MGE 7'1

1

• Session 7 Business Cycles
• Goal Why do we see Booms and Recessions?
• What are Business Cycles?
• What causes Business Cycles?
• Short run vs. Long run in ISLM

Loïc Sadoulet Macroeconomics in a Global
Economy P3 Jan-Feb. 2004
2
Why do we see Booms Recessions?

• Up to now
• Determinants of total output
• Accumulation of production factors (to meet
  aggregate demand)
• Determinants of long-term growth
• Increases in total factor productivity
• How changes in autonomous spending and policy can
  influence total output
• The aggregate demand multiplier effect
• Today Economic fluctuations
• Business Cycles - definition
• What causes Business Cycles?
• Short run vs. Long run in ISLM

3
Economic Fluctuations
4
Economic Fluctuations
5
Difference between GDP and Trend
Negative output gap does not mean recession
just growing slower than trend
6
Business Cycle
7
II. What causes Business Cycles?

• Standard explanation
• Exogenous shocks
• Oil shocks
• Changes in taxes, government exp.
• Changes in monetary policy

• Other explanation
• Endogenous cycles
• Changes in expectations (self-fulfilling
  expectations)

• No unique explanation of business cycles
• Some can be pinned down (oil shocks) others
  hard to identify
• For us, what matters is Demand or Supply
  shock

8
A useful tool Aggregate Demand / Aggregate
Supply

• Analogy to microeconomics
• Good that economy produces GDP
• Inputs labor, capital, TFP
• Who demands the Good (i.e. GDP)
• Customers C I G NX
• Price of good Price level P

9
Aggregate Demand / Supply
Price level(inflation)
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
10
Aggregate Demand / Supply
Price level(inflation)
SRAS
P
Normal inflation(expected)
AD C I G NX
YFE
Output / Income(growth)
Potential GDP(normal)
11
Aggregate Demand / Supply
Price level(inflation)
SRAS
P
2 inflation
AD C I G NX
YFE
Output / Income(growth)
3 growth
12
Why do we get Business Cycles?

• AD shocks (C I G NX)
• Shocks to consumption behavior(consumer
  confidence, )
• Shocks to investment behavior(corporate taxes,)
• Shocks to government spending(elections,)
• Shocks to foreign consumption behavior(devaluatio
  n,)

• AS shocks
• Shocks to prices of inputs (L,K,)(wages,
  devaluation,)
• Shocks to TFP(IT, infrastructure,)

13
Aggregate Demand shocks
Price level(inflation)
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
14
Aggregate Demand shocks
Price level(inflation)
Increase in AD
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
15
Aggregate Demand shocks
Price level(inflation)
Decrease in AD
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
16
Aggregate Supply shocks
Adverse supply shock
Price level(inflation)
SRAS
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
17
Aggregate Supply shocks
Positive supply shock
Price level(inflation)
SRAS
SRAS
P
AD C I G NX
YFE
Output / Income(growth)
18
Economy hit by multitude of AD / AS Shocks
Real GDP
time
19
Why do we get Business Cycles?

• Key Prices are Sticky (i.e. do not adjust
  right away)
• Prices / wages do not responds to every change in
  supply or demand
• Catalogs (menu costs)
• Wages and contracts (timing downward
  rigidity)
• Evidence Less than 50 of businesses change
  prices more than once a year

20
Increase in Aggregate Demand

• Short-run response
• To meet this demand, firms will have to employ
  more labor (or capital)
• Increase wages to attract people who are
  voluntarily unemployed(ie. who did not want to
  work at the current wage)
• Pay overtime to currently employed people
• Short run not all firms can adjust their prices
• Menu costs prices are expensive to change
• Fixed contracts workers cannot ask for
  compensation for inflation
• Result more production (at slightly higher
  inflation)

SOME INFLATION
BUT LIMITED
21
Short-run response to AD shock



Price level

(Inflation)


SRAS
P

ADCIGNX

Output/income

(Growth)

Y
FE


22
Increase in Aggregate Demand

• Long-run response
• Over longer periods, all firms will have printed
  new catalogues, changes prices, negotiated new
  labor contracts
• Prices are fully flexible in the long run!

23
Long run response to AD shock



Price level

(Inflation)

P
LR


SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)

Y
Y
FE

SR

24
How do we know that the economy comes back to
YFE?

• Short answer
• Producing beyond potential output leads to
  overheating gt inflation
• Longer answer
• NAIRU / Natural rate of Unemployment
• Philips Curve and inflation expectations

Well see this next time
25
Response to AD shock




LRAS
Price level

(Inflation)


SRAS
P

ADCIGNX

Output/income

(Growth)

Y
FE

26
Short-run response to AD shock





LRAS
Price level


(Inflation)






SRAS



P
SR



P

ADCIGNX

Output/income

(Growth)

Y
Y
FE

SR

27
Long-run response to AD shock




LRAS
Price level

(Inflation)

P
LR


SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)

Y
Y
FE

SR

28
Response to AS Shock



Price level


LRAS
(Inflation)


SRAS
P

ADCIGNX

Output/income

(Growth)
Y

FE

29
Short-run response to AS Shock



Price level


LRAS
(Inflation)


SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)
Y
Y

FE

SR

30
Long-run response to AS Shock



Price level


LRAS
(Inflation)

• LR response

SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)
Y
Y

FE

SR

31
SUMMARY

• Response to adverse AS shock
• Short-term prices are sticky
• Slight Inflation and fall in output (stagflation)
• Long-term prices adjust
• Wages fall and economy adjusts back to potential
  GDP.

• Response to positive AD shock
• Short-term prices are sticky
• Slight inflation and increase in output
• Long-term prices adjust
• Wages increase and economy adjusts back to
  potential GDP

32
AD shock in ISLM (an increase in G, for example)


(exogenous increase in government spending)



S
Interest

old

rate




DG

r
1




I



Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate




r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
old

old

Balances

P

33
Short-Run response to AD shock in ISLM


(exogenous increase in government spending)


Snew

S
Interest

old

rate

• An increase in G
• leads to a fall in Aggregate Savings
• and raises interest rates on stock market

r


DG

r
1




I



Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate




r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
old

old

Balances

P

34
Short-Run response to AD shock in ISLM


(exogenous increase in government spending)


Snew

S
Interest

old

rate


r


DG

r
1




I



First step interest rate with Y is fixed
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

r


ISnew

r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
old

old

Balances

P

35
Short-Run response to AD shock in ISLM


(exogenous increase in government spending)


Snew

S
Interest

old

rate


r

(2) Lower interest rates in bond market than in
stock market leads to arbitrage
r2

DG

r
1




I



Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

r

r2

ISnew

r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
old

old

Balances

P

36
Short-Run response to AD shock in ISLM


(exogenous increase in government spending)


Snew

S
Interest

old

rate


(3) The flow of funds to the stock market lowers
the interest rate on loanable funds which
stimulates investment a bit
r

r2


r
1




DI
I



Inew
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

r

r2

ISnew

r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
old

old

Balances

P

37
Short-Run response to AD shock in ISLM


(exogenous increase in government spending)


Snew

S
Interest

old

rate


(4) All this leads to higher output
r

r2

• I has fallen (crowding out)
• but aggregate demand multiplier effect

r
1




I



Inew
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

r

r2

ISnew

r
r
1

1

L
(
Y
)

old
IS
old

DY
Output

Real
Ynew
M

Y
old

old

Balances

P

38
AD shock Short-Run Adjustment
New Equilibrium
SSR

S
Interest

old

• higher output
• higher interest rates
• lower private investment
• higher aggregate spending (C G)

rSR


r
1




I



ISR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate


rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

Y
old

old

Balances

P

39
Long run adjustment




LRAS
Price level

(Inflation)

P
LR


SRAS
P
SR

P

ADCIGNX

Output/income

(Growth)

Y
Y
FE

SR

40
AD shock Long-run Adjustment
Long run inflation
SSR

S
Interest

old



rSR


r
1




I



ISR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate


rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

M

Y
old

old

Balances

P

P

LR
41
AD shock Long-run Adjustment
Reduction in real money supply Increases interest
rates (Y is fixed gtLM shifts up)
SSR

S
Interest

old



rSR


r
1




I


LM
LR

ISR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate


rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

M

Y
old

old

Balances

P

P

LR
42
AD shock Long-run Adjustment
SLR
Higher rates in bond market than in loanable
funds market gt arbitrage
SSR

S
Interest

old


rLR

rSR


r
1




I


LM
LR

ISR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

rLR

rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

M

Y
old

old

Balances

P

P

LR
43
AD shock Long-run Adjustment
SLR
Investment falls which leads to a fall in output
SSR

S
Interest

old


rLR

rSR


r
1




I


LM
LR

ISR
ILR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

rLR

rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

M

Y
old

old

Balances

P

P

LR
YLR
44
AD shock Long-run Adjustment Summary
SLR
SSR

S
Interest

old


rLR

rSR


r
1




I


LM
LR

ISR
ILR
Aggregate Savings, Investment

I
old


LM
Interest
Interest
old


rate

rate

rLR

rSR

ISSR

r
r
1

1

(
)

L
Y
SR
L
(
Y
)

old
IS
old

Output

Real
YSR
M

M

Y
old

old

Balances

P

P

LR
YLR
45
In summary, after a positive aggregate demand
shock

• The short run sees
• Higher growth
• Higher inflation
• Higher interest rates
• Some crowding out of private Investment
• Lower unemployment (employment is beyond full
  employment overtime)
• The long run equilibrium has
• Back to full employment (long-term growth)
• Even higher interest rates
• Even higher inflation
• More crowding out of private Investment

46
At home try to do the reaction to an adverse
supply shock
Price level (Inflation)

S
Interest

old

rate


LRAS

SRAS


r
1


P

AD

I




YFE
I
Output/income (Growth)
old


LM
Interest
Interest
old


rate

rate




r
r
1

1

L
(
Y
)

old
IS
old

Output

Real
M

Y
FE

old

Balances

P

47
From Short Run to Long Run

• Lengthy adjustment process leads to cycles in
  economic activity.
• Adjustment of sticky prices
• Falls in real wages (rarely cut eroded by
  inflation)
• Conversion of industries after supply shocks
• Role for stabilization policies can come into
  play
• Expansionary Monetary policy or Fiscal policy to
  reduce the length of recessions
• Contractionary Monetary or Fiscal policy to
  cool the economy

48
Stabilization policy affects mainly AD!

• Monetary policy and fiscal policy influence the
  economy mainly through their role on aggregate
  demand.
• To the extent that interest rates or government
  spending affect aggregate supply through their
  effect on productivity, aggregate supply shifts
  too.
• Confidence in institutions affects how fast an
  economy will react (e.g. Greenspan)

49
Summary Session 7Business Cycles

• Business cycles are created by shocks (aggregate
  demand or aggregate supply shocks) and propagated
  by rigidities in economies (contracts, menu
  costs)
• Business cycles are short-run phenomena
• In long run, prices (output and factor prices)
  adjust and economy returns to full employment
  level.
• Role for monetary policy and fiscal policy to
  speed up adjustment process
• Length and severity of business cycles depend on
• Price rigidities (flexibility of labor contracts,
  ease of changing prices)
• Convertibility of industries
• Confidence in institutions (to do the right
  thing)