Real Business Cycles FIN 30220: Macroeconomic Analysis

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

Since WWII, the US has experienced 10 contractions lasting an average of 10 months (from peak to trough) – 63 months from peak to peak

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 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 unaffected Non-Labor income is 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

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

Drop in capital A second labor market response further lowers real wages and employment – production falls further Even at the lower wage, a drop in the capital stock further depresses labor demand

Drop in expected future employment A second capital market response further lowers savings, and investment – with both investment and savings affected, the interest rate effect is ambiguous A drop in the capital stock creates expectations of persistent declines in employment which begin to influence investment demand Income continues to fall

How do we know when we’ve hit rock bottom (i.e. the trough)? Falling employment lowers the productivity of capital (labor and capital are compliments while a falling capital stock raises the productivity of capital (diminishing MPK). Eventually, these two effects offset each other.

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

Are recessions caused by high oil prices? Recession Dates

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

What was different about the 2001 Recession? Productivity was actually growing during the 2001 recession!! Productivity (% Deviation from trend)

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

Can preference shocks cause recessions? If recessions are caused by a sudden drop in labor supply, then wages would be countercyclical (rising during expansions)

Can preference shocks cause recessions? If households suddenly lower consumption expenditures (increase savings), the drop in interest rates should trigger an offsetting rise in investment spending

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? Is it possible to separate technology from capital? Haven’t we left something out?