1. Copyright SDA Bocconi 2004 1 MBA34 Managerial Excellence – 1° Term Business cycles and stabilization policies Class 17 The firm and its environment Francesco Giavazzi

2. Copyright SDA Bocconi 2004 2 Class outline  Definitions  Facts  Scope for stabilization policies

3. Copyright SDA Bocconi 2004 3 Definition: business cycles Actual GDP data mix up two parts, permanent and transient  Permanent GDP = potential GDP or output  Lecture 1, 2 and 3 on growth are about growth of potential GDP  Transient part is business cycle component of GDP. Expansions and recessions around path of potential GDP Same for unemployment. Actual rate of unemployment fluctuates around the Natural Rate of Unemployment (NRU)

4. Copyright SDA Bocconi 2004 4 Definition: the “output gap” Output gap - a synthetic measure of fluctuations = (GDP-GDP potential ) / GDP potential  If output gap positive, economy overheated, inflation mounting  if output gap negative, economy working at less than full capacity, inflation cooling down When economy in recession, “output gap” gets smaller. It may still be positive though. See next

5. Copyright SDA Bocconi 2004 5 Output gaps in practice Output gaps in the US and the Euro area move together. But swings in the US economy usually come before (  1 year) and are sharper than those in the EU

6. Copyright SDA Bocconi 2004 6 Computing the output gap on the flip side of your business card Output gap t  output gap t-1 + (actual growth t – potential growth t ) Euro area2005200620072008 Actual GDP growth 1.72.92.61.7 Potential GDP growth 2.12.02.12.0 Output gap-1.6-2.0-1.1-0.6

7. Copyright SDA Bocconi 2004 7 Definition: Okun’s law Over the cycle: GDP and unemployment co-vary negatively. Need rule of thumb to translate U rate above or below its natural rate in terms of output gap. Okun’s law is such rule of thumb Okun’s law: Any extra % point of actual unemployment corresponds to 2 % points of output gap (1:2 relation) An empirical regularity. With a rationale  GDP fluctuates more than U. Why?  As GDP falls, labor hoarding; as GDP rises, overtime  In both cases, changes in U lag behind changes in GDP

8. Copyright SDA Bocconi 2004 8 Reminder: what is a “recession” Business cycle: alternating expansions and recessions. What is a “recession”? Oft-cited definition: GDP growth <0 over two consecutive quarters  Not very useful: sequence of quarterly GDP growth of - 2%, +0.01%, -2%, +0.01 would not be a recession, although the yearly number would be sharply negative Common practice -- business cycle dating committees look at broad set of variables (GDP, industrial production, total employment, retail sales)

9. Copyright SDA Bocconi 2004 9 Business cycle facts Expansions last longer than recessions aa Recessions are sharper than expansions bb GDP is less volatile in rich countries

10. Copyright SDA Bocconi 2004 10 Real GDP volatility: Germany vs. Peru

11. Copyright SDA Bocconi 2004 11 Business cycle and stabilization policies What can govt do to affect the level of GDP over the cycle? Can Govts stabilize growth of actual GDP? Answer: to some extent yes, but at a cost

12. Copyright SDA Bocconi 2004 12 What can Govts do in a recession? Governments want high GDP and low inflation In a recession GDP is low. Inflation low or high, depending on what caused the recession in the first instance

13. Copyright SDA Bocconi 2004 13 When recession caused by  demand, low GDP and low inflation Price Level Real GDP AD AS P0P0 Y0Y0 Y1Y1 P1P1 LRAS Government responds by increasing demand Increase G Decrease T Increase M

14. Copyright SDA Bocconi 2004 14 When recession caused by  supply, low GDP and high inflation Price Level Real GDP AD AS P0P0 Y0Y0 LRAS If Gov’t responds by increasing demand Maxi increase in price, GDP back to potential

15. Copyright SDA Bocconi 2004 15 How to read supply and demand shocks in the data: the US in the 1990s 1990s: GDP up & inflation down, symptom of positive supply shock 2001-02: both GDP & inflation down, symptom of negative demand shock US economy 1991-931994-961997-002001-02 GDP growth 2.43.24.21.3 inflation3.22.72.61.7

16. Copyright SDA Bocconi 2004 16 Back to main question -- what can Govts do in a recession? Plausibly, in the short run, only AD can be shifted Through fiscal policy (  G or  T) or monetary policy (  discount rate). In both cases AD shifts to the right Results?  GDP but  P as well  To have  GDP,  inflation to be tolerated  Hence, at most, only one goal at a time By raising AD in recession (and reducing it in booms), stabilizing effect of policy on GDP

17. Copyright SDA Bocconi 2004 17 More extensive use of stabilization (“Keynesian”) policies may explain lengthened expansions and shortened contractions after WWII

18. Copyright SDA Bocconi 2004 18 Arguments against stabilization policies Uncertainty Policy Lags Problems with Fiscal Policy (Ricardian Equivalence) Longer discussion postponed to classes on fiscal and monetary policy

19. Copyright SDA Bocconi 2004 19 Can Govts accelerate GDP growth indefinitely by raising AD? Suppose GDP at its potential and U = natural rate. But elections very close and Govt badly wants higher GDP now Idea: expand AD (e.g. cut taxes)  AD to the right, P up. GDP up & U down Great? Only temporarily, at most GDP gains don’t’ last, for workers raise wage claims upwards. Then real labor costs up, GDP down, U up. Back to long-run equilibrium (same GDP but inflation higher).

20. Copyright SDA Bocconi 2004 20 The Phillips curve GDP-inflation dilemma can be rephrased in terms of inflation and unemployment  As GDP up, U temporarily down and inflation up  As GDP down, U temporarily up and inflation down  The negative relation between inflation and unemployment is the “Phillips curve” (PC)  as with GDP and inflation, the inflation- unemployment dilemma is there in the short run (SR-PC), not in the long run (vertical LR-PC)

21. Copyright SDA Bocconi 2004 21 Conclusions on business cycles and stabilization policies Business cycles are costly  Govts can do something to smooth recessions, but stabilizing GDP is not a free lunch. It comes at the cost of higher inflation  Govts can’t make the economy grow indefinitely faster by AD policies only  AS policies needed too  encouraging technical change and K accumulation is key for long-run growth

22. Copyright SDA Bocconi 2004 22 Expansions last longer than recessions aa

23. Copyright SDA Bocconi 2004 23 Recessions are sharper bb