Official Master in Economics

Macroeconomics II
Spring term – 2013-2014

Topic I - INTRODUCTION

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The evolution
of GDP in
some Western
countries

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 Formal definition

“Business cycles are a type of fluctuation found in the aggregate

economic activity of nations that organize their work mainly in
business enterprises: a cycle consists of expansions occurring at
about the same time in many economic activities, followed by
similarly general recessions, contractions and revivals which
merge into the expansion phase of the next cycle; this sequence of
changes is recurrent but not periodic; in duration business cycles
vary from more than one year to ten or twelve years; they are not
divisible into shorter cycles of similar character with amplitudes
approximating their own.” By Burns and Mitchell (1946)

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 Nazi vote share

Unemployment rate

Unemployment and political extremism in Germany, 1924-1933

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 WHY UNDERSTANDING BUSINESS CYCLES IS
IMPORTANT

• Recessions bring considerable economic

hardship.

• Thus understanding business cycles is not

only of academic interest.

• It may help the economist to offer advice to

policy makers on reducing business
fluctuations.

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 DATING BUSINESS CYCLES

 The length of the business cycle is measured

from trough to trough.

 From the figure on the following slide we see

that:
– Business cycles are far from regular and
periodic.
– Business cycle expansions have tended to
last longer and contractions have on
average been shorter after the Second
World War.
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US business
cycle
expansions
and
contractions

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 MEASURING BUSINESS CYCLES

• We need a method for separating the growth trend from the cyclical component
of a variable like GDP

where is the log of GDP, is the growth trend, and the cyclical component.

yt  gt  ct (2)
yt gt
ct

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How do we disentangle the two components of y?

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 MEASURING BUSINESS CYCLES
• Hodrick-Prescott filter. When detrending an
economic time series, the growth component
is found by minimizing

T
HP    yt  g t  
2

t 1 (3)
with respect
T 1 to all of the .
   gt 1  gt    gt  gt 1 
2

t 2
gt
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Real GDP
and trend
With HP
filter

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 Detrending time series with the HP filter, we obtain
estimates of the g ts, which can be used to determine our
estimates of the ct s.

Basic Business Cycle Identification Rules

A)A trough must be followed by a peak and

viceversa.
B)Expansion and contraction phases lasts min 2
quarters each.
C)A BC must span min 5 quarters.

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 WHAT HAPPENS DURING BUSINESS CYCLES?

We first study the variability in different

economic variables during a ’typical’
business cycle:

1 T
  xt  x 
2
sX 
T  1 t 1

(4)
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Volatility,

UK and
USA

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Volatility,
Denmark
and Finland

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Volatility,
Belgium
and
Netherlands

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 WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 1:
Investment is much more volatile over the business cycle than GDP.
It is the most volatile component of aggregate demand.

• Stylized business cycle fact 2:

Foreign trade volumes are typically two to three times as volatile as
GDP.

• Stylized business cycle fact 3:

Employment is considerably less volatile over
the business cycle than GDP, typically 60-
80% as volatile.
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 WHAT HAPPENS DURING BUSINESS CYCLES?

We now study whether and to what extent the

cyclical components of the economic variables
move in the same direction as GDP.

x t  x  ct  c 
  xt , ct   T
t 1
T
(6)

x  x   c c
2 2
t t
t 1 t 1

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Correlation,
UK and USA

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Correlation,
Denmark
and Finland

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Correlation,

Belgium
and
Netherlands

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 WHAT HAPPENS DURING BUSINESS CYCLES?

• Stylized business cycle fact 4:

Private consumption, investment and imports are strongly positively correlated
with GDP.

• Stylized business cycle fact 5:

Employment is procyclical and much more strongly correlated with GDP than
real wages and labour productivity. Labour productivity tends to be procyclical,
whereas real wages tend to be very weakly correlated with GDP.

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 WHAT HAPPENS DURING BUSINESS CYCLES?

• Stylized business cycle fact 6:

In most countries inflation is positively correlated with GDP,
although the correlation is not very strong.

• Stylized business cycle fact 7:

Employment is a lagging variable; inflation and nominal interest
rates also tend to be lagging variables.

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 WHAT HAPPENS DURING BUSINESS CYCLES?

Last but not least, we want to study the degree of persistence in the economic variables.
That is, we compute the coefficient of autocorrelation

for different values of n.

  xt , xt  n 

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Autocorrelation,
UK and USA

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Autocorrelation,
Denmark and
Finland

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Autocorrelation,
Belgium and
Netherlands

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 WHAT HAPPENS DURING BUSINESS CYCLES?

• Stylized business cycle fact 8:

There is considerable persistence in GDP and about the
same degree of persistence in private consumption.

• Stylized business cycle fact 9:

Employment tends to be even more persistent than GDP.

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 THE PRODUCTION FUNCTION APPROACH

• A way to estimate the output gap which makes use of the

concept of an aggregate production function:

• And the following

 1definition
Yt  Bt K t Lt , 
0  1
of total working hours:
(7)

Lt  1  ut  N t H t (8)

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 THE PRODUCTION FUNCTION APPROACH

• Inserting (7) in (8) yields:

• Suppose that the above variables fluctuate around som long-run trend values. Trend output can then be written as (capital is fully utilized):
1
Yt  Bt K t 1  ut  N t H t  t 
(9)

1
Yt  Bt K t 1  ut  N t H t  t (10)

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 THE PRODUCTION FUNCTION APPROACH

• Taking logs on both sides of (9) and (10), and subtracting one from the other, yields:

• An estimate and decomposition of (11) for annual US data yields:

yt  yt  ln Bt  ln Bt  1     ln N t  ln N t 
 1     ln H t  ln H t   1    ln ut  ln ut 
(11)

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The US output gap and its
components estimated by
the production function
method

Data is annual. HP-λ=100

in this case.

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 THE PRODUCTION FUNCTION APPROACH

• Stylized business cycle fact 10:

Total labour input varies in a strong procyclical manner, explaining most of the variation in the
output gap. Total factor productivity, TFP, also varies procyclically and the cyclical component
of TFP accounts for a large fraction of the total output gap at business cycle peaks and troughs.

• Stylized business cycle fact 11:

Most of the cyclical variation in total labour input stems from fluctuations in cyclical
unemployment, but average working hours, and to some extent the total labour force, also vary
procyclically.

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International Business Cycles

Rebelo (2005)
International
Business
Cycles
Ambler et al. (2004)

Cross-correlations
are positive (with
very few exceptions)

Corr(y,y*)>corr(z,z*)>
corr(c,c*)
 Five Schools of Thought
• Keynesian Economics (General Theory,
1936). Role of AD and authorities’ power to affect it.
• Monetarism (Friedman, 1960s). AS back to the
fore (AS=Mon. Phillips C., AD:IS-LM) Authorities much smaller role.

• New Classical Economics (Lucas, 1970s).

Effectiveness of authorities tied to rational expectations.

• Real Business Cycle Theory (Prescott,

1980s). Classical view again: fluct due to optimal response of
agents to TFP variations.

• New Keynesian Economics (Bernanke,

Blanchard, Stiglitz, Mankiw, 1970s-80s).
RBC-style models with keynesian assumptions.
 School 1: Keynesian Economics
(General Theory, 1936)
Supply side:
•AS fully determined by factors.
•AS does NOT create its own demand.

Demand side:
•I is exogenous and can suffer from shocks.

•The multiplier accelerator model introduces shocks and generates Frisch-kind-of

business cycles (Frisch, R. 1933, First Nobel prize in economics, 1969. See slide notes).

Criticism:
•Based exclusively on goods market
•Addressed by Hicks with IS-LM and Mundell and Fleming for open eco:
caring about r, sticky prices and XR regime.

Main conclusion:
We should manage demand (both in the short and long run) with policies and we
will be able to sustain permanent increases in Ȳ.

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 School 2: Monetarism
Laidler (1976) kind of model
•Money growth is the only source of fluctuations.

Supply side:
_
• Ȳ and L (long run) linked to supply-side factors
•There’s no Phillips Curve in the long run.
•There’s an accelerationist Phillips Curve: changes in π are linearly related to
output→supply-side relevant again.

Demand side:
•Market forces are efficient

Criticism:
•Dunlop-Tarshis critique applies: counter-cyclical real wages.
•Initially, only frictional u.
• Layard et al. (1991) intro unions to get structural u.
_
h
y
 
No demand side parameters appear!
Main conclusion:
•Accurate timing difficult for authorities: better to establish stable and predictable
policies. 38
 School 3: New Classical Economics
Lucas (1972, 1973) adds rational expectations.

Supply side:
• Producers have imperfect information on P. After some algebra:

 y  P  E P
Authority:
• CB has an imperfect control of m and follows:
  
mt  a   b j mt  j   c j yt  j   d j pt  j  t ,
j 1 j 1 j 1

a, b, c, d policy parameters.
Demand side:
•Quantity theory holds.

Main conclusion:
•Fluct due to mistaken perceptions of relative prices.
•CB policies ineffective because predicted. Keep a stable and predictable m.

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 School 3: New Classical Economics
Criticism:
• Anticipated monetary policy can be effective too
(Mishkin, 1982; Boschen&Grossman, 1982,…)

• Lack of variable persistence: y is white noise!

Addressed by introducing
1. Physical K (Lucas 1975)
2. Employment adjustment costs (Sargent 1979)
3. Inventory investment (Blinder and Fischer 1981)
– They generate serially correlated deviations of y.

• Lucas Critique (general, not only to this literature):

Econometric estimates of policy effects hold
expectations constant, but they are not due to
rational expectations.
 School 3: New Classical Economics
Prove the rationality of these agents. They assume that
Ei  P      pi where  and  are set such that
E  P     pi 
2
is minimized.

To prove rationality we must show that the minimization implies:

1)  1    E  P  and
 p2
2) = 2
 p   2

Try yourself now (using model equations, of course).

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