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).

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

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

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

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

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

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)

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

Example: A Negative supply shock

Example: A negative supply shock

The Recession of 2001

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