1. FIN 30220: Macroeconomic Analysis
Real Business Cycles

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

3. Here, we are plotting percentage deviation of GDP from a HP trend
The recessions are pretty easy to spot!

4. While the average unemployment rate (excluding recessions) has been around 5% since 1957, the average unemployment rate during recessionary periods averages around 7%.
Unemployment Rate
Shaded areas indicate recessions

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

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

7. 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)

8. 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)

9. 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
Correlation = .003
The deficit is an example of an acyclical variable (zero correlation)

10. All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
Productivity is pro-cyclical and leads the cycle

11. All business cycles are “alike” in that there are regular relationships between various macroeconomic statistics
Inflation is pro-cyclical and lags the cycle

12. Business Cycles: Stylized Facts
Variable
Correlation
Leading/Lagging
Consumption
Pro-cyclical
Coincident
Unemployment
Countercyclical
Real Wages
Interest Rates
Productivity
Leading
Inflation
Lagging
The goal of any business cycle model is to explain as many facts as possible

13. We have a simple economic model consisting of two markets
Capital markets determine Savings, Investment, and the real interest rate
Labor markets determine employment and the real wage
Employment determines output and income
Real business cycle theory suggest that the business cycle is caused my random fluctuations in productivity

14. We have three possibilities for productivity shocks that hit the economy.
Persistence parameter

15. For a given level of employment and capital, production drops
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

16. 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
Drop in productivity
The first market to respond is the labor market

17. 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
The drop in employment creates an additional drop in production

18. The capital market reacts next
The drop in income relative to wealth causes a decline in savings
Wealth is (relatively) unaffected
Drop in Income
Non-Labor income is (relatively) unaffected
Expected Future productivity is unaffected
Expected Future employment is unaffected
The interest rate will need to adjust to equate the new level of savings

19. The drop in savings creates excess demand for loanable funds
Wealth is unaffected
Drop in Income
Non-Labor income is unaffected
Expected Future productivity is unaffected
Expected Future employment is unaffected
The real interest rate rises and levels of savings and investment fall

20. Let’s take stock … Correlations With GDP + -
Real Wage
Employment
Savings
Consumption
Investment
Real Interest Rate
Productivity
Predicted + -
Actual
We are not generating the correct correlation with interest rates…what if the shock was permanent…

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

22. 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
Now we have interest rates moving in the right direction

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

24. A shock with a little persistence (but not too much persistence) is what we need.
Productivity shock
Persistence parameter
Not enough movement in employment
Just right!
Countercyclical interest rate

25. Recall that today’s investment determines tomorrow’s capital stock.
Depreciation Rate
Purchases of New Capital
Tomorrow’s capital stock
Remaining portion of current capital stock
If investment falls enough, the capital stock shrinks – this is what gives the recession “legs”

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

27. 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.

28. What about savings? Savings depends on expectation of the future..
During the downturn, next years income is always lower than this years…savings increases

29. With lower investment, the capital stock continues to fall
The drop in the capital stock worsens the recession – labor demand declines further
Capital stock declines
Drop in capital
With lower investment, the capital stock continues to fall

30. What about investment?
Eventually, the marginal product of capital starts to rise again.

31. What about savings? Savings depends on expectation of the future..
During the recovery, next years income is always higher than this years…savings decreases

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

33. The capital stock begins to rise, which raises labor demand…
Capital stock declines
Increase in capital
Employment starts to increase!

34. The Recession of 1981 is officially dated from July 1981 to November 1982

35. The Recession of 1991 is officially dated from July 1990 to March 1991

36. The most recent recession is officially dated from March 2001 to November 2001

37. Collapse of the stock market
As was mentioned earlier, the 2001 recession was different in that it was almost entirely driven by capital investment rather than productivity
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

38. Are recessions caused by high oil prices?
Recession Dates

39. 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?