Chapter 27 Business cycles ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The business cycle short-term fluctuations of total output around its trend path Trend output grows steadily as productive potential increases. Trend output Actual output fluctuates around this trend. Actual output Output A – slump A B – recovery phase has begun B C – Boom C D – recession under way D E – slump again E Time ©McGraw-Hill Companies, 2010 2

Growth of UK output and productivity, 1975–2009 -6 -4 -2 2 4 6 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 The growth of output and productivity fluctuates in the short run. Productivity and GDP Although not perfectly regular, there is evidence of a cycle of around 5 or 6 years. Typically, output fluctuations used to precede fluctuations in productivity by about a year, but since the mid 1990s this gap has been reduced. During 1995-2007 it appeared that cycles had become less pronounced, but the output fall of 2009 was the worst of the post war period. Source: Economic Trends Annual Supplement ©McGraw-Hill Companies, 2010 3

The political business cycle Some commentators have suggested that there is a political business cycle, whereby governments adopt tight monetary and fiscal policy soon after an election, but then adopt more expansionary policies as the election approaches to encourage a ‘feel-good’ factor. Recent institutional changes to improve policy credibility – particularly central bank independence –reduce the scope for political business cycles in the future. ©McGraw-Hill Companies, 2010 4

Theories of the business cycle The multiplier-accelerator theory: the multiplier communicates the effects of changing investment to aggregate demand the accelerator assumes that firms gauge future demand by reference to past output growth this model can produce fluctuations in output level in response to a shock. ©McGraw-Hill Companies, 2010 5

The multiplier-accelerator Invest- ment It Period Yt–1 – Yt – 2 Output Yt Period 1: Output Y1 = 100. Investment I1 = 10 - the investment needed to offset depreciation. Period 2: Y2 rises by 20. Output increases from 100 to 120. Period 3: I3 increases by 10 (the accelerator) → increase of 20 (from 120 to 140) in Y3 (the multiplier) If last period’s income grew by 2x units, firms raise current investment by x units. The multiplier is 2. ©McGraw-Hill Companies, 2010 6

The multiplier-accelerator Invest- ment It Period Yt–1 – Yt – 2 Output Yt Period 4: I4 remains at 20 since Y3 – Y2 = 20. Thus Y4 remains at 140. Period 5: I5 falls to 10, since Y4 – Y3 =0. This fall of 10 units in investment leads to a multiplied fall in Y5 of 20 If last period’s income grew by 2x units, firms raise current investment by x units. The multiplier is 2. ©McGraw-Hill Companies, 2010 7

Fluctuations in stock-building Stock-building may also be a cause of fluctuations in output. Firms tend to use stocks to smooth production in the face of fluctuating demand. Output per worker tends to rise in times of boom, and fall in times of recession. ©McGraw-Hill Companies, 2010 8

Fluctuations in stock-building UK stock-building £bn -6 -5 -4 -3 -2 -1 1 2 3 4 5 2006i 2006iii 2007i 2007iii 2008i 2008iii 2009i 2009iii During 2006-07, the level of stocks fluctuated randomly. In the first quarter of 2008, aggregate demand fell and firms were left with unsold goods. Firms began to cut back production, reducing stocks of work in progress. Once production had fallen more than demand, stocks start to increase again. ©McGraw-Hill Companies, 2010 9

©McGraw-Hill Companies, 2010 Real business cycles In this view of the world, fluctuations in actual output are fluctuations in potential output … so there is no point in trying to stabilize output over the business cycle. Although some swings in potential output do occur, many short-run fluctuations are more likely to reflect Keynesian departures from potential output. ©McGraw-Hill Companies, 2010 10

An interconnected world? Annual GDP growth (%) -6.0 -4.0 -2.0 0.0 2.0 4.0 6.0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Italy Japan France Germany UK USA Output growth has been similar across countries since 2000. The dot.com bust and the financial crisis were global events. Independent central banks have pursued rather similar monetary policies. These patterns warn us how interdependent the leading countries have become in the modern world. Economies are becoming more open. ©McGraw-Hill Companies, 2010 11

An interconnected world? (2) Increasingly the business cycle is transmitted from one country to another. In part by them following similar policies The considerable integration of advanced economies prompts a further question: are the leading emerging market economies, particularly China and India, on the way towards similar integration with the their longer-established partners? ©McGraw-Hill Companies, 2010 12

An interconnected world? (3) Prior to the crisis, Asian economies had been growing much more quickly as they caught up with the OECD. Annual real output growth (%) -6 -4 -2 2 4 6 8 2007 2008 2009 2010 USA EU Emerging Asia The cyclical pattern in response to the global crisis was very similar to OECD countries, albeit from a higher baseline rate of growth. ©McGraw-Hill Companies, 2010 13

Some maths: A simple cycle C = A +cY-1 I = a [Y-1-Y -2] Y = C+I Y = A +cY-1 + a [Y-1-Y -2 ] (1) Using y to denote Y-Y*, the deviation of output from its long run level, we can subtract Y* from both sides of equation (1) to yield: y = cy-1 + a [y-1-y -2 ] (2) ©McGraw-Hill Companies, 2010 14

Some maths: A simple cycle (2) y = cy-1 + a [y-1-y -2 ] (2) Depending on the values of c and a, equation (2) can yield constant cycles, damped cycles that gradually get smaller and smaller, or explosive cycles that get larger and larger. ©McGraw-Hill Companies, 2010 15