Real Business Cycles

FIN 30220: Macroeconomic

Analysis
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recession
Expansion
Peak
Trough
A Complete Business Cycle consists of an expansion and a contraction
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Here, we are plotting percentage deviation of GDP from a HP trend
The recessions are pretty easy to spot!
Business Cycle Dates Duration (In Months)
Peak Trough Contraction
(peak to trough)
Expansion
(Previous trough to
this peak)
Cycle
(Peak from previous
peak)
August 1929 March 1933 43 21 34
May 1937 June 1938 13 50 93
Feb 1945 Oct 1945 8 80 93
Nov 1948 Oct 1949 11 37 45
July 1953 May 1954 10 45 56
Aug 1957 April 1958 8 39 49
April 1960 Feb 1961 10 24 32
Dec 1969 Nov 1970 11 106 116
Nov 1973 March 1975 16 36 47
Jan 1980 July 1980 6 58 74
July 1981 Nov 1982 16 12 18
July 1990 March 1991 8 92 108
March 2001 Nov 2001 8 120 128
December 2007 June 2009 18 73 91
Average 13 55 69
The US has had 12 Recessions since the great depression
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12
Jan-57 Jan-67 Jan-77 Jan-87 Jan-97 Jan-07
While the average unemployment rate (excluding recessions) has been
around 5% since 1957, the average unemployment rate during recessionary
periods averages around 7%.
Shaded areas indicate recessions
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A useful rule of thumb is know as Okuns Law. It states that every 1% rise in
unemployment above the natural rate results in a 2.5% drop in GDP
Recession Contraction
(in Months)
Average
Unemployment
Rate
Approximate
Cost (Loss of
real GDP)
Aug 1957 April 1958 8 6.9 $73B
April 1960 Feb 1961 10 6.1 $57B
Dec 1969 Nov 1970 11 5.9 $76B
Nov 1973 March 1975 16 6.7 $244B
Jan 1980 July 1980 6 7.1 $137B
July 1981 Nov 1982 16 9.2 $728B
July 1990 March 1991 8 6.1 $128B
March 2001 Nov 2001 8 5.5 $81B
Average 13 6.8 $191B
Based on the current population, $191B represents approximately $650
per person or $1,300 per worker
Lets look at the behavior of inflation around the business cyclenotice that
inflation tends to decline during recessions and increase during expansions.
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Jan-58 Jan-68 Jan-78 Jan-88 Jan-98
Unemployment Rate Inflation Rate
Recall that average unemployment was around 5%. We call this the Non-
Accelerating Inflation Rate of Unemployment (NAIRU). Its also known as the
Natural rate of unemployment. When unemployment falls below NAIRU,
inflation typically increases.
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Shaded areas indicate recessions
How about interest rates? Here is the return on a 90 Day T-Bill. Interest rates
tend to decline during recessions.
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Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07
10 Year T-Note AAA Bonds
Shaded areas indicate recessions
Lets look at the return to US Treasuries (risk free) vs. Corporate Bonds.
Shaded areas indicate recessions
Here is a plot of the difference between returns to corporate bonds and T-Bills. It
represents the premium paid on assets with default risk. The risk premium tends
to rise during recessions.
Shaded areas indicate recessions
Here is a plot of Treasuries with different maturities. What do you see?
The yield curve shows returns to bonds of varying maturities. Lets
compare the yield curve prior to a recessionary period and compare it
with that following a recession
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90 Day 1 Year 5 Year 10 Year
1981 1983
Lets try again.
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90 Day 1 Year 5 Year 10 Year
1990 1994
And again.
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90 Day 1 Year 5 Year 10 Year
2000 2003
Yield curves tend to flatten out or invert prior to a recession and then
get steeper afterwards
What about stock pricesthis is trickier because stock prices depend
on interest rates as well as corporate profits.
This plot shows a
typical stock market
cycle in relation to a
typical business cycle
indicating points at
which various sectors
tend to out perform the
broader market
Source: Fidelity Investments
All business cycles are alike in that there are regular relationships
between various macroeconomic statistics
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GDP Consumption
Correlation = .81
Consumption is one of many pro-cyclical variables (positive correlation)
All business cycles are alike in that there are regular relationships
between various macroeconomic statistics
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GDP Unemployment Rate
Correlation = -.51
Unemployment is one of few counter-cyclical variables (negative correlation)
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GDP Deficit
Correlation = .003
All business cycles are alike in that there are regular relationships
between various macroeconomic statistics
The deficit is an example of an acyclical variable (zero correlation)
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1980 1988 1996
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GDP Productivity
All business cycles are alike in that there are regular relationships
between various macroeconomic statistics
Productivity is pro-cyclical and leads the cycle
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1980 1988 1996
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GDP Inflation
All business cycles are alike in that there are regular relationships
between various macroeconomic statistics
Inflation is pro-cyclical and lags the cycle
Business Cycles: Stylized Facts
Variable Correlation Leading/Lagging
Consumption Pro-cyclical Coincident
Unemployment Countercyclical Coincident
Real Wages Pro-cyclical Coincident
Interest Rates Pro-cyclical Coincident
Productivity Pro-cyclical Leading
Inflation Pro-cyclical Lagging
The goal of any business cycle model is to explain as many facts
as possible
We have a simple economic model consisting of two markets
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Labor markets determine
employment and the real
wage
Capital markets determine
Savings, Investment, and
the real interest rate
Employment determines
output and income
Real business cycle theory
suggest that the business cycle
is caused my random
fluctuations in productivity
We have developed a model with a labor market and a capital market. Suppose that a random,
temporary, negative productivity shock hits the economy. (Assume no government deficit)
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Drop in
productivity
For a given level of employment and
capital, production drops
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Drop in
productivity
The first market to respond
is the labor market
At the pre-recession real wage, the demand for labor
drops due to the productivity decline
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The drop in employment
creates an additional drop in
production
The drop in labor demand creates excess supply of labor real wages fall
and employment decreases
Drop in
employment
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Expected
Future
productivity
is unaffected
Expected
Future
employment
is unaffected
Drop in
Income
Wealth is
unaffected
Non-Labor
income is
unaffected
The interest rate will need to
adjust to equate the new level of
savings
The capital market reacts next
The drop in income
relative to wealth causes
a decline in savings
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Expected
Future
productivity
is unaffected
Expected
Future
employment
is unaffected
Drop in
Income
Wealth is
unaffected
Non-Labor
income is
unaffected
The real interest rate rises and
levels of savings and investment
fall
The drop in savings creates excess demand for loanable
funds
Recall that todays investment determines
tomorrows capital stock.
I K K + = ) 1 ( ' o
Tomorrows
capital stock
Remaining
portion of current
capital stock
Depreciation Rate
Purchases of New
Capital
If investment falls enough, the capital stock
shrinks this is what gives the recession
legs
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Drop in
capital
The drop in the capital stock creates an
additional drop in production
The drop in the capital stock worsens the recession
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Drop in
capital
A second labor market
response further lowers real
wages and employment
production falls further
Even at the lower wage, a drop in the capital stock
further depresses labor demand
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Drop in
expected
future
employment
A second capital market
response further lowers
savings, and investment
with both investment and
savings affected, the
interest rate effect is
ambiguous
A drop in the capital stock creates expectations of persistent declines in
employment which begin to influence investment demand
Income
continues to
fall
How do we know when weve hit rock bottom (i.e. the trough)?
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MPK
' K
Falling employment lowers the productivity of capital (labor
and capital are compliments while a falling capital stock
raises the productivity of capital (diminishing MPK).
Eventually, these two effects offset each other.
MPK
The Recession of 1981 is officially dated from July 1981 to November
1982
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Productivity Employment GDP Investment
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Productivity Employment GDP Investment
The Recession of 1991 is officially dated from July 1990 to March 1991
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2001 2002 2003 2004 2005
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Productivity Employment GDP Investment
The most recent recession is officially dated from March 2001 to
November 2001
What was different about the 2001 Recession?
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2001 1991 1981
Productivity was actually growing during the 2001 recession!!
Productivity (% Deviation from trend)
Collapse of the stock market
The Dow dropped 30% from its Jan 14, 2000 high of $11,722
The Nasdaq dropped 75% from its March 10, 2000 high of
$5,132
The S&P 500 dropped 45% from its July 17, 2000 high of
$1,517
Y2K/Capital Overhang
A sharp rise in oil prices (oil prices doubled in late 1999)
Enron/Accounting scandals
Terrorism/SARS
As was mentioned earlier, the 2001 recession was different in that it
was almost entirely driven by capital investment rather than
productivity
Are recessions caused by high oil prices?
Recession Dates
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2001 1991 1981
Are jobless recoveries the new norm?
Look at the change in employment following the last three recessions!
Employment (% Deviation from trend)
Can preference shocks cause recessions?
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If recessions are caused by a
sudden drop in labor supply,
then wages would be
countercyclical (rising during
expansions)
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Can preference shocks cause recessions?
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If households suddenly lower
consumption expenditures
(increase savings), the drop
in interest rates should trigger
an offsetting rise in
investment spending
It seems as if random fluctuations to productivity are a good
explanation for business cycles. However, there are a couple
problems
If productivity is the root cause of
business cycles, we would expect a
correlation between productivity and
employment/output to be very close to
1. The actual correlation is around .65
Where do these productivity
fluctuations come from? Is it possible
to separate technology from capital?
Havent we left something out?