FIN 30220: Macroeconomic Analysis Real Business Cycles

A Complete Business Cycle consists of an expansion and a contraction recession Peak Trough Expansion

Here, we are plotting percentage deviation of GDP from a HP trend The recessions are pretty easy to spot!

While the average unemployment rate (excluding recessions) has been around 5% since 1957, the average unemployment rate during recessionary periods averages around 7%. Unemployment Rate Shaded areas indicate recessions

Lets look at the behavior of inflation around the business cycle…notice that inflation tends to decline during recessions and increase during expansions.

How about interest rates. Here is the return on a 90 Day T-Bill How about interest rates? Here is the return on a 90 Day T-Bill. Interest rates tend to decline during recessions. Shaded areas indicate recessions

All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics 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 Correlation = -.51 Unemployment is one of few counter-cyclical variables (negative correlation)

The deficit is an example of an acyclical variable (zero correlation) All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics Correlation = .003 The deficit is an example of an acyclical variable (zero correlation)

All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics Productivity is pro-cyclical and leads the cycle

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 Real Wages Interest Rates Productivity Leading Inflation 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 Capital markets determine Savings, Investment, and the real interest rate Labor markets determine employment and the real wage Employment determines output and income Real business cycle theory suggest that the business cycle is caused my random fluctuations in productivity

We have three possibilities for productivity shocks that hit the economy. Persistence parameter

For a given level of employment and capital, production drops 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) Drop in productivity For a given level of employment and capital, production drops

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 Drop in productivity The first market to respond is the labor market

The drop in employment creates an additional drop in production The drop in labor demand creates excess supply of labor – real wages fall and employment decreases Drop in employment The drop in employment creates an additional drop in production

The capital market reacts next The drop in income relative to wealth causes a decline in savings Wealth is (relatively) unaffected Drop in Income Non-Labor income is (relatively) unaffected Expected Future productivity is unaffected Expected Future employment is unaffected The interest rate will need to adjust to equate the new level of savings

The drop in savings creates excess demand for loanable funds Wealth is unaffected Drop in Income Non-Labor income is unaffected Expected Future productivity is unaffected Expected Future employment is unaffected The real interest rate rises and levels of savings and investment fall

Let’s take stock … Correlations With GDP + - Real Wage Employment Savings Consumption Investment Real Interest Rate Productivity Predicted + - Actual We are not generating the correct correlation with interest rates…what if the shock was permanent…

A permanent shock creates a larger drop in NLI which causes an increase in labor supply Drop in employment We get a bigger drop in the real wage and the effect on employment becomes ambiguous

Now we have interest rates moving in the right direction Next, the permanent drop in income has no effect on savings, but the permanent decline in productivity lowers investment Drop in employment Now we have interest rates moving in the right direction

Correlations With GDP – Temporary Shock + - Let’s take stock … Correlations With GDP – Temporary Shock Real Wage Employment Savings Consumption Investment Real Interest Rate Productivity Predicted + - Actual Correlations With GDP – Permanent Shock Real Wage Employment Savings Consumption Investment Real Interest Rate Productivity Predicted + ?? Actual What we need is a shock that is permanent enough to lower investment, but not enough to raise labor supply

A shock with a little persistence (but not too much persistence) is what we need. Productivity shock Persistence parameter Not enough movement in employment Just right! Countercyclical interest rate

Recall that today’s investment determines tomorrow’s capital stock. Depreciation Rate Purchases of New Capital Tomorrow’s capital stock Remaining portion of current capital stock If investment falls enough, the capital stock shrinks – this is what gives the recession “legs”

The drop in the capital stock worsens the recession – labor demand declines further Capital stock declines Drop in capital The drop in the capital stock creates an additional drop in production

What about investment? Falling employment lowers the productivity of capital (labor and capital are compliments while a falling capital stock raises the productivity of capital (diminishing MPK). During the downturn, the marginal product of capital falls which continues to lower investment.

What about savings? Savings depends on expectation of the future.. During the downturn, next years income is always lower than this years…savings increases

With lower investment, the capital stock continues to fall The drop in the capital stock worsens the recession – labor demand declines further Capital stock declines Drop in capital With lower investment, the capital stock continues to fall

What about investment? Eventually, the marginal product of capital starts to rise again.

What about savings? Savings depends on expectation of the future.. During the recovery, next years income is always higher than this years…savings decreases

The rise in MPK raises investment, while expected increases in income lower savings Drop in capital Now, the upturn begins!

The capital stock begins to rise, which raises labor demand… Capital stock declines Increase in capital Employment starts to increase!

The Recession of 1981 is officially dated from July 1981 to November 1982

The Recession of 1991 is officially dated from July 1990 to March 1991

The most recent recession is officially dated from March 2001 to November 2001

Collapse of the stock market As was mentioned earlier, the 2001 recession was different in that it was almost entirely driven by capital investment rather than productivity 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

Are recessions caused by high oil prices? Recession Dates

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? Haven’t we left something out?