Download Business cycle fluctuations – Part I

Understanding the World Economy
Master in Economics and Business
Business cycle fluctuations – Part I
Nicolas Coeurdacier
Lecture 6
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Lecture 6 : Business cycle fluctuations – Part I
1. Definitions
2. Business cycle facts
3. What is driving the cycle?
What is the business cycle?
Two slightly different views:
A) Conventional view is that the business cycle describes
medium term fluctuations in the level of economic activity
(GDP) around a long term trend.
B) An alternative view is that the business cycle refers to the
way in which activity is bunched over time, whereby the
economy oscillates between periods of high and low
production.
The second definition is more general as it does not define
business cycles as relative to a trend.
18000
US Real GDP level: do you see the business cycle?
16000
14000
12000
Real GDP (Billions of 2009 dollars)
Potential Real GDP
10000
8000
6000
4000
2000
2003
2005
2007
2009
2011
2013
1947
1948
1950
1952
1954
1956
1958
1959
1961
1963
1965
1967
1969
1970
1972
1974
1976
1978
1980
1981
1983
1985
1987
1989
1991
1992
1994
1996
1998
2000
2002
0
Source: BEA
Output gap
The output gap is the difference between the trend level of output
and actual output:
GDP level = GDP trend + (GDP level – GDP trend)
(GDP level – GDP trend) = Output Gap
Some problems :
1. get your definition of the trend wrong then also get business
cycle wrong.
2. timing of booms and recessions sensitive to exact choice of trend.
3. trend output itself may fluctuate (technology).
Output gap and trend output
(GDP level – GDP trend) = Output Gap
How to compute the trend?
• Parametric trend
Linear trend or linear + quadratic trend, eventually with breaks.
• Filtering
For instance, keep medium (and high) ‘frequencies’ for business cycle
fluctuations. Low frequencies for trend fluctuations.
Issue: what if the ‘business cycle is the trend’? Long-run fluctuations
with highly persistent shocks.
US business cycle fluctuations
(% deviations from trend)
Source: Federal Reserve Economic Data
US business cycle fluctuations
(Annual % Change Real GDP)
Source: Federal Reserve Economic Data
Output gaps across countries (1990-2014)
deviation of actual GDP from potential GDP (% of potential GDP)
6
4
2
0
-2
-4
France
Japan
United Kingdom
United States
-6
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
Source: OECD
Business cycle vocabulary
Business cycle vocabulary
Pro/counter cyclical
(a): pro-cyclical variable x
= positive correlation between
x and y (output gap) along the
business cycle
(a): counter-cyclical variable x
= negative correlation between
x and y (output gap) along the
business cycle
Dating business cycles
• Classical approach (Burns and Mitchell, 1946, adopted by NBER and
CEPR)
• Identify local max and min of selected series and then use judgement
to determine peaks and troughs of unobserved ``state of the
economy’’.
• Duration: number of quarter from peak to trough in a recession or
from trough to the next peak in an expansion.
• Amplitude: the % change in real GDP from peak to trough in a
recession, or from trough to the next peak in an expansion.
Dating business cycles
• GDP measured with error and large revisions. Other
variables co-move with GDP (see later): joint analysis should
give accurate estimate of state of the economy.
• NBER uses monthly variables beside GDP: industrial
production, sales, income, employment. CEPR does the
same, but more emphasis on quarterly variables.
• NBER and CEPR do not define a recession in terms of two
consecutive quarters of decline in real GDP. Rather, a
recession is a significant decline in economic activity spread
across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment,
industrial production, and wholesale-retail sales.
Dating recessions
3.5
3.0
US recession
EU recession
2.5
Recession in both
US GDP
EU GDP
2.0
1.5
1.0
0.5
CEPR and NBER dating (1970-2010)
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
0.0
Lecture 6 : Business cycle fluctuations – Part I
1. Definitions
2. Business cycle facts
3. What is driving the cycle?
Comovements
• The business cycle is an aggregate phenomena.
• Key thing about the business cycle is comovement.
• The business cycle is reflected in all of the major
macroeconomic variables i.e GDP, consumption, investment,
unemployment, etc….
• The majority of sectors are doing well/badly simultaneously.
• Comovements across regions in a given country (and across
countries as shown in the next lecture) of main aggregate
variables.
Business cycle and employment
• Employment co-move positively with the business cycle.
• US correlation of employment (hours) and output gap ≈ 0.9
• In demand driven expansions, labour demand increases and
so does employment. What about wages?
• In supply driven (think productivity) expansions, if wages
increase, so does labour supply (if upward sloping).
Employment should increase.
• What happens if wages and prices do not adjust
immediately?
Employment and business cycles
Real Wage
w/p
(short run)
Employment
If labour supply
labour demand
upward sloping in the short-run, increase in
triggers an increase in employment.
U.S. Output Gap and unemployment (1948-2010)
%
10
Unemployment Rate
8
6
4
2
0
-2
Output Gap
-4
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
1951
1948
-6
Output gap and unemployment: Okun’s law
Unemployment rate= c - d*(output gap) with c>0 and d>0
Unemployment
when output gap > 0
(i.e when output potential > actual output)
If output gap = 0, unemployment rate = c = natural rate
Or:
% change unemployment = c - d* % change output
US 1961-2011: c= 1.30, d= 0.39
Cyclical unemployment (%)
Okun’s Law in the U.S. (1949Q1-2009Q4)
If output gap = 0, unemployment at its natural rate. When output gap increases,
unemployment falls.
Annual percentage change in employment
across selected sectors during the last U.S. recessions
10
July 1990 - March 1991
March 2001 - Nov. 2001
Dec. 2007 - June 2009
5
0
-5
-10
-15
Construction
Manufacturing
Retail trade
Professional &
business services
Financial
activities
Education and
health services
Source: BLS
US Annual % Change of GDP (Expenditure Components)
40
%
Gross domestic product
Personal consumption expenditures
Gross private domestic investment
Government consumption expenditures and gross investment
30
20
10
0
-10
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
-20
Fluctuations in real consumption and real GDP in the U.S. (2000-2015)
6%
Real annual growth rate of consumption
4%
2%
0%
-2%
-4%
Real annual growth rate of GDP
-6%
2015q1
2014q1
2013q1
2012q1
2011q1
2010q1
2009q1
2008q1
2007q1
2006q1
2005q1
2004q1
2003q1
2002q1
2001q1
2000q1
6%
20%
Real annual growth rate of consumption
15%
4%
10%
2%
5%
0%
-2%
-4%
0%
-5%
Real growth rate of non-durable consumption
-10%
Real growth rate of consumption of services
-15%
Real growth rate of durable consumption [right-scale]
-6%
Source: BEA
-20%
Business cycle moments
U.S. business cycle moments. Quarterly data 1948Q1-2010Q4. HP filtered series
Source: Eric Sims, 2011
Alabama
Alaska
Arizona
California
Colorada
Connecticut
Delaware
District of Colombia
Florida
Georgia
Hawaii
Idaho
Illinois
Indiana
Iowa
Kansas
Kentucky
Louisana
Maine
Maryland
Massachussets
Michigan
Minneapolis
Mississippi
Missouri
Montana
Nebraska
Nevada
New Hampshire
New Jersey
New Mexico
New York
North Carolina
North Dakota
Ohio
Oklahoma
Oregon
Pennsylvania
Rhodes Island
South Carolina
South Dakota
Tennessee
Texas
Utah
Vermont
Virginia
Washington
West Virginia
Wisconsin
Wyoming
Output correlation across U.S States 1980-2000
1,0
0,8
0,6
0,4
0,2
0,0
Business cycle facts I
Describe what “typically” happens but every recession/expansion tend to
be slightly different.
1. Consumption varies less than GDP. High in expansions and low in
recessions. Durable consumption often very volatile while non-durable
and service goods consumption (which dominate) are smooth. Why?
Savings and dis-savings allow to smooth consumption.
2. Investment is very volatile (2/3 times more volatile than output) and
highly procyclical. Why? If consumption less volatile than GDP,
investment must be more volatile! Savings are procyclical (and so is
investment)
3. Total input of labour almost as volatile as output and very procyclical.
High in expansion and low in recessions as explained previously. Note
that fluctuations in hours are due more to fluctuations in
(un)employment than to fluctuations in average hours/person.
Business cycle facts II
4. Real wages typically much smoother than output (and employment).
Wage rigidities? Or strong response of labour supply?
5. All domestic expenditures variables very procyclical except
government spendings (especially so if government runs contracyclical
policies). In the data G is nearly acyclical.
6. Sectors differ in their exposure to the business cycle. The
construction industry is heavily exposed to the investment cycle.
Manufacturing industry is exposed to fluctuations in trade, investment
and productivity. Services are more stable than manufacturing and
construction with public services the least cyclical as they are not
exposed to the market.
The business cycle in real time
Identifying business cycles is important information for the
public. However, high quality data become available only with a
delay – nobody knows exactly what current GDP is – due both
to revisions and to delay in data collection.
For that reason leading and co-incident indicators are valuable:
Leading indicators: Indicators that have predictive power for
business cycle turning points and phases.
Co-incident indicators: Indicators that have predictive power
for current state of the economy.
What are the U.S. Leading Indicators?
1.
Average weekly hours, manufacturing
2.
Average weekly initial claims for unemployment insurance
3.
Manufacturers' new orders, cons goods and materials
4.
Vendor performance, slower deliveries diffusion index
5.
Manufacturers' new orders, nondefense capital goods
6.
Building permits, new private housing units
7.
Stock prices, 500 common stocks
8.
Money supply, M2
9.
Interest rate spread, 10-year Treasury bonds less federal funds
Labor market
Production
Investment
Monetary
conditions
Expectations
10. Index of consumer expectations
Leading Economic Index (1962-2015)
Source: Conference-Board
Lecture 6 : Business cycle fluctuations – Part I
1. Definitions
2. Business cycle facts
3. What is driving the cycle?
Understanding the business cycle
• A core macroeconomic model is that of aggregate supply and
demand with dynamically optimizing agents and firms.
• Here offers a ‘simplistic & static’ view of the business cycle in
terms of fluctuations in supply and demand.
•Health warning : this is a very simple model which
immediately provides some analytical insights into the
business cycle. Treat with care - In reality supply and demand
very interconnected and business cycle crucially driven not
just by current prices but expectations of future events. Here,
for simplicity, we keep the future as given, in particular future
prices.
What is aggregate demand?
• Aggregate demand is the expenditure on goods and services
produced in an economy
• It is made up of (remind lecture 1):
- Consumers’ expenditure
- Investment (business, government and housing)
- Government consumption of goods and services
- Exports less imports (net trade)
Y=C+I+G+X-M
Aggregate demand shocks
Aggregate Demand can therefore increase because:
• People want to spend more of given income (e.g
conspicuous consumption of 1920s and 1980s). Also when
they feel wealthier due to booming asset prices.
• Entrepreneurs feel more buoyant and want to invest
more without changes in interest rates (“animal spirits”)
• Government increases expenditure or announces tax
cuts.
•Overseas demand increases for domestically produced
goods.
•Supply of money increases. Why?
Aggregate Demand
Price
Demand Shock = for a given price
consumer can buy more and Aggregate
Demand Curve shifts out.
Output
What is aggregate supply?
• In our analysis of output in the growth model, we
showed that what mattered for supply was the capital
stock (human and physical), the labour force,
technology and various socio-cultural factors.
• Therefore output did not depend on the price level but
real factors and so the long run aggregate supply curve
is vertical - output does not change with prices.
• Then, in the long run increases in aggregate demand
just produce higher prices and no change in output - not
a good business cycle model.
Long-run effect of a shift in aggregate demand
Prices
Long Run Aggregate Supply
Aggregate Demand increases
Output
What is aggregate supply?
• When firms face rise in demand they can either increase output and
sales or raise prices. Raises the issue - how do firms set prices?
• Standard theory says that prices are set as a mark up over marginal
costs (cost of producing extra unit of output).
• Economists propose two sets of arguments over why prices may not
rise in response to stronger demand (or at least only partially such
that output fluctuates)
- Real rigidities - the idea here is that marginal costs do not change
much over the business cycle and nor does the mark up firms wish to
charge
- Nominal rigidities - firms have to pay costs (reprinting menus,
catalogues, etc)
Price
Constant marginal cost and mark
up mean price does not change
over cycle.
Price
Rising costs (overtime, etc) or
means upward sloping supply
curve.
Output
Output
Price
No scope for higher output. Prices
adjust fully. Only prices change.
Output
Frequency of Price Changes per Year
40
35
30
25
20
15
10
5
0
More than 125-12
3-4
2
1
0
Source: Survey of U.K. firms
Initial Response to demand increase
Overtime
More Workers
Increase Prices
Increase Capacity
Increase Sub-contractors
Increase delivery lags
Other
0
10
20
30
40
50
60
70
Source: Survey of U.K. firms
The short run equilibrium
Aggregate Demand Curve
Prices
Short Run
Supply Curve
Output
Demand driven cycles
Aggregate Demand Curve
Prices
Expansion
Short Run
Supply Curve
Recession
Output
From short to long run equilibrium
Long Run Supply Curve
Prices
Long run equilibrium
Short Run
Supply Curve
Short run equilibrium
Aggregate Demand Curve
Output
Dynamics after a permanent shock to aggregate demand
[eg. permanent increase in the money supply]
Demand driven cycles
• Changes in demand lead to higher output as firms change output rather than
prices to meet demand.
• In the very short run the increase in demand is met by lowering inventories
rather than increasing output.
• However in the short run firms start to hire more workers/overtime to meet
demand. Employment and output increase.
• Eventually the firm cannot expand output further - capacity constraints, rising
overtime/wages, etc and so raises prices to restrain demand.
• Demand begins to fall and eventually prices rises sufficiently for output to
return to level determined by long run aggregate supply curve.
•Note if the demand shock is only transitory, output goes back to long run
equilibrium without further rise in prices.
Aggregate supply shocks
• Have focused on aggregate demand as a cause of business cycles but
business cycles maybe generated by aggregate supply changes.
• Supply may not increase smoothly, because the process of capital
accumulation is uneven or because technological progress is subject to
shocks.
• Supply can also vary due to other changes in marginal costs of producing
(pressure on wags by unions, costs of intermediary inputs such as
energy…). A typical example is an increase in oil prices.
• Note that there may be shocks to the short-term aggregate supply curve
as well as to aggregate demand (e.g pressure on wages, tax increases).
Supply driven cycles
Aggregate Demand Curve
Prices
Short Run
Supply Curve
Recession
Expansion
Output
Oil shock and aggregate supply
Aggregate Demand Curve
Prices
Rising oil
prices
Short Run
Supply Curve
Recession
Output
An increase in the price of oil means firm is making less profit per unit of output and
so will wish to supply less (rising marginal costs). In other words an increase in oil
prices shifts the aggregate supply curve to the left.
Oil and the business cycle
Oil and the business cycle
Jim Hamilton, Univ. Of California:
Before last recession, evidence is that nine out of ten of post WWII recessions in
the US have been preceded by increase in oil prices
But be careful! price of oil is not exogenous / driven by global demand
difficult to identify an ‘exogenous’ oil shock
Need to look at ‘exogenous ‘disruption of supply to identify the impact of the
shock.
The business cycle and oil
Oil and the (last) ‘Great recession’
Whereas historical oil price shocks were primarily caused by physical
disruptions of supply, the price run-up of 2007-08 was caused by strong
demand confronting stagnating world production.
Hamilton: “although the causes were different, the consequences for the
economy appear to have been very similar to those observed in earlier
episodes, with significant effects on overall consumption spending and
purchases of domestic automobiles in particular. In the absence of those
declines, it is unlikely that we would have characterized the period 2007:Q4 to
2008:Q3 as one of economic recession for the U.S. The experience of 2007-08
should thus be added to the list of recessions to which oil prices appear to have
made a material contribution’’.
Summary
• Business cycles are medium term fluctuations in the economy
between expansions and recessions. Business cycles last
around 6-10 years.
• Business cycle characterised by co-movements across sectors
and aggregate variables. Employment and investment and
investment are very exposed to the business cycle.
• Business cycle fluctuations in output can be caused by
demand and supply shocks.
• Shocks to aggregate demand affect output due to sticky prices
and a non-vertical short-run supply curve.