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Business Fluctuations and
Forecasting
Week 3
SF Intermediate Economics
Professor McAleese
THE BUSINESS CYCLE WILL NOT DISAPPEAR
….
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
A MORE UPBEAT VIEW ….
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
US 1961-2001
(Real GDP Growth)
8
average growth rate
3.
6
4
2
0
2001
1991
1980\82
1975
-4
1961
-2
JAPAN 1961 - 2001
(Real GDP Growth)
14
12
10
8
6
4
2
0
1993
1983
1971
-4
1965
-2
GERMANY 1961-2001
(Real GDP Growth)
12
10
8
6
4
2
0
-2
1993
1987
1977
-6
1962
-4
UK 1961-2001
(Real GDP Growth)
8
6
4
2
0
2000
-4
1962
-2
OUTLINE
 What are business fluctuations?
 Why do they matter?
 What causes them?
 What can be done about them?
BUSINESS FLUCTUATIONS
Business fluctuations are fluctuations in
aggregate economic activity that are widely
diffused throughout the economy and have
identifiable “peaks” and “troughs”
FLUCTUATIONS  CYCLES
Cyclical Variables
 Pro-cyclical: industrial output, investment
 Counter-cyclical: unemployment rate,
bankruptcies and bad debts
 A-cyclical: health services, staple foods,
primary education
FACTS ABOUT FLUCTUATIONS
 Negative growth infrequent
 Different periodicity
 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
Table 1. Business fluctuations characteristics
US
Canada
Japan
Germany
France
UK
Italy
Spain
Belgium
Netherlands
Ireland
Luxembourg
Recession
Expansion
Total
Duration Total
Duration
change
in
change
in
in output months
in output months
8,672
15
22,512
46
9,195
14
21,330
35
10,095
13
28,878
56
11,373
24
33,708
77
7,862
11
12,350
42
9,810
14
18,445
45
13,742
15
35,491
63
16,529
13
26,353
90
11,417
14
17,323
39
9,247
20
15,408
30
10,641
15
39,219
53
21,821
16
30,362
39
Average
-
11,700
15
25,046
51
Source:M.J. Artis, Z. Kontolemis and D. Osborn, “Classical Business Cycles for G7
and European Countries”, Journal of Business
WHY DO BUSINESS FLUCTUATIONS
MATTER?
 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 up office in 1998, declared his determination to rid
Britain of the boom-bust, stop-go cycle
WHY SHOULD BUSINESS FLUCTUATIONS BE
DISLIKED?
BOOMS
POSITIVE EFFECTS
 Higher incomes and prosperity
 Enables government to implement reforms (tax, social
welfare, deprived communities, environment)
NEGATIVE EFFECTS
 Main problem – they don’t last!
 Downturn causes more disutility than upturn caused
utility
 Inflation leads to haphazard income effects, social
unease
Recessions
POSITIVE EFFECTS
 Structural adjustment and creative
destruction (Schumpeter)
NEGATIVE EFFECTS
 Unemployment (hysteresis)
 Difficulty in re-starting the economy
 Adverse effect on innovation
WHAT CAUSES BUSINESS FLUCTUATIONS?
Intrinsic instability of the free market
 Random external shocks
 Policy-induced shocks
 Private sector demand shocks
 Banking and financial crises
WHY DO SHOCKS LEAD TO FLUCTUATIONS?
Keynesian-type explanations based on:
 Extreme instability of investment
 Multiplier
 Accelerator
 Nominal price and wage rigidities
Recent explanations emphasise:
 Contagion effects
 Propagation mechanisms
WHY HAS AMPLITUDE OF CYCLE FALLEN?
 Size of government
 Tertiary sector (shift in composition of output)
 Automatic stabilisers
 Discretionary fiscal + monetary policy
 Confidence ”thinking makes it so”
MULTIPLIER-ACCELERATOR MODEL
Output determined as follows:
Y=C+I
C = a Y-1 ……….(a)
I = b (Y-1 - Y-2) + I0 (b)
(I0 is 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.
WHAT CAN BE DONE ABOUT BUSINESS FLUCTUATIONS?
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.
2. Establish Best Possible Estimates of Potential GNP
and Derive Reliable, Timely Estimates of Current GNP
 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 procyclical instead of counter-cyclical.
 Solution may be to implement coarse tuning rather than fine-tuning
policies
 Adhere to strict overall guidelines
4. Manage Monetary Policy so that Price Stability is the
Central Objective
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
CONCLUSIONS
Government has on balance diminished the overall
amplitude of fluctuations.
Bad economic policies have created fluctuations in the
past
Policy activism means that the danger of extreme
collapse and boom is diminished. There has been a
permanent raising of the ‘floor’ of the business cycle and
a lowering of the ‘ceiling.’ Policy is difficult because
nobody is quite sure when these ceilings and floors are
near to being reached.
Danger of really serious Japanese-type downturn cannot
be ruled out.
REPEATING HISTORY: IS THE
WORLD ECONOMY
ENTERING INTO A SERIOUS
DOWNTURN?
THINK ABOUT THIS QUESTION
DURING THE NEXT WEEKS –
AND SEE IMF WORLD
ECONOMIC OUTLOOK MAY 2001
(NOW IN LIBRARY)