Investment and Real Business Cycles by fla46398

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									FIN 30220: Macroeconomic
Analysis

   Real Business Cycles
A Complete Business Cycle consists of an expansion and a contraction


                        recession
Peak

       2.00

       1.50

       1.00

       0.50

       0.00
               2000-I               2002-I          2004-I
       -0.50                                                 Trough
       -1.00

       -1.50

       -2.00

                                             Expansion
                                            GDP: Deviations from Trend:1947-2005


   6

   4

   2

   0
                         1955-II




                                                    1966-II




                                                                               1977-II




                                                                                                          1988-II




                                                                                                                                     1999-II
                 1949-

                          1952-




                                            1960-

                                                     1963-




                                                                       1971-

                                                                                1974-




                                                                                                  1982-

                                                                                                           1985-




                                                                                                                             1993-

                                                                                                                                      1996-




                                                                                                                                                        2004-
        1947-I




                                   1958-I




                                                              1969-I




                                                                                         1980-I




                                                                                                                    1991-I




                                                                                                                                               2002-I
   -2

   -4

   -6

   -8

Since WWII, the US has experienced 10 contractions lasting an average
of 10 months (from peak to trough) – 63 months from peak to peak
All business cycles are “alike” in that there are regular relationships
between various macroeconomic statistics

    2.5
                Correlation = .81
     2

    1.5

     1

    0.5

     0
       1990-I   1992-I   1994-I   1996-I   1998-I   2000-I   2002-I   2004-I
   -0.5

     -1

   -1.5

     -2

   -2.5

                                    GDP     Consumption


 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

    2.5                                                                          8
                         Correlation = -.51
      2
                                                                                 7
    1.5
                                                                                 6
      1
                                                                                 5
    0.5

      0                                                                          4
       1990-I   1992-I   1994-I    1996-I    1998-I   2000-I   2002-I   2004-I
    -0.5
                                                                                 3
     -1
                                                                                 2
    -1.5
                                                                                 1
     -2

    -2.5                                                                         0

                                  GDP       Unemployment Rate


Unemployment is one of few counter-cyclical variables (negative correlation)
All business cycles are “alike” in that there are regular relationships
between various macroeconomic statistics

     2.5                                                                        1000
             Correlation = .003
       2
                                                                                800
     1.5

       1                                                                        600

     0.5
                                                                                400
       0
        1990-I   1992-I   1994-I   1996-I   1998-I   2000-I   2002-I   2004-I   200
     -0.5

      -1                                                                        0
     -1.5
                                                                                -200
      -2

     -2.5                                                                       -400

                                       GDP       Deficit

   The deficit is an example of an acyclical variable (zero correlation)
All business cycles are “alike” in that there are regular relationships
between various macroeconomic statistics

     6                                                            5

                                                                  4
     4
                                                                  3
     2                                                            2

                                                                  1
     0
          1980              1988                    1996          0
     -2
                                                                  -1

     -4                                                           -2

                                                                  -3
     -6
                                                                  -4

     -8                                                           -5

                             GDP     Productivity

   Productivity is pro-cyclical and leads the cycle
All business cycles are “alike” in that there are regular relationships
between various macroeconomic statistics

     6                                                            16

     4                                                            14

                                                                  12
     2
                                                                  10
     0
          1980              1988                  1996            8
     -2
                                                                  6
     -4
                                                                  4

     -6                                                           2

     -8                                                           0

                              GDP     Inflation


   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

                                                              Capital markets determine
           Labor markets determine
                                                              Savings, Investment, and
  w        employment and the real

  p
           wage
                                      l s (NLI )
                                                         r    the real interest rate
                                                                                          S W , Y 

       *
 w
 
 p                                                     r*
 


                                      l d ( A, K )                                        I  A' , L'
                                                                                                    S, I
                                                 L                        S, I
                        L*

 Y            Employment determines
              output and income
                                         F ( A, K , L)    Real business cycle theory
Y*                                                        suggest that the business cycle
                                                          is caused my random
                                                          fluctuations in productivity


                        L*
                                               L
  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)

  w
  p                            l s (NLI )
                                                             r                             S W , Y 

       *
 w
 
 p                                                         r*
 


                               l d ( A, K )                                                I  A' , L'
                                                                                                     S, I
                                          L                                  S, I
                   L*
                                              Drop in
                                              productivity
 Y
                                  F ( A, K , L)
Y*

                                                     For a given level of employment and
                                                     capital, production drops

                   L*
                                        L
                At the pre-recession real wage, the demand for labor
                drops due to the productivity decline

  w
  p                      l s (NLI )                 r                       S W , Y 

       *
 w
 
 p                                               r*
                                  Drop in
                                    productivity


                           l d ( A, K )                                     I  A' , L'
                                                                                      S, I
                                    L                              S, I
           L*

 Y
                            F ( A, K , L)
Y*
                                                         The first market to respond
                                                         is the labor market



           L*
                                  L
The drop in labor demand creates excess supply of labor – real wages fall
and employment decreases

  w
  p                      l s (NLI )                r                          S W , Y 

       *
 w
 
 p                                              r*
 


                         l d ( A, K )                                         I  A' , L'
                                                                                        S, I
                                    L                              S, I
                L*                          Drop in
                                            employment

 Y
                            F ( A, K , L)
Y*
                                                         The drop in employment
                                                         creates an additional drop in
                                                         production

               L*
                                  L
  The capital market reacts next               The drop in income
                                                                                  Wealth is      Drop in
                                               relative to wealth causes          unaffected     Income
                                               a decline in savings
  w
  p                       l s (NLI )                    r                                S W , Y 

       *                          Non-Labor                                                        Expected
 w
 
 p
                                  income is
                                                    r   *                                          Future
                                unaffected                                                       productivity
                                                                                                   is unaffected


                          l d ( A, K )                                                    I  A' , L'
                                                                                                    S, I
                                     L                                     S, I
                L*
                                                                                          Expected
                                                                                          Future
 Y                                                                                        employment
                             F ( A, K , L)                                                is unaffected

Y*
                                                            The interest rate will need to
                                                            adjust to equate the new level of
                                                            savings

                L*
                                   L
  The drop in savings creates excess demand for loanable
  funds                                                              Wealth is      Drop in
                                                                     unaffected     Income
  w
  p                      l s (NLI )               r                         S W , Y 

       *                         Non-Labor                                            Expected
 w
 
 p
                                 income is
                                              r   *                                   Future
                               unaffected                                           productivity
                                                                                      is unaffected


                         l d ( A, K )                                        I  A' , L'
                                                                                       S, I
                                    L                         S, I
                L*
                                                                             Expected
                                                                             Future
 Y                                                                           employment
                            F ( A, K , L)                                    is unaffected

Y*
                                                  The real interest rate rises and
                                                  levels of savings and investment
                                                  fall


               L*
                                  L
           Recall that today’s investment determines
           tomorrow’s capital stock.


                Depreciation Rate

         K '  (1   ) K  I

                                Purchases of New
Tomorrow’s
                                Capital
capital stock


        Remaining
        portion of current       If investment falls enough, the capital stock
        capital stock            shrinks – this is what gives the recession
                                 “legs”
 The drop in the capital stock worsens the recession


  w
  p                      l s (NLI )                     r                           S W , Y 

       *
 w
 
 p                                                   r*
 


                          l d ( A, K )                                               I  A' , L'
                                                                                               S, I
                                     L                                S, I
                L*
                                             Drop in
                                             capital
 Y
                             F ( A, K , L)
Y*


                                              The drop in the capital stock creates an
                                              additional drop in production

                L*
                                   L
                Even at the lower wage, a drop in the capital stock
                further depresses labor demand

  w
  p                     l s (NLI )                    r                       S W , Y 

       *
 w
 
 p
                                                  r*
                                       Drop in
                                       capital

                        l d ( A, K )                                           I  A' , L'
                                                                                         S, I
                                   L                                  S, I
           L*

 Y
                           F ( A, K , L)
Y*
                                                       A second labor market
                                                       response further lowers real
                                                       wages and employment –
                                                       production falls further
           L*
                                 L
           A drop in the capital stock creates expectations of persistent declines in
                                                                                                  Income
           employment which begin to influence investment demand
                                                                                                  continues to
                                                                                                  fall
  w
  p                                     l s (NLI )                r                        S W , Y 
                                                                                                    Drop in
 w
       *                                                                                            expected
 
 p                                                             r*                                 future
                                                                                                  employment



                                        l d ( A, K )                                       I  A' , L'
                                                                                                     S, I
                                                   L                                S, I
                           L*

 Y                                                                    A second capital market
                                           F ( A, K , L)              response further lowers
Y*                                                                    savings, and investment –
                                                                      with both investment and
                                                                      savings affected, the
                                                                      interest rate effect is
                                                                      ambiguous
                           L*
                                                 L
 How do we know when we’ve hit rock bottom (i.e. the trough)?


               Falling employment lowers the productivity of capital (labor
  Y            and capital are compliments while a falling capital stock
               raises the productivity of capital (diminishing MPK).
               Eventually, these two effects offset each other.




MPK
                                              MPK


                                              K
          K'            K
The Recession of 1981 is officially dated from July 1981 to November
1982
 4                                                                6

 3                                                                4
 2
                                                                  2
 1
                                                                  0
 0
                                                                  -2
     1981                  1982             1983
-1
                                                                  -4
-2
                                                                  -6
-3

-4                                                                -8

-5                                                                -10

-6                                                                -12

            Productivity     Employment    GDP       Investment
The Recession of 1991 is officially dated from July 1990 to March 1991


 6                                                                   8

                                                                     6
 4
                                                                     4
 2
                                                                     2

 0                                                                   0
     1990       1991          1992         1993          1994
                                                                     -2
-2
                                                                     -4
-4
                                                                     -6

-6                                                                   -8

            Productivity    Employment      GDP       Investment
The most recent recession is officially dated from March 2001 to
November 2001

 8                                                                 6

 6                                                                 4

 4                                                                 2

 2                                                                 0

 0                                                                 -2
     2001        2002        2003          2004         2005
-2                                                                 -4

-4                                                                 -6

-6                                                                 -8

-8                                                                 -10

            Productivity    Employment     GDP       Investment
Are recessions caused by high oil prices?
                                            Recession Dates
Are jobless recoveries the new norm?
 6


 4


 2


 0
      0          4              8           12        16
 -2


 -4


 -6
      Employment (% Deviation from trend)
 -8

                         2001       1991   1981

 Look at the change in employment following the last three recessions!
What was different about the 2001 Recession?

4


2


0
       0              4               8            12        16
-2


-4


-6

           Productivity (% Deviation from trend)
-8

                               2001       1991   1981

     Productivity was actually growing during the 2001 recession!!
As was mentioned earlier, the 2001 recession was different in that it
was almost entirely driven by capital investment rather than
productivity

   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
   Can preference shocks cause recessions?

  w
                       l s (NLI )
                                         r
  p                                                                S Y ,W 


       *
                                         r*
 w
 
 p
 
                        l d ( A, K )                                I  A, L 
                                                                               S, I
               l*               L                       SI

  Y
                         F ( A, K , L)        If recessions are caused by a
 Y*                                           sudden drop in labor supply,
                                              then wages would be
                                              countercyclical (rising during
                                              expansions)

              L*
                               L
     Can preference shocks cause recessions?

 w
                         l s (NLI )
                                           r
 p                                                                    S Y ,W 

       *
 w
 
 p                                       r*
 


                          l d ( A, K )                                 I  A, L 
                                                                                  S, I
                 L*               L                       SI
  Y
                                                If households suddenly lower
                           F ( A, K , L)        consumption expenditures
     *
 Y                                              (increase savings), the drop
                                                in interest rates should trigger
                                                an offsetting rise in
                                                investment spending

                L*
                                 L
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?


                            Haven’t we left something out?

								
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