Real Business Cycles FIN 30220: Macroeconomic Analysis

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

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%. Shaded areas indicate recessions Unemployment Rate

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

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

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)

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 VariableCorrelationLeading/Lagging ConsumptionPro-cyclicalCoincident UnemploymentCountercyclicalCoincident Real WagesPro-cyclicalCoincident Interest RatesPro-cyclicalCoincident ProductivityPro-cyclicalLeading InflationPro-cyclicalLagging 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 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 three possibilities for productivity shocks that hit the economy. Productivity shock Persistence parameter

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

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

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

Expected Future productivity is unaffected Expected Future employment is unaffected Drop in Income Wealth is (relatively) unaffected Non-Labor income is (relatively) 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

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

Let’s take stock … Real WageEmploymentSavingsConsumptionInvestmentReal Interest Rate Productivity Predicted Actual Correlations With GDP We are not generating the correct correlation with interest rates…what if the shock was permanent…

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

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

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

Recall that today’s investment determines tomorrow’s capital stock. 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”

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

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

Drop in capital The drop in the capital stock worsens the recession – labor demand declines further Capital stock declines 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

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

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

Are jobless recoveries the new norm? Look at the change in employment following the last three recessions! Employment (% Deviation from trend)

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?