Macroeconomic Analysis for Business Cycle by bng58526

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									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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