FIN 30220: Macroeconomic Analysis

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

4. 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)

5. 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)

6. 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)

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

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

9. Business Cycles: Stylized Facts The goal of any business cycle model is to explain as many facts as possible

10. 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

11. 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

12. 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

13. 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

14. The capital market reacts next The drop in income relative to wealth causes a decline in savings Wealth is unaffected Drop in Income Non-Labor income is 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

15. 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

16. 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”

17. The drop in the capital stock worsens the recession Drop in capital The drop in the capital stock creates an additional drop in production

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

19. A drop in the capital stock creates expectations of persistent declines in employment which begin to influence investment demand Income continues to fall 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

20. 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.

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

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

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

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

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

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

27. 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

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

29. 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

30. 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?