Economic Fluctuations

1. Economic Fluctuations Tom Longwell University of Minnesota April 19, 2013 Longwell University of Minnesota

2. Goal: Explain Why Economic Output Fluctuates • The main goal for today’s lecture is to lay out some theories for why we observe fluctuations in macro economic variables • This is not a settled question, so we will have a few competing theories • Any credible theory has to be able to explain unemployment • We might also like to explain why some countries have bigger fluctuations than others, and also what determines long they last Longwell University of Minnesota Tom Longwell University of Minnesota

3. Example: Argentina Longwell University of Minnesota Tom Longwell University of Minnesota

4. Example: US Longwell University of Minnesota Tom Longwell University of Minnesota

5. Measuring Fluctuations • We measure fluctuations by breaking the data of interest (GDP, employment, etc.) into two components: trend and cycle • Trend represents the “long-run average” for the variable • Cycle represents deviations from the trend • When the cycle is above the trend, we are in a boom, while the cycle is below the trend when we are in a slump or recession. Longwell University of Minnesota Tom Longwell University of Minnesota

6. Trend Example (US) Longwell University of Minnesota Tom Longwell University of Minnesota

7. Cycle Example (US) Longwell University of Minnesota Tom Longwell University of Minnesota

8. Employment • Note that GDP is not the only economic variable which fluctuates • Employment tends to tightly track GDP • So when GDP is in a slump, employment usually is too • Some variables (leaders) tend to move before GDP • Building permits and the stock market • Other variables (laggards) tend to move after GDP • Average duration of unemployment Longwell University of Minnesota Tom Longwell University of Minnesota

9. Unemployment Example (US) Longwell University of Minnesota Tom Longwell University of Minnesota

10. Explaining Economic Fluctuations • Now that we have a basic idea what the business cycle is, we need to try to explain it (No biggie) • We need to • Explain what economic factors cause it to exist • Explain why booms and slumps can persist • Explain why boons and slumps never last forever Longwell University of Minnesota Tom Longwell University of Minnesota

11. Theories of the Business Cycle • Theories for explaining the business cycle fall into two main camps: • Real Business Cycle Theory, or the Neo-Classical Model • In an RBC model, the business cycle represents real changes in the ability of an economy to produce goods and services • Keynesian models • In Keynesian models, the business cycle is generated by underuse (and sometimes overuse) of productive capacity Longwell University of Minnesota Tom Longwell University of Minnesota

12. Real Business Cycle Models • We will focus our analysis on explanation of recessions • In a Real Business Cycle Model, recessions are caused some fundamental economic object shifts in a bad way • Remember: A recession represents a decrease in the production of goods and services in an economy • Let’s consider a few examples Longwell University of Minnesota Tom Longwell University of Minnesota

13. Real Wage Rate Employment Possibility One: Labor Supply Decreases Recession Labor Supply? Normal Labor Supply E Labor Demand G $30 $25 If the labor supply decreases, less labor is used, thus fewer things are produced. Is this convincing? Longwell University of Minnesota Tom Longwell University of Minnesota

14. Real Wage Rate Employment Possibility One: Labor Supply Decreases Recession Labor Supply? Normal Labor Supply E Labor Demand G $30 $25 Not generally convincing, as instances of mass abandonment of working are rare Longwell University of Minnesota Tom Longwell University of Minnesota

15. Possibility One: Labor Supply Decreases • The Neo-Classical model has a hard time explaining a large shift in labor supply • People generally like stability of employment, not wild changes in their work habits • It’s also hard to explain events like the Great Depression where millions of people wanted to work but couldn’t find employment as being caused by a labor supply decrease Longwell University of Minnesota Tom Longwell University of Minnesota

16. Real Wage Rate Employment Possibility Two: Labor Demand Decreases Labor Supply E Normal Labor Demand Recession Labor Demand? F 20 $25 If labor demand decreases, we also get less labor used, Is this better? Longwell University of Minnesota Tom Longwell University of Minnesota

17. Real Wage Rate Employment Possibility Two: Labor Demand Decreases Labor Supply E Normal Labor Demand Recession Labor Demand? F 20 $25 Sometimes. Can you think of any reasons why employers might suddenly lower their demand for labor? Longwell University of Minnesota Tom Longwell University of Minnesota

18. Possibility Two: Labor Demand Decreases • It is sometimes possible to generate a believable story for a decrease in labor demand • Robots might be used to replace human workers • A new technology may be introduced that makes existing goods or production processes obsolete • Blacksmiths • Handloom weavers • If workers need time to retrain following a shift, labor demand may stay low for some time Longwell University of Minnesota Tom Longwell University of Minnesota

19. Possibility Three: Total Factor Productivity Decreases • Here’s a generalization of example two: • We can model the economy as follows: • Output = f(labor,capital,technology) • For example, Y = Z*K.3*L.7 • Z represents our ability to turn capital and labor into goods and services • TFP could be lowered temporarily by many things • Lack of natural resources (Arab Oil Embargo) • Breakdown of trade agreements (Hawley-Smoot tariff of 1930 and subsequent retaliation) • Low TFP means recession (Can’t make stuff easily) Longwell University of Minnesota Tom Longwell University of Minnesota

20. Grading the RBC Model • Ultimately, the RBC models works part of the time • It does a good job of explaining the 1970s, for example • It can arguably explain the Great Depression (at least why it lasted so long) • It doesn’t do a great job of explaining recent events, amongst other historical recessions • FYI: The RBC model rests of a controversial assumption called efficient markets Longwell University of Minnesota Tom Longwell University of Minnesota

21. Implications of the RBC Model • There are many public policy implications of the RBC model, but they generally boil down to one big one: • The government cannot interfere in the economy to “fix” the business cycle • The government can act to aid people who are harmed by a recession • Such aid will always come at the cost of long run economic growth • Generally speaking, the government should do nothing and let the situation fix itself • The RBC model obeys Says’ Law (Supply creates its own demand) Longwell University of Minnesota Tom Longwell University of Minnesota

22. Problems in the RBC Model • Buried in the RBC model are several problematic assumptions, first noted by Keynes himself • Real wage = marginal disutility of working, always • The real wage is constantly fluctuating due to price changes • Evidence that workers care more about nominal wage • Savings = Investment • The problem here is people may stick their money under their mattress • It’s hard to generate “structural” unemployment Longwell University of Minnesota Tom Longwell University of Minnesota

23. Keynesian Models • The other class of available models are named after the British economist John Maynard Keynes • His big idea is that multiple equilibria are possible in the economy • Some will have more output than others (and thus be better) • In Keynesian models, the government can often improve the equilibrium by using deficit spending • Keynesian models often rely on people repeatedly behaving irrationally from an economic perspective Longwell University of Minnesota Tom Longwell University of Minnesota

24. An Example Keynesian Model • Here is a simple example of a Keynesian model • The economy starts in a good equilibrium • Kim Jong Un threatens to turn California into a nuclear desert • Investors pull their money from Californian businesses • These investors are scared, and hoard their money • California produces fewer goods and services • People lose their jobs and spend less • More businesses cut back, as do investors • Downward spiral Longwell University of Minnesota Tom Longwell University of Minnesota

25. Keynesian Assumptions • The previous model is making some hidden assumptions • The biggest is that desperate workers should lower their wage demands, and investors their rate-of-return demands • Entrepreneurs should then try to take advantage of these cheap inputs • In the Keynesian model, some combination of fear and an inability for prices to adjust prevent this from happening Longwell University of Minnesota Tom Longwell University of Minnesota

26. Grading the Keynesian Model • The Keynesian model usually fits, but it has some problems • It requires people to not learn from their mistakes • It is very hard to write down microeconomic models that generate Keynesian macroeconomic behavior • While the government may be able to profitably interfere in theory, doing an intervention ineptly can do more harm than good, and getting it right is very hard • The Keynesian model breaks Says’ Law (Probably a plus) Longwell University of Minnesota Tom Longwell University of Minnesota

27. The Lucas Critique of Countercyclical Spending • Robert Lucas came up with the following: • To do countercyclical spending, we estimate • Yt+1 = F(Yt,Xt,θ,εt) • X represents “forcing variables”, things that should affect the economy and can be chosen, like tax rates or spending • εt is a random error • θ are parameters to be estimated • Lucas noted that changing government policies will generally change the relationships between Y, X, θ and ε Longwell University of Minnesota Tom Longwell University of Minnesota