1. THE ECONOMY IN THE SHORT RUN
Chapter 13
Introducing
Advanced Macroeconomics:
Growth and business cycles
THE ECONOMY IN THE SHORT RUN 1

2. WHY UNDERSTANDING BUSINESS CYCLES IS IMPORTANT
Recessions bring considerable economic hardship.
Thus understanding business cycles is not only of academic interest.
It may help the economist to offer advice to policy makers on reducing business fluctuations. 2

3. The evolution of GDP in some Western countries

4. Unemployment and political extremism in Germany, 1924-1933

5. DEFINING BUSINESS CYCLES
“Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years; they are not divisible into shorter cycles of similar character with amplitudes approximating their own.” 5

6. DATING BUSINESS CYCLES
The length of the business cycle is measured from trough to trough.
From the figure on the following slide we see that:
Business cycles are far from regular and periodic.
Business cycle expansions have tended to last longer and contractions have on average been shorter after the Second World War. 6

7. US business cycle expansions and contractions

8. MEASURING BUSINESS CYCLES
We need a method for separating the growth trend from the cyclical component of a variable like GDP where is the log of GDP, is the growth trend, and the cyclical component.
(2) 8

9. MEASURING BUSINESS CYCLES
One such method is the Hodrick-Prescott filter. When detrending an economic time series, the growth component is found by minimizing
with respect to all of the .
(3)

10. Real GDP and trend

11. WHAT HAPPENS DURING BUSINESS CYCLES?
Detrending time series with the HP filter, we obtain estimates of the s, which can be used to determine our estimates of the s. We first study the variability in different economic variables during a ’typical’ business cycle:
(4) 11

12. Volatility, UK and USA

13. Volatility, Denmark and Finland

14. Volatility, Belgium and Netherlands

15. WHAT HAPPENS DURING BUSINESS CYCLES?
Stylized business cycle fact 1: Investment is much more volatile over the business cycle than GDP. It is the most volatile component of aggregate demand.
Stylized business cycle fact 2: Foreign trade volumes are typically two to three times as volatile as GDP. 15

16. WHAT HAPPENS DURING BUSINESS CYCLES?
Stylized business cycle fact 3: Employment is considerably less volatile over the business cycle than GDP, typically 60-80% as volatile.

17. WHAT HAPPENS DURING BUSINESS CYCLES?
We now study whether and to what extent the cyclical components of the economic variables move in the same direction as GDP.
(6)

18. Correlation, UK and USA

19. Correlation, Denmark and Finland

20. Correlation, Belgium and Netherlands

21. WHAT HAPPENS DURING BUSINESS CYCLES?
Stylized business cycle fact 4: Private consumption, investment and imports are strongly positively correlated with GDP.
Stylized business cycle fact 5: Employment is procyclical and much more strongly correlated with GDP than real wages and labour productivity. Labour productivity tends to be procyclical, whereas real wages tend to be very weakly correlated with GDP. 21

22. WHAT HAPPENS DURING BUSINESS CYCLES?
Stylized business cycle fact 6: In most countries inflation is positively correlated with GDP, although the correlation is not very strong.
Stylized business cycle fact 7: Employment is a lagging variable; inflation and nominal interest rates also tend to be lagging variables. 22

23. WHAT HAPPENS DURING BUSINESS CYCLES?
Last but not least, we want to study the degree of persistence in the economic variables. That is, we compute the coefficient of autocorrelation
for different values of n.

24. Autocorrelation, UK and USA

25. Autocorrelation, Denmark and Finland25

26. Autocorrelation, Belgium and Netherlands

27. WHAT HAPPENS DURING BUSINESS CYCLES?
Stylized business cycle fact 8: There is considerable persistence in GDP and about the same degree of persistence in private consumption.
Stylized business cycle fact 9: Employment tends to be even more persistent than GDP. 27

28. THE PRODUCTION FUNCTION APPROACH
A way to estimate the output gap which makes use of the concept of an aggregate production function:
And the following definition of total working hours:
(7)
(8)

29. THE PRODUCTION FUNCTION APPROACH
Inserting (7) in (8) yields:
Suppose that the above variables fluctuate around som long-run trend values. Trend output can then be written as (capital is fully utilized):
(9)
(10)

30. THE PRODUCTION FUNCTION APPROACH
Taking logs on both sides of (9) and (10), and subtracting one from the other, yields:
An estimate and decomposition of (11) for annual US data yields:
(11)

31. The US output gap and its components estimated by the production function method

32. THE PRODUCTION FUNCTION APPROACH
Stylized business cycle fact 10: Total labour input varies in a strong procyclical manner, explaining most of the variation in the output gap. Total factor productivity, TFP, also varies procyclically and the cyclical component of TFP accounts for a large fraction of the total output gap at business cycle peaks and troughs.
Stylized business cycle fact 11: Most of the cyclical variation in total labour input stems from fluctuations in cyclical unemployment, but average working hours, and to some extent the total labour force, also vary procyclically. 32

33. In Chapters 14 through 16 we derive the aggregate demand curve.
A LOOK AHEAD
We want to construct an economic model that may explain short-run fluctuations in output, employment and inflation.
In Chapters 14 through 16 we derive the aggregate demand curve.
In Chapter 17 the aggregate supply curve is constructed. 33

34. The last three chapters are dedicated to studying the open economy.
A LOOK AHEAD
We set up the AS-AD model in Chapter 18 and try to reproduce some of the presented stylized facts.
Chapters 19 through 22 extend the basic model in order to analyse the problems of macroeconomic stabilization policy.
The last three chapters are dedicated to studying the open economy. 34