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Macroeconomic Analysis for Business Cycle document sample
Macroeconomic Analysis for Business Cycle document sample
FIN 30220: Macroeconomic Analysis Real Business Cycles A Complete Business Cycle consists of an expansion and a contraction Peak recession Trough Expansion Here, we are plotting percentage deviation of GDP from a HP trend The recessions are pretty easy to spot! The US has had 12 Recessions since the great depression Business Cycle Dates Duration (In Months) Peak Trough Contraction Expansion Cycle (peak to trough) (Previous trough to (Peak from previous this peak) 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 While the average unemployment rate (excluding recessions) has been around 5% since 1957, the average unemployment rate during recessionary periods averages around 7%. Unemployment Rate Shaded areas indicate recessions A useful rule of thumb is know as Okun’s Law. It states that every 1% rise in unemployment above the “natural rate” results in a 2.5% drop in GDP Recession Contraction Average Approximate (in Months) Unemployment Cost (Loss of Rate 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 cycle…notice that inflation tends to decline during recessions and increase during expansions. 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. ??? How about interest rates? Here is the return on a 90 Day T-Bill. Interest rates tend to decline during recessions. 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? Shaded areas indicate recessions 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… Lets try again…. And again…. Yield curves tend to flatten out or invert prior to a recession and then get steeper afterwards What about stock prices…this 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 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 Correlation = -.51 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 Correlation = .003 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 Productivity is pro-cyclical and leads the cycle 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 Capital markets determine Labor markets determine employment and the real Savings, Investment, and wage 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) Drop in productivity For a given level of employment and capital, production drops At the pre-recession real wage, the demand for labor drops due to the productivity decline Drop in productivity The first market to respond is the labor market The drop in labor demand creates excess supply of labor – real wages fall and employment decreases Drop in employment The drop in employment creates an additional drop in production The capital market reacts next The drop in income Wealth is Drop in relative to wealth causes unaffected Income a decline in savings Non-Labor Expected income is Future unaffected productivity is unaffected Expected Future employment is unaffected The interest rate will need to adjust to equate the new level of savings The drop in savings creates excess demand for loanable funds Wealth is Drop in unaffected Income Non-Labor Expected income is Future unaffected productivity is unaffected Expected Future employment is unaffected The real interest rate rises and levels of savings and investment fall Recall that today’s investment determines tomorrow’s capital stock. Depreciation Rate 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 Drop in capital The drop in the capital stock creates an additional drop in production Even at the lower wage, a drop in the capital stock further depresses labor demand Drop in capital A second labor market response further lowers real wages and employment – production falls further A drop in the capital stock creates expectations of persistent declines in Income employment which begin to influence investment demand continues to fall 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 How do we know when we’ve hit rock bottom (i.e. the trough)? 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. The Recession of 1981 is officially dated from July 1981 to November 1982 The Recession of 1991 is officially dated from July 1990 to March 1991 The most recent recession is officially dated from March 2001 to November 2001 What was different about the 2001 Recession? Productivity (% Deviation from trend) 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 Are recessions caused by high oil prices? Recession Dates Are jobless recoveries the new norm? Employment (% Deviation from trend) Look at the change in employment following the last three recessions! Can preference shocks cause recessions? If recessions are caused by a sudden drop in labor supply, then wages would be countercyclical (rising during expansions) Can preference shocks cause recessions? 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? Haven’t we left something out?
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