Deviations from Trend:1947-2005
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Since WWII, the US has experienced 10 contractions lasting an average of 10 months (from peak to trough) – 63 months from peak to peak
All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
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GDP Consumption
Correlation = .81
Consumption is one of many pro-cyclical variables (positive correlation)
All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
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GDP Unemployment Rate
Correlation = -.51
Unemployment is one of few counter-cyclical variables (negative correlation)
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GDP Deficit
Correlation = .003
All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
The deficit is an example of an acyclical variable (zero correlation)
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GDP Productivity
All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
Productivity is pro-cyclical and leads the cycle
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GDP Inflation
All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
Inflation is pro-cyclical and lags the cycle
Business Cycles: Stylized Facts
Variable Correlation Leading/Lagging
Consumption Pro-cyclical Coincident
Unemployment Countercyclical Coincident
Real Wages Pro-cyclical Coincident
Interest Rates Pro-cyclical Coincident
Productivity Pro-cyclical Leading
Inflation Pro-cyclical Lagging
The goal of any business cycle model is to explain as many facts as possible
We have a simple economic model consisting of two markets
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Labor markets determine employment and the real wage
Capital markets determine Savings, Investment, and the real interest rate
Employment determines output and income
Real business cycle theory suggest that the business cycle is caused my random fluctuations in productivity
We have developed a model with a labor market and a capital market. Suppose that a random, temporary, negative productivity shock hits the economy. (Assume no government deficit)
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Drop in productivity
For a given level of employment and capital, production drops
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Drop in productivity
The first market to respond is the labor market
At the pre-recession real wage, the demand for labor drops due to the productivity decline
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The drop in labor demand creates excess supply of labor – real wages fall and employment decreases
Drop in employment
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Expected Future productivity is unaffected
Expected Future employment is unaffected
Drop in Income
Wealth is unaffected
Non-Labor income is unaffected
The interest rate will need to adjust to equate the new level of savings
The capital market reacts next The drop in income relative to wealth causes a decline in savings
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Expected Future productivity is unaffected
Expected Future employment is unaffected
Drop in Income
Wealth is unaffected
Non-Labor income is unaffected
The real interest rate rises and levels of savings and investment fall
The drop in savings creates excess demand for loanable funds
Recall that today’s investment determines tomorrow’s capital stock.
IKK )1('
Tomorrow’s capital stock
Remaining portion of current capital stock
Depreciation Rate
Purchases of New Capital
If investment falls enough, the capital stock shrinks – this is what gives the recession “legs”
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Drop in capital
The drop in the capital stock creates an additional drop in production
The drop in the capital stock worsens the recession
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Drop in capital
A second labor market response further lowers real wages and employment – production falls further
Even at the lower wage, a drop in the capital stock further depresses labor demand
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Drop in expected future employment
A second capital market response further lowers savings, and investment – with both investment and savings affected, the interest rate effect is ambiguous
A drop in the capital stock creates expectations of persistent declines in employment which begin to influence investment demand Income
continues to fall
How do we know when we’ve hit rock bottom (i.e. the trough)?
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Falling employment lowers the productivity of capital (labor and capital are compliments while a falling capital stock raises the productivity of capital (diminishing MPK). Eventually, these two effects offset each other.
MPK
The Recession of 1981 is officially dated from July 1981 to November 1982
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Productivity Employment GDP Investment
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Productivity Employment GDP Investment
The Recession of 1991 is officially dated from July 1990 to March 1991
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Productivity Employment GDP Investment
The most recent recession is officially dated from March 2001 to November 2001
Are recessions caused by high oil prices?
Recession Dates
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Are jobless recoveries the new norm?
Look at the change in employment following the last three recessions!
Employment (% Deviation from trend)
What was different about the 2001 Recession?
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Productivity was actually growing during the 2001 recession!!
Productivity (% Deviation from trend)
Collapse of the stock market The Dow dropped 30% from its Jan 14, 2000 high of $11,722 The Nasdaq dropped 75% from its March 10, 2000 high of
$5,132 The S&P 500 dropped 45% from its July 17, 2000 high of
$1,517 Y2K/Capital Overhang A sharp rise in oil prices (oil prices doubled in late 1999) Enron/Accounting scandals Terrorism/SARS
As was mentioned earlier, the 2001 recession was different in that it was almost entirely driven by capital investment rather than productivity
Can preference shocks cause recessions?
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Can preference shocks cause recessions?
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If households suddenly lower consumption expenditures (increase savings), the drop in interest rates should trigger an offsetting rise in investment spending
It seems as if random fluctuations to productivity are a good explanation for business cycles. However, there are a couple problems…
If productivity is the root cause of business cycles, we would expect a correlation between productivity and employment/output to be very close to 1. The actual correlation is around .65
Where do these productivity fluctuations come from? Is it possible to separate technology from capital?
Haven’t we left something out?