Business Fluctuations and Forecasting Week 3 SF Intermediate Economics Professor McAleese THE BUSINESS CYCLE WILL NOT DISAPPEAR ….
SF Intermediate Economics
The inevitability of the business cycle, as it used to be called, I take for granted. Good times bring into existence: first, incompetent business executives; second, wrongful government policies; and, third, speculators. Working together, they ensure the eventual bust.
J K Galbraith “Challenges of the New Millennium” Finance and Development December 1999 p 5
It is not enough to assert that since there have always been business cycles there always will be business cycles. Understanding what causes business cycles and how these causes have changed suggests that business cycles will not be as important in the future as they were in the past.
S. Weber “The end of the business cycle” Foreign Affairs July 1997
What are business fluctuations?
Why do they matter?
What causes them?
What can be done about them?
Business fluctuations are fluctuations in aggregate economic activity that are widely diffused throughout the economy and have identifiable “peaks” and “troughs”
Pro-cyclical: industrial output, investment
Counter-cyclical: unemployment rate, bankruptcies and bad debts
A-cyclical: health services, staple foods, primary education
Negative growth infrequent
No evidence of systematic long run cycles
Sustained period of growth followed by relative or absolute downturn
Industrial countries stay 3 times longer in the expansion phase of the cycle then in recession
Even fast growing economies experience cycles
Strong synchronisation (contagion) effects – few cycles “made at home”
Fluctuations have decreased in amplitude in post-war period
Source:M.J. Artis, Z. Kontolemis and D. Osborn, “Classical Business Cycles for G7 and European Countries”, Journal of Business
Growth is generally higher when stability is greater. (Zarnovitz)
People prefer a stable growth path to an unstable, boom-and-bust growth path.
Chancellor of the Exchequer, Gordon Brown, shortly after taking upoffice in 1998, declared his determination to rid Britain of the boom-bust, stop-go cycle
Higher incomes and prosperity
Enables government to implement reforms (tax, social welfare, deprived communities, environment)
Inflation leads to haphazard income effects, social unease
Structural adjustment and creative destruction (Schumpeter)
Difficulty in re-starting the economy
Adverse effect on innovation
Intrinsic instability of the free market
Random external shocks
Private sector demand shocks
Banking and financial crises
Keynesian-type explanations based on:
Extreme instability of investment
Nominal price and wage rigidities
Recent explanations emphasise:
Size of government
Tertiary sector (shift in composition of output)
Discretionary fiscal + monetary policy
Confidence ”thinking makes it so”
Output determined as follows:
Y = C + I
C = aY-1……….(a)
I = b (Y-1 - Y-2) + I0 (b)
(I0is exogenous investment determined by ‘animal spirits’)
Combining (a) and (b), we have
Y = (a + b) Y-1 – b Y-2 + I0
Output is a function of its lagged levels in the two periods. Given plausible parameters, a cyclical behaviour following a rise in I0 can be generated by this model.
1. Study and Understand their Causes:
Not one but many theories of business fluctuations “Business cycle theory reminds is that we do not understand economic fluctuations as well as we would like. Fundamental questions about the economy remain open to dispute. Is the stickiness of wages and prices key to understanding economic fluctuations? Does monetary policy have real effects?” (Mankiw, p. 388)
The problem is that fluctuations are often caused by random shocks. There are many and diverse types of shock and, by definition, all are unpredictable.
Effects of these shocks magnified by propagation mechanisms such as the multiplier and accelerator.
Nominal rigidities in wages and prices explain why these real fluctuations may be prolonged.
To derive potential GNP estimates, careful modelling of the economy needed. This is an on-going exercise.
3. Implement counter-cyclical fiscal policy
Dismal record of many governments’ fiscal policy – often pro- cyclical instead of counter-cyclical.
Solution may be to implement coarse tuning rather than fine-tuning policies
Adhere to strict overall guidelines
Bad monetary policy, and inflation, can be sources, not cures, of business fluctuations because of ‘long and variable’ lags between monetary policy action and its effects on the real economy
5. …. but allow for some counter-cyclical role
Hence only limited scope for counter-cyclical intervention
6. Government can also Help by ‘Talking Down’ Booms and ‘Talking Up’ Recessions
….but such verbal of symbolic interventions are of limited value in practice
Bad economic policies have created fluctuations in the past
THINK ABOUT THIS QUESTION DURING THE NEXT WEEKS – AND SEE IMF WORLD ECONOMIC OUTLOOK MAY 2001 (NOW IN LIBRARY)