business cycle

Prof. Manoj V. Pradhan Business Cycles: Competing Philosophies Department of Economics 2001 SUNY at Stony Brook BUSINESS CYCLES Ever since Economics was first studied in a rigorous framework, there have been attempts to explain the observed performance of the economy. Better understanding of the working of the economy should lead to better understanding of how present and future events will affect the economy and how (if it is at all possible to do so) the economy may be directed towards a course of sustained growth without excessive economic fluctuations. Paradoxically, even as understanding of the working of the economy grew tremendously over the century, the competition among the various explanations (which matured into full-fledged schools of thought) only intensified. Some of the schools of thought that we discuss here have had their day in the sun in the past while some continue to guide macroeconomic thinking today. We will discuss their philosophies while keeping an eye on the waxing and waning of their popularity. Before we get to the schools of thought that compete for explanations of what causes business cycles, it may be worthwhile to see what the fuss is all about. What are the issues that lie behind this great debate that has ensued for decades and promises to continue unabated? Probably the most direct approach to get an insight into the underlying issues is to take a quick look at the ‘stylized facts’ (observations made consistently over a large period of time) of ‘business cycles’ (alternating periods of prosperity and poor performance). Business Cycles: Stylized Facts  The upswings and downswings caused by the business cycle are NOT restricted to a few industries or variables but manifest themselves over the entire economy at the same time. This does not imply that all industries or variables are equally sensitive to the severity of the business cycle. Some industries and variables are more affected than others.  Business cycles follow a familiar pattern: a boom followed by a slowdown followed by a boom and so on. However, the length of time for which a boom or a slowdown persists is not known and cannot be predicted with certainty.  Once either a boom or a slowdown shows up in the economy, it tends to stick around for a while. Thus, the business cycle shows a considerable amount of persistence.  There is no conclusive evidence that the business cycle has become less volatile in the US since World War II.  Observing data on production provides a good idea of the part of the business cycle that the economy is in at the present time. E.g., if production is growing, we can safely infer that GDP is going to grow.  Production of durable goods is MORE sensitive to the business cycle than the production of non-durable goods. Note that this is probably because people buy big-ticket items (usually durable goods) only when they expect to do well personally. Usually, people expect to do well on a personal level when the economy is doing. Thus, when an economy is in a boom, people will expect to do well and will be more willing to make big-ticket purchases. Similarly, when the economy slows down, people don’t expect to do quite as well and they usually end up postponing purchasing durable goods. Thus, the production of durable goods suffers more when the economy isn’t doing too well.  If expenditure on durable goods (which are usually big-ticket items) increases, it usually Spring Schools Prof. Manoj V. Pradhan          indicates that the economy will do well in the near future. The logic here is similar to the earlier argument. Expenditure on durable goods increases when people (businesses and households) are quite sure that they will be fairly well off over the next few years. They don’t mind locking in some money into purchases that will take at least a couple of years to pay off. This positive outlook on the part of businesses and households helps the economy perform better. Also, note that once you’re locked yourself on to a 2-year payment plan for the purchase of a stereo system or a dishwasher or a car, the economy can be assured that you will be shelling out money for the next 2 years. Thus, it is assured of some expenditure for 2 years and that helps performance. Unemployment moves in the opposite direction from GDP movements. When GDP is above Potential GDP, Unemployment is below its Natural Rate. Capacity Utilization moves in the same direction as GDP. When GDP is above Potential, Capacity Utilization is above its 85% ‘comfort zone’. Workers are more productive when the economy is experiencing a boom. Workers aren’t quite as productive when the economy is experiencing a slowdown. The purchasing power of wages of workers increases very slightly when the economy is doing well. This implies that the dollar amount of wages that the worker takes home (nominal wages) increases faster than prices when an economy is in a boom. A decrease in the growth rate of money supply is usually followed by a slowdown in GDP. Note that the role of money supply is extremely controversial and we should be careful not to conclude that the decrease in the growth rate of money supply causes the slowdown in GDP. Inflation is seen to respond to changes in the growth rate of money after a lag. Thus, a decrease in the growth rate of money is followed by a decrease in the inflation rate after a period of time. Economists usually agree on the relationship between money supply and inflation though they disagree vehemently about the relationship between money supply and GDP. A consistent rise in the stock market usually indicates that the economy is going to perform better in the near future. However, this should not be interpreted as a strict rule because the stock market also reacts to the performance of the economy. That is to say, if the stock market gets information that the economy is not doing well, the rising trend of the stock market may well reverse itself. Nominal interest rates increase after the economy begins a boom and they start falling once the economy experiences a slowdown. The behavior of the nominal interest rate has a lot to do with the expected value of inflation. When the economy enters a boom period, people expect prices and inflation to start rising. Since (nominal interest rate) = (real interest rate) + (expected inflation), the nominal interest rate increase as people’s expectation of the inflation rate increase. Large fluctuations in the GDP of large countries affect the GDP of their trading partners. Labyrinth of Relationships These are multiple relationships that we have just outlined. In fact, here’s a test: If you read the list of ‘stylized facts’ above and came away without a clue about how all these ‘facts’ can be explained by a single, consistent theory, CONGRATULATIONS!! You are on the right track. In fact, you’re on the very same track that every economist finds himself/herself. The different schools of thought we’re going to discuss (Classical, Keynesian, etc.) evolved from attempts to create exactly that: a single, consistent theory that explains the multiple relationship between macroeconomic variables. If this theory can explain the relationship between variables, it should also explain the behavior of the economy, the causes of business cycles and possible cures (if any are needed or exist) for business cycles. We now go on to examine the most prominent among Schools Prof. Manoj V. Pradhan these theories. Schools Prof. Manoj V. Pradhan COMPETING PHILOSOPHIES Classical Economics Classical Economics was the first coherent theory put forward to explain the behavior of the economy. Influenced by great minds like Adam Smith, David Ricardo, John Stuart Mills and Joseph Schumpeter, the broad beliefs and principles of the Classical School are:  Markets work perfectly and fulfill their functions of getting buyers and sellers together as well as allocating resources towards the efficient production of goods that society desires.  Prices are fully flexible and move to clear markets of excess demand (in which case prices rise to clear the market) and excess supply (in which case prices fall to clear the market).  Remember that wages are also a kind of price (price for labor) and are also perfectly flexible. Thus, a period of excess supply of labor (what we call Unemployment) cannot persist because wages will fall to get rid of the excess supply.  Given that markets are efficient, there is an extremely limited role for the Government to play. The Government should perform basic functions like national defense, maintaining law & order and ensuring that monopolies and cartels do not exist. Beyond that, the Government should lay its hands off the economy - laissez-faire Keynesian Economics Classical Economics flourished until the onset of the Great Depression. During this period, the economy did not show any tendency to correct itself. Prices and wages were falling but that did not get rid of the economic slowdown or the unemployment problem. Classical economics was in disfavor and there seemed to be no cure in sight. At this juncture, John Maynard Keynes forcefully advocated his doctrine, which was to become a ‘mantra’ among economists of the world for decades. The basic assumptions and principles of Keynesian economics are:  Prices are not flexible. The aggregate price level does not change very easily.  Wages are not flexible either. This is especially true for downward movements in wages. Increases in wages are observed much, much more frequently than decreases.  Given that prices don’t move around too much, excess demand or excess supply may persist in a market for a considerable period of time. Thus, markets don’t always work well.  The performance of the economy is frequently hampered by the lack of expenditure. This is equivalent to the Aggregate Demand curve being too much to the left.  The Government has an extremely important role to play in the performance of the economy. If the performance of the economy is being hampered by a lack of expenditures, the Government can step in and use expansionary fiscal policy (increase G or decrease T or both). The New Classical Revolution Keynesian economics dominated economic thinking till the early 1970’s. At this point in time, Milton Friedman and Robert E. Lucas, Jr. introduced the ‘Monetarist’ model of economics while Edward Prescott and Finn Kydland proposed the ‘Real Business Cycle’ model. Both, the Monetarist and the Real Business Cycle (which we will call RBC from now on) model, are part of the ‘New Classical’ school because they adopt some of the most important foundations of the Classical school of thought, namely: efficient markets and flexible prices. However, the contribution of these schools of thought has been to revolutionize the thinking behind economics. Further, though both belong to the New Classical school, they have large differences in emphasis. Over the last 3 decades, the importance of Monetarists has more or less disintegrated. The only significant impact that Monetarists have made is to make policymakers conscious of the dangers Schools Prof. Manoj V. Pradhan of letting money supply fluctuate too much. The RBC school too has suffered some setbacks recently after enjoying growing popularity among economists across the country (though not comparable to the popularity of Keynesian economics at its height). Many propositions put forward by RBC economists (such as perfectly flexible prices and perfect markets) have lost favor with most economists. However, the RBC school has made at least two significant, surviving contributions to the study of macroeconomics: the use of computational methods and the importance of productivity and real factors in explaining business cycles. Given the criticism faced by RBC economists, they have successfully repackaged themselves as the Dynamic Stochastic General Equilibrium (DSGE/RBC) school of thought. These economists use models that use all sectors of the economy (which explains the ‘general equilibrium’ part), explicitly take account of relationships over time (hence the ‘dynamic’) and incorporate random variations in the variables in the models (i.e., stochastic elements are included). The New Keynesian Resurgence The New Keynesian school of thought reemerged around the 1980’s amidst skepticism. However, it enjoyed the support of some of leading economists and some leading Universities. The New Keynesian school of thought gets its name because its adopts some of the most important principles of the Keynesian school of thought, namely: markets are not efficient and wages or prices are not fully flexible (they are sticky). New Keynesian economists used many of the technical tools developed by New Classical economists. Using these tools, they are able to explain the reasoning behind their propositions that prices and wages are sticky rather than flexible. New Keynesianism evolved because New Classical economics could not provide fully satisfactory explanations for Unemployment. One such basic problem was the New Classical view of Unemployment. With the New Classical assumption that markets cleared and that wages were flexible, there cannot be a situation in which a person cannot find a job if he/she is willing to work at a sufficiently low wage rate. Thus, a decrease in employment must clearly be the result of laborers unwilling to work rather than being unable to find a job. New Keynesians were not pleased with this explanation. According to them, there are several episodes of unemployment which result from firms being unwilling to hire labor even at low wages and workers being unable to find jobs. Thus, New Keynesians advanced theories that explained unemployment as a result of wage stickiness. Similarly, they argued that product prices too were sticky and hence the goods market could not move to equilibrium instantaneously. The basic principals, propositions and policy implications of the New Keynesian school of thought are outline in a table on the next page. Current Situation As of today, almost-comprehensive explanations for the behavior of the economy come from RBC economists as well as New Keynesians. However, neither school has been able to come up with a FULLY satisfactory theory of the working of the economy. Most economists today seem to agree with some (but NOT all) of the propositions that these schools have put forward. In fact, there is a growing list of publications in scholarly journals which carry out ‘cross-fertilizations’. That is to say, many economists are adopting parts of the theories put forward by the RBC school along with parts of theories put forward by New Keynesians. Many RBC economists now align themselves as part of a school which produces Dynamic Stochastic General Equilibrium (DSGE/RBC) models. These models incorporate most of the assumptions of the RBC school. Recently, DSGE/RBC models with price stickiness have shown up in the academic and professional journals. The debate continues… Schools Prof. Manoj V. Pradhan Markets Prices Wages Unemployment MONETARISTS Work well if prices are fully flexible Flexible (but this may not always be the case) Flexible Can persist for a little while but the economy will be able to adjust fairly quickly Frequent changes in money supply due to erratic Monetary Policy. Note that this implies a shift in the AD curve The Demand side (since monetary policy affects the Money Market which is on the Demand side of the economy) Y can deviate from YPOT for some period of time but the economy will adjust to move Y closer to YPOT DSGE/RBC Always work efficiently Always fully flexible Always fully flexible An increase in the number of people without jobs is because workers either have trouble finding jobs which need their skills or don’t want to work Productivity shocks. Examples of these are changes in: technology, labor productivity, oil prices, management strategy, labor union strategy, etc. The Supply side (since productivity shocks affect the cost of production which is on the Supply side of the economy) Y is always equal to YPOT and the increase or decrease in GDP is caused by a movement in YPOT (rather than a deviation of Y from YPOT). Thus, it is the LRAS curve which moves around due to productivity shocks Money Supply has NO effect on GDP. In fact, a change in GDP causes a higher demand for money, higher i and prompts and increase in Money Supply. Thus, a change in GDP causes a change in Money Supply Monetary Policy has no effect on GDP and, anyway, Y is always equal to YPOT NEW KEYNESIANS Don’t work efficiently NOT flexible NOT flexible Can persist for long periods of time and may require help from policy to move back to the Natural rate of Unemployment Unpredictable movements of the AD curve (and sometimes the AS curve) which are NOT caused by monetary of fiscal policy. The Demand side is most important given the importance of the AD curve. However, the AS curve and the Supply side also have a significant role to play Y can deviate from YPOT for significant periods of time. Sometimes, policy is needed to move Y back towards YPOT What causes the business cycle (deviation of Y from YPOT) Which side of the economy is responsible for the business cycle Y compared to YPOT Relationship between Money Supply & GDP A change in Money Supply leads to a change in GDP (given the inside and outside lags) A change in Money Supply causes a change in GDP (given the inside and the outside lag) Does Monetary Policy bring Y closer to YPOT Role of Fiscal Policy NO! Because of the inside and outside lags and the ‘fool in the shower’ paradigm, Monetary Policy moves Y away from YPOT. Thus, Monetary Policy is ‘destabilizing’ Expansionary Fiscal Policy causes an increase in Y YES! Monetary Policy can move Y closer to YPOT. Thus, Monetary policy is ‘stabilizing’ Expansionary Fiscal Policy causes an Expansionary Fiscal Policy causes an increase in Y Schools Prof. Manoj V. Pradhan increase in YPOT Schools Prof. Manoj V. Pradhan Another way to look at the information presented above Are Prices and Wages flexible How quickly does the SRAS adjust to deviations of Y from YPOT Can Y stay away from YPOT from long periods of time Are changes in MS needed to move Y back towards YPOT So, what causes increase/decrease in GDP that we read about? What does that imply about the correlation between changes in MS and Y MONETARISTS Not very flexible but not quite sticky either Fairly quickly since prices and wages are somewhat flexible DSGE/RBC Very flexible Very quickly since prices and wages are very flexible NEW KEYNESIANS Not flexible at all Not quickly at all since prices and wages are not flexible at all Not for very long periods of time since the SRAS adjusts fairly quickly Not really! For 2 reasons: (1) SRAS moves fairly quickly (2) the outside lag means that Monetary Policy may make fluctuations in Y even worse Demand side factors (see table above) which implies the AD curve. Y is almost always close to YPOT since SRAS moves very quickly No! Since the SRAS moves very quickly Changes in MS are responsible for aggravating the business cycle and thus obviously lead to changes in Y Y is always close to YPOT so it must be YPOT that is increasing or decreasing. This implies that it is the SRAS and the LRAS curves that are responsible for the business cycle Changes in MS lead to shifts of the AD curve which has no effect on Y. Thus, it must be changes in Y that lead to changes in MS. Y can stay away from YPOT for long periods of time because the SRAS doesn’t move quickly at all Yes! Since the SRAS doesn’t move quickly at all, Y may need help from Monetary Policy to move back towards YPOT Y can stay away from YPOT due to changes in the AD and/or the SRAS curve while YPOT (and hence the LRAS) remain fairly stable. A change in MS is required to bring Y back to YPOT so changes in MS obviously lead to changes in Y Schools