FIN 30220: Macroeconomics

FIN 30220: Macroeconomics The Business Cycle

Looking at real GDP over the last 67 years, we should see two basic features in the data $12,129B 2014Q1 Billions of 2000 Dollars The US economy grows over time The US doesn’t grow at a constant rate $1,938B (1947Q1)

The business cycle is a repeated pattern of recessions followed by recoveries Recession (Below Trend Growth) Recovery (Above Trend Growth) GDP Trend (Average growth) Peak Peak “Business Cycle” (deviations from average growth) Trough Time

Once we have identified the trend we can remove it and isolate the business cycle. We end up with a series that looks like this % Deviation From Trend Recovery Recession Peak Peak 0 Trough Time

The United States has had 22 full cycles since 1900. Fed dual mandate established in 1977 Employment Act of 1946 % Deviation from trend Industrial Production Great Depression WWII

Real GDP: 7.5% Real GDP: -4.5% $13,750B Real GDP (2009 dollars) $13,326B The most recent cycle began in Dec. of 2007 $12,746B Dec. 2007 June 2009

June 2009 “Trough” Recession Recovery 2.5% % Deviation from trend GDP The most recent cycle in terms of deviation from trend -2.8% Dec. 2007 “Peak”

Business Cycles all look alike! In the 1930’s, Burns and Mitchell began document a set of remarkably consistent business cycle regularities… Arthur Burns (1904 – 1987) Wesley Mitchell (1874 – 1948) This was reconfirmed by Hodrick/Prescott in the 1980’s… Edward Prescott (1940 - ) Robert Hodrick (1950 -) Nobel Prize 2004 This tells us that the nature of these fluctuation in the economy are independent of institutional factors or country specific issues!!

By “regularities”, we are referring to statistical relationships…. X Procyclical variables move in the same direction as GDP GDP CORR(GDP, X) >0 Time Countercyclical variables move in the opposite direction as GDP GDP CORR(GDP, X) <0 X Time Acyclical variables have no obvious relationship to GDP GDP CORR(GDP, X) =0 X Time

Total Employment is highly procyclical… Peak Employment (% Deviation from Trend) Industrial Production (% Deviation from Trend) Correlation = .77 Trough

The statistical relationship between employment and GDP should be too surprising given that labor is a major input into production. In most economic models, we assume that production is related to three basic inputs: “Is a function of” Real GDP Total hours worked Pro-cyclical CORR(GDP, L) = .77 “Productivity” Total Physical Capital Stock Pro-cyclical CORR(GDP, A) = .78 Acyclical CORR(GDP, K) = 0

Every good or service that is produced is purchased by somebody. This leads to the following accounting identity… Net Exports = Exports - Imports Government Purchases • Consumer Expenditures • Durables • Non-Durables • Services • Business Investment Expenditures • Structures • Equipment • Inventories • Residential Investment The correlation between expenditures and GDP has to be 1 (by definition), but what about the components?

Here’s the consumer… Peak GDP (Deviation from Trend) Trough Correlation = .83

Note that business investment is much more volatile that GDP (i.e. fluctuates more) Peak % Deviation from Trend Trough Correlation = .78

Government purchases are acyclical, but tax revenues are very highly procyclical. Peak % Deviation from Trend Trough Correlation = -.007

During recessions, we buy less from abroad (and they might buy more from us)…hence a countercyclical trade balance Peak GDP (Deviation from Trend) Trade Balance (Difference from Trend Billions of Dollars) Trough Correlation = -.34

Real wages are procyclical….barely! Peak Deviation from Trend Trough Correlation = .12

The fact that wages are procyclical makes sense as well… Productivity is procyclical, so with higher productivity, we are producing more output with any given level of inputs If inputs are producing more output, they should be compensated at higher levels! Further, more production means more income…in particular, more labor income (however, be careful, employment is higher as well) Labor Income + Capital Income

The price level is countercyclical (barely), but…. % Deviation from trend Price % Deviation from trend GDP Correlation = -.18

The growth in prices (the inflation rate) is procyclical Annual Inflation Rate Real GDP (Deviation from Trend) Correlation = .18

The correlation of the real interest rate depends on the behavior of the nominal interest rate and inflation CORR(INF, GDP) = .18 CORR(r, GDP) = -.13

Peak 1 Year Treasury Rate Industrial Production (% Deviation from Trend) Correlation = -.13 Trough

So, we have a set of facts to explain…how do we go about doing this? Methodology: How do you go about modelling the economy? Ideology: How do you believe the world works?

Classical Economics Say's law states that the production of goods creates its own demand. In 1803, John Baptiste Say explained his theory. This view suggests that the key to economic growth is not increasing demand, but increasing production. Adam Smith (1723 – 1790) John Stuart Mill (1806 – 1873) Jean-Baptiste Say (1767 -1832) David Ricardo (1772 – 1823) Thomas Malthus (1766 – 1834) It should be noted that while classical economists were aware of what was called at the time the “Boom Bust cycle”, they weren’t overly concerned about it and focused primarily on microeconomic issues.

The General Theory of Employment, Interest and Money (1936) "I believe myself to be writing a book on economic theory which will largely revolutionize—not I suppose, at once but in the course of the next ten years—the way the world thinks about its economic problems. I can't expect you, or anyone else, to believe this at the present stage. But for myself I don't merely hope what I say,--in my own mind, I'm quite sure." John Maynard Keynes (1883 – 1946) Keynesian Economics is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation. *Note: The Nobel prize in economics was first awarded in 1969. The statutes of the Nobel Foundation stipulate that the prize cannot be awarded posthumously.

Keynesian Macroeconomics…an Example Consider, for simplicity, an economy with no government that does not trade with the rest of the world… Suppose that, investment in this economy increases by $100 The $100 investment generates $100 increase in GDP +$100 +$100 So, what happens next?

Because any production should translate into income, our national income should increase by $100. +$100 +$100 But, an increase in income should effect aggregate consumption* expenditures… Marginal Propensity to Consume The fraction of each additional dollar earned that we spend Autonomous consumption *Keynesian Economics is a “Top Down” approach…rather than looking at individual decisions, the focus is on aggregate variables

So, if national income increases by $100M, consumption should increase … But consumption will add to GDP …. But the increase in GDP should increase national income again which further increases consumption…. This continues on and on and on and on…

So, what’s the end result…. A little mathematical magic here! So, GDP increases by a multiple of the initial increase in investment spending! For example,

Putting it together…. The Keynesian Expenditure Model In the steady State,

The Keynesian Expenditure Model In our example,

The Keynesian Expenditure Model Suppose that GDP is currently $200 1 2 3 200 1032 720 200 Steady State

We end up with a time series that looks like this…. Y 1398 C 1331 1219 1032 720 I

Keynesian Economics and the Case of the Broken Window Suppose that this kid broke the neighbor’s window….the window costs $50 to replace. Should he be punished? Absolutely not! The $50 spent by the neighbor will generate a multiplied effect on income/output in the community…. In our example, MPC is .6 While the neighbor might be out $50, the net benefit to the overall community is $125!!!

So, if investment expenditures rise by $50… $50 $50

Y $125 C $75 Here’s how the transition looks over time… I $50

The paradox of thriftis a paradox of economics, popularized by John Maynard Keynes, though it had been stated as early as 1714 in The Fable of the Bees. The paradox states that if everyone tries to save more money during times of economic recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth.

Now, let’s try something a little more complicated… Marginal Propensity to Consume The fraction of each additional dollar earned that we spend Autonomous consumption We will leave consumption the same… Let’s assume that businesses base investment decisions on past production increases Change in Capital “Accelerator Parameter” Change in GDP

Putting everything together…. In the Steady State, GDP is constant In the steady state, GDP is constant (and, hence, investment is zero)

Let’s Suppose the following Same as before Let the accelerator parameter equal 1 We need two initial values for GDP to get started….

We end up with a time series that looks like this…. 1250 C Y I

Suppose that we see a decline in consumer spending… 250 C Y I

Major problem: Suppose we set the accelerator parameter to a number greater (empirically, it should be around 2) than 1 (empirically, things blow up 1250 Y

Major problem: Suppose we set the accelerator parameter to a number less than 1. 1250 Y

Keynesian Economics Fundamental belief: The economy is demand driven. The business cycle is a result of random fluctuations is spending behavior (“Animal Spirits”) Modelling Strategy: Use macroeconomic data and time series analysis to develop relationships between macroeconomic variables

Problem: If this is true, then GDP should be much more volatile than investment!! Peak % Deviation from Trend Trough Note that business investment is much more volatile that GDP (i.e. fluctuates more)

Problem: Keynesian economics suggests that GDP responds to changes in demand. If demand goes up, where does this extra production come from? If aggregate demand exceeds supply (i.e. we are trying to buy more goods than are available) what happens? • In an open economy, the trade deficit worsens (we get the extra goods from overseas. • In a closed economy, the interest rate rises (higher interest rates should discourage spending) Neither of these effects are mentioned!!!!

Have you ever heard the story about the economist and the NFL? Typical Economist

The moral of the economist and the NFL Where do we get these parameters? They are estimated using regression analysis from past data There is no reason to believe that parameters from the past will remain constant in the future are individuals adjust to ever changing “rules of the game”

"...it is the econometric tradition, or more precisely, the 'theory of economic policy' based on this tradition, which is in need of major revision. More particularly, I shall argue that the features which lead to success in short term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies." ("Econometric Policy Evaluations: A Critique", 1976) Robert Lucas Jr. (1937 - ) Nobel Prize 1995 Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory Friedrich Hayek (1899 - 1992 ) Nobel Prize 1974

FIN 30220: Macroeconomics