BUSINESS CYCLES AND GROWTH Chap. 21, 22, 23, 27 & 29.

LONG TERM PROSPERITY Chap Chap ,

Living Standards Headline measure of living standards is GDP per Capita How to compare across countries since GDP data is collected in national currencies. Must convert them into a single measure. Could use exchange rates, but this is volatile and biased.

Exchange Rate Conversion Method

GDP in Intl$ PPP’s are used to construct comparable measures of GDP for multiple countries by converting them into international dollars. Per capita GDP in international dollars is headline way of comparing living standards. World Development Indicators

Conceptually PPP is the cost of the goods purchased by consumers in their country relative to the cost of those same goods in US$ terms. International Comparison Project

World Development Indicators

Developing countries tend to be relatively cheap with PPP’s being lower than exchange rates.

Use real GDP growth rates to construct path of constant price International $GDP for comparisons of production levels across time and space.

GDP per Capita vs. Productivity Per Capita GDP can be broken down into two parts: GDP per Capita = Productivity GDP per Engaged Person Employment Rate Engaged Person per Capita X

Most differences due to Worker Productivity

Determinants of Output per Worker Physical Capital Human Capital Hours per Worker Technology Frontier

Capital Accumulation Capital Productivity: Capital investment is a central part of advancing productivity in developing economy but displays diminishing returns.

BUSINESS CYCLES AND THE DYNAMICS OF GDP Chap , Chap ,

Hong Kong Census & Statistics

Two Impressions 1. GDP Volume is growing over time. 2. Growth is variable. Sometimes fast, sometimes flat, sometimes negative. Decompose the series into two parts which capture each of these phenomena. 1.Potential GDP 2.Output Gap

GDP and Productivity GDP is output per worker times number of workers.

Unemployment Rates The population resides in 1 of 3 categories Not in the Labor Force: Not working and not actively seeking work Labor Force Employed: Currently working. Unemployed: Not working but seeking work. Unemployment Rate

Natural Rate of Unemployment Always people losing or leaving jobs and looking for new ones. Always people joining the labor force. In natural state of labor market, people looking for jobs will match the number of people who find jobs. u N = Natural Rate: Rate at which there is neither excess demand nor supply in labor market. (mostly stable).

Potential Employment and Output Potential employment is the level of employment when unemployment equals the natural rate. Potential output is GDP when employment equals potential employment

HK GDP vs. Estimate of HK Potential GDP Hong Kong Census & Statistics

Recessions and Expansions The path of the economy is often divided into periods called recessions and periods caused expansions. No precise definition of “recession” or “expansion” exists, sometimes as consecutive quarters of growth. Business cycles are defined by the Output Gap, Sometimes the period from peak of the output gap to the trough is a recession and the period when the output gap is increasing is an expansion. US Business Cycle Dates

RecessionExpansion

Output and Unemployment

BUSINESS CYCLES Chap ; Chap. 27, 29 Focus on explaining fluctuations in real GDP, Y, and the GDP Deflator, P. Framework reminiscent of the supply and demand model.

Global Financial Crisis Statistics OECD Why did output fall globally, why so much, and why has it lasted so long?

HK Contraction and Recovery Hong Kong Census & Statistics

SUPPLY

Two Aspects of Potential Output Potential Output is unrelated to the price level but is determined by capital infrastructure, efficiency of labor markets, population, technological know- how. Output increases above potential only if unemployment falls below natural level; if unemployment rises above natural level, output will be below potential.

Potential output and labor market. Potential output can be viewed as a level consistent with equilibrium in labor market. Wages hit a level so workers want to work as many hours as firms want to hire. When output is above potential output, low unemployment and the search for workers will push up wages. When output is below potential, high unemployment and the surplus of workers will push down wages.

P Y Potential Output Upward Pressure on Wages Downward Pressure on Wages YPYP Unemployment below natural rate Unemployment above natural rate

Why does SRAS Slope Up? Take wages as given in Short Run Money wages paid to workers adjust dynamically over time through negotiation. At a given wage, a rise in the price level reduces the cost of labor relative to value of goods produced making hiring labor to produce goods more attractive. At a given wage rate, higher prices induce higher production → in the short run, supply is positively associated with output.

P Y SRAS Short Run Aggregate Supply Curve YPYP

1. Shift in Potential Output Advance in Technology Frontier, PP& E, or expansion in potential labor force (population, demographics). Shifts SRAS w/ potential output. 2. Shifts in SRAS When dollar cost of labor (or prices of energy) shift, changes in costs are passed on into prices. Wages and other cost shifters shift SRAS at a given level potential output.

P Y SRAS 1. Expansion in Output Potential YPYP Y P ' SRAS ' Normal for technological progress to increase potential output.

P Y SRAS 2. Increase in Wages YPYP SRAS '

DEMAND

Two Views Demand: The quantity of real GDP desired for purchase at any level of the GDP deflator. Monetarist View: Demand can be described by liquidity/money Keynesian View: Demand best Viewed as Elements of Expenditure

Quantity Theory Simplest monetary theory is the Quantity Theory of Money. Purchasing power of money is equal to the quantity of money (M t ) times the speed of circulation (V, # of transactions) Purchasing power means # of goods (Y t ) multiplied by price per good (P t ) P t * Y t = Money t * Velocity

P Y AD Aggregate Demand Curve Holding money & velocity constant

MONEY SUPPLY THE STOCK OF THE MEDIUM OF EXCHANGE. Types of Financial Assets M1 Currency in Hands of the Public [C] + Demand Deposits [D] M2 M1 + Savings Deposits + “Small” Time Deposits + [Liquid Money Market Instruments inc/ “Small” NCD’s] M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Japan’s Money Supply

Monetary Aggregates in HK HKMA Monthly Statistical Bulletin

Expenditure: C + I + G + NX Wealth Effect – Real value of liquid/monetary assets rises as prices fall. This adds to wealth of households stimulating consumption. Competitiveness Effect – Holding exchange rate constant, a lower price level makes domestic exports more attractive and foreign imports less stimulating net exports. Prices and Spending For now, hold interest rate and exchange rate constant. Keynesian View: Expenditure constrained not by liquidity but by behavior of purchasers of goods.

P Y AD Aggregate Demand Curve Wealth Effect, Competitiveness Effect

AS-AD MODEL

Equilibrium Equilibrium in the competitive market occurs when the price is set at a level (P*) such that the amount that consumers want to buy is equal to the amount that sellers want to sell (Y*). Excess Supply If P were above equilibrium, sellers would want to sell more goods than buyers would want to buy. Competition between sellers would force prices down. Excess Demand If P were below equilibrium, customers would want to buy more goods than people would want to sell. Competition between buyers would force prices up.

P Y SRAS Equilibrium GDP and Price Level AD P* Y*

P Y SRAS Output below potential: Recessionary Gap. YPYP AD P* 1 Y* GAP

P Y SRAS Output above potential: Inflationary Gap. YPYP AD P* 2 Y* GAP

Self Correction Process Business cycles have a natural end. In short run, Y* may be greater than or less than potential output. However, in that case surplus or shortage of workers in labor markets will be putting downward or upward pressure on wages. Pressure on wage costs will shift the supply curve until equilibrium output is equal to potential output.

P Y AS Movement to Long Term Equilibrium AD YPYP 2 1 W↓W↓ AS 1 AS 2 W↑W↑

Cyclical Fluctuations Period-by-period, different important events will impact the economy. We will think of these events as primarily driving the demand side of the economy (shifting the AD curve) or primarily driving the supply side (shifting the supply side). The strength of these will determine the correspondence between movements in output and inflation.

P Y SRAS Demand side shocks cause output and prices to move together. AD 1 P* Y* AD 2 Y** P** 1 2 Excess Supply

P Y SRAS Output below potential. Downward pressure on wages. Cost of production falls and AS shifts down YPYP AD 2 Y*** P*** 1 2 SRAS 2 Wages fall 3 As costs fall, competitive prices fall, there is a movement along the AD curve.

P Y SRAS 3 Wages will keep falling until the surplus of labor is absorbed – when prices fall enough that demand reaches potential output YPYP AD 2 4 SRAS 2 Wages keep falling 3

What shifts the AD curve? Shift Outward In AD Shift Inward In AD Increasing OptimismIncreasing Pessimism Increasing Value of AssetsFalling Value of Assets Increasing Foreign GDPDecreasing Foreign GDP Expansionary Monetary PolicyContractionary Monetary Policy Expansionary Fiscal Policy Spending Hikes Tax Cuts Contractionary Fiscal Policy Spending Cuts Tax Hikes

P Y SRAS YPYP SRAS ' AD Supply Shocks – Shocks to resource prices or labor relations may shift supply curve. 1 2 Higher Prices, Negative Output Gap Stagflation

AS-AD and Expected inflation Potential GDP generally increases at a consistent rate. On average, aggregate quantity of liquid assets tends to increase faster than potential GDP. Workers wages will tend to rise to match increases in the cost of living. AD does not always rise evenly with GDP.

Rule of Thumb Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

Money and Inflation Assuming stable velocity Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

Money & Inflation:

Dynamics of Stable Policy If the economy’s potential output shifts out by a constant amount on an annual basis…. ….and velocity is constant…. ….then policy-makers can keep inflation and the output gap stable by increasing demand smoothly with potential output. Target inflation becomes expectation.

P Y SRAS t Dynamic AS-AD Model: Stability AD t Yt*Yt* YtPYtP Y P t+1 AD t+1 SRAS t+1 Y* t+1 Pt*Pt* P* t+1 Demand expansion matches supply expansion Average Inflation Ch. 29,

P Y AS t Dynamic AS-AD Model: Inflation Acceleration AD t Yt*Yt* YtPYtP Y P t+1 AD t+1 AS t+1 Y* t+1 Pt*Pt* P* t+1 Gap Demand expands faster than expected Expected Inflation Positive Output Gap Inflation rises more than usual Actual Inflation

Inflation Acceleration: π t – π t-1

P Y AS t Dynamic AS-AD Model: Recession, Inflation Deceleration AD t Yt*Yt* YtPYtP Y P t+1 AD t+1 AS t+1 Y* t+1 Pt*Pt* P* t+1 Expected Inflation Gap Demand expands slower than expected Negative Output Gap Inflation rises less than usual Actual Inflation

Expenditure Side Declining Consumption and Investment in most affected countries (mostly those that received inflows prior to the crisis). Declining net exports for surplus countries.

Link

Learning Outcomes Students should be able to: Define the terminology of business cycles. Calculate unemployment rate with labor data. Calculate the output gap with GDP and potential GDP data.

Learning Outcomes Students should be able to Explain how various events will shift the aggregate supply or demand curves. Construct an aggregate supply and demand model of business cycles and use it to explain equilibrium outcomes. Describe the short-term and long-term dynamics of business cycles.