SIS 628 Jan. 23, 2019 BUSINESS CYCLES

Income: Long Run vs. Short Run The long-run component of income is called the trend or potential income. Fluctuations around the trend or potential are the short-run component of income. When income is above trend, the economy is said to be in the boom phase of the cycle or in an expansion; when income trend, the economy is experiencing a slowdown or a slump. Output gap: the difference between income and its trend (or potential) Negative output gap: income is below trend Positive output gap: income is above trend

BUSINESS CYCLES

U.S. Real Per Capita Income

U.S. Real Income: Trend

U.S. Real Income: Cycle or Output Gap (income after removing trend)

Real Income: Trend and Cycle

Twin Goals of Economic Policies 1) Boost trend (“growth”) 2) Minimize cycles (“stabilization”)

Snapshot of mainstream advice Policies Long Run Short Run Criticism from the ‘Left’ Criticism from the ‘Right’ Monetary and exchange rate policies - Keep inflation low and predictable - Countries are free to choose their exchange rate regime (but, in general, exchange rate flexibility can be good) - Recognize that chosen exchange rate regime requires support from other policies - Countries with floating exchange rates can use interest rates to stabilize - Advice too ‘inflation-focused’ and neglects goals of growth. - IMF not flexible enough on use of capital controls; too focused on exchange rate flexibility - Advice permits devaluation as a way to overcome financial crises; creates problems of credibility Fiscal Policies - Taxation: expand tax base to generate sufficient revenues; advocacy of VAT - Expenditure: govt. spending essential to support private economy - Debt: keep it sustainable - Let automatic stabilizers work - Too worried about fiscal deficits & debt sustainability; not ‘growth-friendly’ - Tax advice (e.g. on VAT) is ‘regressive’ (hurts the poor) - Allows too much build-up of debt in low-income economies, leading to periodic need for debt forgiveness, Financial Sector Policies - Well-capitalized banks - Well-regulated financial sector - Macroprudential policies - counter-cyclical capital buffers? - Not critical enough of financial sector inefficiency or excesses - Complicit in ‘bailouts’, creating moral hazard (Other) Structural Policies: Labor markets - Aim for ‘micro’ and ‘macro’ flexibility while providing basic support to workers - Let automatic stabilizers work (e.g. unemployment insurance benefits) - Too focused on flexibility, not enough on support to workers -- Too much protection, kills dynamism of labor markets (Other) Structural Policies: Product markets - Avoid excessive regulation; ensure competition; privatization - Be cognizant of state of economy when introducing reforms - Gets rids of regulation that protects workers & consumers -- Throttles business, particularly small and medium enterprises.

Other economic indicators of interest Main indicator of interest: Real income per person (a.k.a. real GDP per capita or real output per capita) Other economic indicators: Unemployment rate Inflation rate Interest rate Exchange rate

Indicator Long Run Short Run Unemployment - Called ‘natural rate of unemployment’ - Depends on institutions & policies - Generally related to the cycle in incomes - Relationship is called Okun’s Law Inflation - Depends on institutions and policies - Often related to difference between growth in money supply and income (or output) growth; relationship is called the ‘Quantity Theory of Money’ - Many central bank set an ‘inflation target’ for the medium- to long run - Can be related to cycle in incomes - Relationship is called Phillips Curve - Phillips Curve has ‘flattened’ in recent years Interest Rate - Depends on balance between saving and investment - Distinction between ‘nominal’ and ‘real’ interest rates - Nominal interest rate = real interest rate + expected inflation (Fisher equation) - Called the neutral rate (r*) - Can be influenced by actions of the central bank - Central banks set interest rate targets based on output gaps and inflation gaps (Taylor Rule) Output gap = difference between output and trend Inflation gap = difference between inflation and target Exchange Rates - Related to long-run difference in incomes (productivity) – the Balassa-Samuelson effect - Related to movements in interest rates (interest rate parity)

Link between jobs and growth

Krugman on Unemployment: July 9, 2011   “Why is unemployment remaining high? Because growth is weak — period, full stop, end of story. Historically, low or negative growth has meant rising unemployment, fast growth falling unemployment (Okun’s Law).” Paul Krugman, The Fatalist Temptation, July 9, 2011

Debate in the Blogosphere: Krugman vs. Karabell   “Why is unemployment remaining high? Because growth is weak — period, full stop, end of story. Historically, low or negative growth has meant rising unemployment, fast growth falling unemployment (Okun’s Law). “ Paul Krugman, July 9, 2011 Jobs Aren’t Coming Back “this is a new problem for the United States in the modern era” “Everyone now alive has only a memory of employment being a cyclical issue, and with every downturn since the middle of the 20th century, unemployment spiked with recession and then recovered as growth resumed. No longer.” Zachary Karabell, The Daily Beast, July 9, 2011

Debate in the Blogosphere: Karabell on Unemployment [Why] Jobs Aren’t Coming Back, July 9, 2011 First of all, it’s clear that companies can make a lot of money with no need for extra bodies. Second, we don’t live in a simple economic system. Some regions are booming (oil states, agricultural states); some are still mired in structural challenges (manufacturing states like Ohio, real-estate bust states like Arizona). We have spent more than $300 billion on unemployment benefits since the recession began because we think that jobs will magically appear as activity picks up and all we have to do is get people through the rough patch. It only makes sense to spend that much on unemployment insurance if it is perceived as temporary or cyclical.

Debate in the Blogosphere: Krugman vs. McKinsey   “There’s no hint in these data that we’ve entered new territory in which decent growth fails to create jobs; the problem is that we haven’t had decent growth.” Paul Krugman, July 9, 2011 “The U.S. jobs challenge today stems from a pattern of jobless recovery that does not conform to the classic cyclical view of recession and recovery. So while healthy GDP growth will be essential [for a return to full employment], it will probably not be sufficient.... it will require major efforts in education, regulation, and even diplomacy.” McKinsey Global Institute, 2011

The Debate in the 1960s: Why was U. S The Debate in the 1960s: Why was U.S. unemployment higher than in Europe? Robert Solow The nature and sources of unemployment in the United States (Wicksell lectures 1964) R. A. Gordon "Has Structural Unemployment Worsened?" Industrial Relations (May, 1964) Lester Thurow "The Changing Structure of Unemployment: An Econometric Study," The Review of Economics and Statistics (May 1965)

Debate since the 1970s … "It takes a heap of Harberger triangles to fill an Okun's gap.” (Tobin, 1977) “There is sometimes the naïve belief that unemployment must be due to a defect in the labor market, as if the hole in a flat tire must always be at the bottom, because that is where the tire is flat” (Solow, 2000). “We impute the higher [European] unemployment to welfare states' diminished ability to cope with more turbulent economic times, such as the ongoing restructuring from manufacturing to the service industry, adoption of new information technologies, and a rapidly changing international economy. “ (Ljungqvist and Sargent, 1998)

Emerging markets & developing countries: Growth Strategies vs Emerging markets & developing countries: Growth Strategies vs. Jobs Strategies Quote from World Bank’s report on “Jobs” (World Development Report 2013) “From a statistical point of view, the relationship between growth and employment (or unemployment) shows substantial variation over time, across countries, and across sectors. In light of this diversity, a given rate of growth does not guarantee a given level of job creation or a given composition of employment.”

Growth Strategies vs. Jobs Strategies Quotes from World Bank’s report on “Jobs” (World Development Report 2013) “These [Okun] elasticities show great variability over time and space, too, making it difficult to forecast net job creation …” “in Tanzania growth elasticities of employment declined from 1.04 in the period 1992–96 to 0.27 in the period 2004–08. Similar trends have been reported for Ethiopia, Ghana, and Mozambique.” “In Latin America, recent estimates show that growth elasticities of employment were much lower during the global financial crisis than in previous crises. In other words, the Great Recession produced comparatively less net employment destruction in that region.”

REVIEW oF Okun’s Law

Okun’s Law and Phillips Curve: in the 1960s, both were visible to the naked eye

U.S. Okun’s Law: then and now

U.S. Phillips Curve: then and now

Guess which of the two relationships macroeconomists think is unstable?

Accusations Against Okun’s Law It’s unstable “An Unstable Okun’s Law, Not the Best Rule of Thumb” (Meyer and Tasci, St. Louis Fed, 2012) It’s dead “The Demise of Okun’s Law” (Robert Gordon, 2011) It broke down during Great Recession April 2010 World Economic Outlook (“Okun’s Law and Beyond”) Recoveries have become “jobless”

Okun’s Law 101 Okun (1962) Textbooks say U.S. coefficient β = –0.5. “Levels” version: Ut – Ut* = β (Yt – Yt *) + εt, β < 0, “Changes” version: ΔUt = α + β ΔYt + ωt Textbooks say U.S. coefficient β = –0.5.

A Review of “Regressions” Regressions: Why Are Economists Obsessed with Them? http://www.imf.org/external/pubs/ft/fandd/2006/03/basics.htm

Deriving Okun’s Law (1) Et – Et* = γ (Yt – Yt *) + ηt γ > 0   (2) Ut – Ut* = δ (Et – Et *) + μt δ < 0 We expect γ < 1.5 (labor as quasi-fixed factor) We expect |δ| <1 (procyclical labor force participation) (3) Ut – Ut* = β (Yt – Yt *) + εt β < 0 β = γδ, |β|<1.5, and εt = μt + δ ηt.

Estimating Okun’s Law (3) Ut – Ut* = β (Yt – Yt *) + εt β < 0 We usually measure Ut* and Yt * with HP filter. Several tests of robustness With HP Alternate values of HP smoothing parameter Addressing end-point problem Without HP Use of forecast errors Use alternate measures of Ut* and Yt * (e.g. for U.S., CBO measures) Use of “changes” specification (4) ΔUt = α + β ΔYt + ωt , holds if U * and ΔY * constant.