Intermediate Macro: Business Cycles: Facts & Theory

What are some examples of productivity shocks?

- Technological changes that affect the productivity of capital and labour. - Introduction of new management techniques. - Changes in the availability of raw materials or energy. - Unusually good or unusually bad weather. - Changes in government regulations affecting production.

What is a coincident variable?

A coincident variable is one whose peaks and troughs occur at about the same time as the corresponding peaks and troughs in real GDP.

How do we measure a complete cycle?

A complete cycle is measured from peak to peak or trough to trough.

What is a lagging variable?

A lagging variable is one whose peaks and troughs tend to occur later than the corresponding peaks and troughs in real GDP.

What do RBC economists believe?

According to the RBC economists: - The economy is continuously buffeted by productivity shocks. - Economic expansion is the result of a positive (or beneficial) productivity shock. - Recession is the result of a negative (or adverse) productivity shock.

What is comovement? (properties of business cycles)

Aggregate economic variables often move together in a similar pattern over the business cycles. This property is called comovement.

What does countercyclical mean?

An economic variable that moves in the opposite direction to real GDP over the business cycle is called countercyclical.

What does procyclical mean?

An economic variable that moves in the same direction as real GDP over the business cycle is called procyclical.

Are business cycles alike? (properties of business cycles)

Business cycles are all alike in the sense that they share some common features. These common features are called the business cycle facts.

Are business cycles symmetrical? (properties of business cycles)

Business cycles are often asymmetric: - The downturn (from a peak to a trough) happens within a rather short period of time. - The recovery and the expansion period is long and slow.

What can the observed changes in real GDP be split into?

Long-term growth trend & business cycles

What are productivity shocks?

Productivity shocks are disturbances that affect the production side (or supply side) of the economy. They are also referred to as real shocks or supply shocks.

What are real wages like?

Real wages are mildly procyclical.

What are business cycles?

Repeated episodes of expansions and declines in output.

What are stock prices like?

Stock prices are generally procyclical and leading (stock prices usually fall in advance of a recession).

RBC Summary

The RBC theory predicts that when there is a temporary negative productivity shock: - Full-employment level of output ↓ (recession) - Real wage ↓ - Employment ↓ - Consumption ↓ - Investment ↓ - Real interest rate ↑ - Price level ↑ (inflation)

What is the long-term growth trend?

The changes over a long period of time.

What does acyclical mean?

Variables that do not display a clear pattern over the business cycle is called acyclical.

What three characteristics do we focus on when comparing the business cycle?

We focus on three important characteristics: - The direction in which a variable moves (increase or decrease) when real GDP increases (i.e., correlation with real GDP). - The timing of the peak and the trough. Whether the peak (or trough) of the variable happens before, after or at the same time as the peak (or trough) of the real GDP. - The volatility of a variable comparing to real GDP.

What do we use when describing business cycle facts?

When describing the business cycle facts, we often use real GDP as our benchmark. We then compare the movement of all other economic variables (such as employment, consumption, investment, real wage etc.) to that of real GDP.

What are the components of consumption like?

o All three components of private consumption expenditures are procyclical. o Durable goods consumption is much more volatile than real GDP and the other two components. o Expenditures on services (e.g., transportation, education, healthcare) have a much lower volatility than real GDP and the other two components.

What is a leading variable?

o An economic variable is a leading variable if it tends to move in advance of real GDP. o This means the peaks and troughs of a leading variable occur before the corresponding peaks and troughs in real GDP. o If an economic variable consistently leads the business cycle, then it can be used to forecast the future course of the economy.

Can we predict business cycles? (properties of business cycles)

o Business cycles are recurrent but unpredictable. o Business cycles do not occur at regular, predictable intervals of time (no one knows for sure when they will happen). o They do not last for a fixed or predetermined length of time (once a cycle begins no one knows when it will end).

Temporary Adverse Productivity Shock

o Consider a temporary adverse (or negative) productivity shock. For each unit of labour, the firms now produce fewer units of output. o This shifts the production function relating output and labour down. o Each worker is now less productive so that the MPN curve also shifts down.

What is a contraction or recession? What is a trough?

o Contraction or recession refers to a period of time during which aggregate economic activity is persistently falling. o In the UK, recessions are generally defined as two consecutive quarters of negative growth in real GDP. o If the recession is particularly severe, it becomes a depression. o The low point of the contraction is called a trough.

Employment

o Employment is strongly positively correlated with real GDP. o The turning points in employment tend to lag the turning points in real GDP. o Employment is less volatile than real GDP

What is expansion or boom? What is a peak?

o Expansion or boom refers to a period of time during which aggregate economic activity is persistently growing. o The high point of the expansion is called a peak.

What is the Real Business Cycle Theory?

o How can we explain the comovement between economic variables over the business cycles? What causes business cycles? Many theories of business cycle have been proposed in macroeconomics, the one that we consider is called the real business cycle (RBC) theory. o The RBC theory is first developed by Nobel laureates Edward Prescott and Finn Kydland. o This theory argues that productivity shocks to the economy are the primary cause of business cycles.

What is inflation like?

o Inflation is procyclical but with some lag. o Inflation typically builds during an expansion, peaks slightly after the business cycle peak, and then falls until some time after the business cycle trough is reached.

Private Investment

o Similar to private consumption, private investment is also strongly positively correlated with real GDP. o Investment is a coincident variable. o Investment is much more volatile than real GDP.

Temporary Decrease in z - Step 2: When price adjustment is completed.

o Suppose the economy is in general equilibrium before the shock. The original equilibrium is point E. o In the IS-LM-FE diagram, the reduction in the full-employment level of output is represented by a shift of the FE line to the left. The new general equilibrium is given by point F. o In order to reach point F, price level has to increase. This will shift the LM curve to the left. The increase in price level means that there is inflation. o In the new general equilibrium point, real output is lower than before while the real interest rate is higher than before. o When real output or current income decreases, people will consume less. So consumption should decrease as well. o Since investment is negatively related to real interest rate, the increase in real interest rate would lower investment.

Temporary Adverse Productivity Shock - Labour market after the shock

o Suppose the labour market is in equilibrium before the shock. The equilibrium point is represented by point E. o The negative productivity shock lowered the amount of labour demanded by the firms. This shifts the labour demand curve down and to the left. o The shock is temporary so the expected future real wage is not affected. This means the labour supply curve is not affected. o The equilibrium real wage and employment decrease as a result.

Chronology of US Business Cycles

o The National Bureau of Economic Research (NBER) is a private non-profit economics research organization in the United States. oThe NBER is well known for marking the start and end dates of recession in the United States.

What does the RBC theory predict?

o The RBC theory correctly predicts that real wage, employment, consumption, investment are procyclical. o It predicts that the real interest rate should be countercyclical but data suggest that it should be acyclical. o It also predicts that there should be inflation during periods of recession which is not consistent with the business cycle facts. o Unemployment is ignored in a typical RBC model, so it cannot make any predictions on the cyclical behavior of unemployment.

Temporary Decrease in z

o The full-employment level of output declines because: - The negative supply shock lowers output for every level of employment - The equilibrium level of employment is also lowered. o Hence a negative productivity shock leads to a recession.

Private Consumption Expenditures

o The percentage deviation from trend in real aggregate consumption and in real GDP are highly positively correlated. o In other words, consumption is strongly procyclical. o Consumption is a coincident variable. o Consumption also tends to be less volatile than real GDP.

Unemployment Rate

o Unemployment rate is strongly countercyclical. o Unemployment rate rises sharply in contractions but falls more slowly in expansions (asymmetry).

How do we describe business cycles?

o When describing business cycles, we only consider deviations of economic variables from their long-term trend. o We refer to these deviations as the cyclical component of the economic variables. o Technical note: In most business cycles research, the long-term trend is constructed using the Hodrick-Prescott filter.