Real Business Cycles

Supply Side Economics

The Real Economy

• Neoclassical (Supply Side) Economics suggests that business cycles are the result of random disturbances to productivity.

The Real Economy

• Neoclassical (Supply Side) Economics suggests that business cycles are the result of random disturbances to productivity.

• The initial impact takes place in labor markets (employment/output)

The Real Economy

• Neoclassical (Supply Side) Economics suggests that business cycles are the result of random disturbances to productivity.

• The initial impact takes place in labor markets (employment/output)

• Capital markets determine the impact on future labor markets (Investment today affects the capital stock in the future)

Example: A negative supply shock

• Consider an unanticipated rise in oil prices (permanent enough to impact capital investment).

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Example: A negative supply shock

• Consider an unanticipated rise in oil prices (permanent enough to impact capital investment).

• This drop in productivity lowers labor demand resulting in lower wages, lower employment, and lower output 0

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Example: A negative supply shock

• Now, moving to capital markets, the drop in productivity ( from lower employment as well as high oil prices) lowers investment demand

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Example: A negative supply shock

• Now, moving to capital markets, the drop in productivity ( from lower employment as well as high oil prices) lowers investment demand

• Lower investment demand causes interest rates, investment, and savings to fall

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Investment and the Capital Stock

• Recall that investment is defined as the purchase of new capital goods.

Investment and the Capital Stock

• Recall that investment is defined as the purchase of new capital goods.

• Capital goods are constantly wearing out (depreciation). Therefore, positive investment is needed to maintain the current capital stock.

Investment and the Capital Stock

• Recall that investment is defined as the purchase of new capital goods.

• Capital goods are constantly wearing out (depreciation). Therefore, positive investment is needed to maintain the current capital stock.

• The capital stock evolves according to

K (Future) = (1-dep)*K + I

Investment and the Capital Stock

• Recall that investment is defined as the purchase of new capital goods.

• Capital goods are constantly wearing out (depreciation). Therefore, positive investment is needed to maintain the current capital stock.

• The capital stock evolves according to

K (Future) = (1-dep)*K + I

• A large enough drop in current investment causes the capital stock to shrink.

Example: A negative supply shock

• With a lower capital stock, labor productivity drops (capital and labor are complements) causing another drop in labor demand

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Example: A negative supply shock

• With a lower capital stock, labor productivity drops (capital and labor are complements) causing another drop in labor demand

• Therefore, wages, employment, and output continue to fall

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Example: A negative supply shock

• Lower employment causes another drop in capital investment (not as big as the previous decline – the capital stock is lower than it was before)

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Example: A negative supply shock

• Lower employment causes another drop in capital investment (not as big as the previous decline – the capital stock is lower than it was before)

• Interest rates and investment continue to fall

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A Negative supply shock

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Example: A negative supply shock

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The Recession of 2001

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The Recession of 2001

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The Recession of 2001

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What caused the 2001 recession?

What caused the current recession?

• 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

What caused the current recession?

• 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

What caused the current recession?

• 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)

What caused the current recession?

• 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

What caused the current recession?

• 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