business cycle course outline
We have now described some facts about business cycles. In the rest of this book our main
goal will be to constmct an economic model which may explain short-mn fluctuations in
aggregate output, employment and inflation. SpeciHcally, we will gradually build up a
model. which may be summarized in the manner depicted in Fig. 14.8. where real output
and the rate or inflation are determined by the intersection of an upward-sloping aggregate
supply curve and a downward-sloping aggregate demand curve. We will then use
this model to study how the economy reacts over time to various sh ocks to the aggregate
supply curve and the aggregate demand curve.
Our goal is to construct a model in which the efl'ects of aggregate demand and supply
shocks tend to persist over time through so-called propagation mechanisrns arising from the
links between central macroeconomic variables. In this view of the world business cycles
are initiated by random shocks to the economy such as an unanticipated change in the oil
price or a change in business confidence due, say, to unexpected political events.
However. the cumulative a11d systematic character of business fluctuations documented in
this chapter will be explained endogenously by the properties of our macroeconomic
model. We hasten to add that we caru1ot promise to explain all the features of business
cycles- economists are still far from having a perfect understanding of this complex phenomenon
-but our model economy will at least have the property that random shocks
tend to generate irregular cycles displaying a certain persistence.
As indicated in Fig. 14.8. the aggregate demand curve and the aggregate supply
curve are the central building blocks of our model. To construct the aggregate demand
curve we must build a theory of private investment and private consumption. This is our
agenda for Chapters 15 and 16. In Chapter 1 7 we combine the insights from Chapters 15
and 16 with a study of monetary policy to derive the aggregate demand curve. Chapter 18
then analyses the relation between inflation and unemployment as a basis for constructing
the aggregate supply curve. This enables us to set up our basic AS -AD model in
Chapter 19 where we use the model to reproduce some of the stylized facts about business
cycles. The subsequent Chapters 20 to 22 extend the basic model in order to analyse the
problems of macroeconomic stabilization policy. In the last four chapters of the book we extend the AS-AD model to the open economy. studying regimes with llxed as well as
flexible exchange rates. and end with a discussion of the choice of exchange rate regime.
1. Business cycles are periods of expansion of aggregate economic activity followed by periods
of contraction in which activity declines. These fluctuations are recurrent but not periodic; in
duration business cycles have varied from a little more than a year to 1 0 - 12 years. The
severity of recessions has also varied considerably, with recessions sometimes turning into
depressions where output and employment fall dramatically.
2. The expansion phase of the business cycle usually lasts considerably longer than the con·
traction phase, reflecting the economy's capacity for long-term growth. In the period since the
Second World War business cycle expansions have tended to last longer, and recessions
have tended to be shorter and milder than was the case before the war. For the post·Second
World War period the average duration of the US business cycle expansions has been
57 months, while recessions have on average lasted 10 months. By contrast, the average
recession lasted about 22 months before the war.
3. The business cycle fluctuation in a macroeconomic time series may be measured as the
deviation of the actual time series from its long·term trer d. The trend may be estimated by
means of the HP filter which allows for smooth changes in the underlying (growth) trend in a
series.
4. The volatility of the cyclical component in a macroeconomic time series may be measured by
its standard deviation. By this measure, investment is a lot more vo latile over the business
cycle than GOP, whereas employment is considerably less volatile.
5. The co-movements in different economic variables over the business cycle may be measured
by their coefficients of correlation with GOP. Private investment, consumption and imports all
have a strong positive correlation with GOP. Employment also displays a clear positive corre·
lation with GOP, but it is a lagging variable, being more strongly correlated with the GOP of
the two previous quarters than with current GOP. Labour productivity tends to vary positively
with GOP, and so does inflation in most countries, although the latter correlation is not very
strong. The nominal short·term interest rate tends to go up in the two quarters following a rise
in GOP, reflecting a tightening of monetary policy.
6. The degree of persistence in a macroeconomic variable may be measured by its coefficients
of correlation with its own lagged values, the so-called coefficients of autocorrelation. There
is considerable persistence in GOP and private consumption, and even more persistence in
employment. This means that once these variables start to move in one direction, they will
continue to move in the same direction for a while, unless they are disturbed by new
significant shocks.
7. The output gap is the percentage difference between actual GOP and trend GOP. The output
gap may be estimated by means of the production function method which allows a decom·
position of the gap into contributions from cyclical variations in unemployment, average working hours, the total labour force, and total factor productivity (TFP). Such a decomposition
shows that fluctuations in TFP - capturing cyclical swings in work intensity and capacity
utilization as well as an uneven pace of technical progress - account for a relatively large
share of the fluctuations in output at business cycle peaks and troughs. The largest part of the
cyclical variation in labour input comes from fluctuations in cyclical unemployment, but
average working hours (and to a minor extent the labour force) also tend to vary positively with
the output gap, reflecting that labour supply tends to increase when there is more work to do.
8. The method of detrending an economic time series by means of the HP filter should be used
with care, because (i) the HP filter gives imprecise estimates of the trend at the end-points of
the time series; (ii) the filter relies on an arbitrary choice of the ,1, -parameter which determines
the smoothness of the estimated trend, and (iii) the HP filter cannot capture structural breaks
in the data series. For these and other reasons there is considerable uncertainty associated
with the measurement of business cycles.
Building blocks of the short run model
the previous chapter showed that private investment is often the most volatile
component of aggregate demand and that it is highly correlated with total output.
Understanding the forces driving private investment is therefore crucial lor understanding
business cycles. In this chapter we present a theory of business investment as
well as a theory of h ousing investment. This will give us an opportunity to study two of the
most important asset markets in the economy: the stock market and the market lor
owner-occupied housing. As we shall see, there is a systematic link between stock prices
and business investment, and a similar systematic impact of housing prices on housing
investment. To w1derstand investment. we must therefore study how asset prices are
formed.
A glance at Fig. 15.1 should make clear why we are interested in asset prices. The
figure is constructed from data for the 16 most important industrial corm tries and shows
the link between the evolution of housing prices and stock prices and the evolution of the
output gap. There is a close relationship betwem asset price.fluctuations and output .fluctuations
and a clear tendency .for stock price movements to lead movements in output. Thus the llgure
suggests that an increase in stock prices or in housing prices will trigger an increase in
economic activity, whereas a signillcant drop in asset prices may be a signal of a future
economic downturn. As we will show in this chapter and the next one, Fig. 15.1 reflects
that higher asset prices tend to stimulate private consumption and investment. In particular,
the present chapter will explain why higher stock prices tend to be followed by
higher business investment, and why higher housing prices provide a boost to housing
investment.
The basic idea underlying our theory of investment may be most easily illustrated by
looking at the housing market. At any point in time there is a certain market price lor
houses of a given size and quality. This price may well exceed the cost of constructing a
new house of similar size and quality (the replacement cost). The more the market price
exceeds the replacement cost. the more prolltable it will be for construction firms to build
and sell new houses. Hence we will observe a higher level of housing investment the
greater the discrepancy between the market price and the replacement cost of housing.
Note that the market price can deviate from the replacement cost for a long time. since it
takes time for new construction to produce a significant increase in the existing housing
goal will be to constmct an economic model which may explain short-mn fluctuations in
aggregate output, employment and inflation. SpeciHcally, we will gradually build up a
model. which may be summarized in the manner depicted in Fig. 14.8. where real output
and the rate or inflation are determined by the intersection of an upward-sloping aggregate
supply curve and a downward-sloping aggregate demand curve. We will then use
this model to study how the economy reacts over time to various sh ocks to the aggregate
supply curve and the aggregate demand curve.
Our goal is to construct a model in which the efl'ects of aggregate demand and supply
shocks tend to persist over time through so-called propagation mechanisrns arising from the
links between central macroeconomic variables. In this view of the world business cycles
are initiated by random shocks to the economy such as an unanticipated change in the oil
price or a change in business confidence due, say, to unexpected political events.
However. the cumulative a11d systematic character of business fluctuations documented in
this chapter will be explained endogenously by the properties of our macroeconomic
model. We hasten to add that we caru1ot promise to explain all the features of business
cycles- economists are still far from having a perfect understanding of this complex phenomenon
-but our model economy will at least have the property that random shocks
tend to generate irregular cycles displaying a certain persistence.
As indicated in Fig. 14.8. the aggregate demand curve and the aggregate supply
curve are the central building blocks of our model. To construct the aggregate demand
curve we must build a theory of private investment and private consumption. This is our
agenda for Chapters 15 and 16. In Chapter 1 7 we combine the insights from Chapters 15
and 16 with a study of monetary policy to derive the aggregate demand curve. Chapter 18
then analyses the relation between inflation and unemployment as a basis for constructing
the aggregate supply curve. This enables us to set up our basic AS -AD model in
Chapter 19 where we use the model to reproduce some of the stylized facts about business
cycles. The subsequent Chapters 20 to 22 extend the basic model in order to analyse the
problems of macroeconomic stabilization policy. In the last four chapters of the book we extend the AS-AD model to the open economy. studying regimes with llxed as well as
flexible exchange rates. and end with a discussion of the choice of exchange rate regime.
1. Business cycles are periods of expansion of aggregate economic activity followed by periods
of contraction in which activity declines. These fluctuations are recurrent but not periodic; in
duration business cycles have varied from a little more than a year to 1 0 - 12 years. The
severity of recessions has also varied considerably, with recessions sometimes turning into
depressions where output and employment fall dramatically.
2. The expansion phase of the business cycle usually lasts considerably longer than the con·
traction phase, reflecting the economy's capacity for long-term growth. In the period since the
Second World War business cycle expansions have tended to last longer, and recessions
have tended to be shorter and milder than was the case before the war. For the post·Second
World War period the average duration of the US business cycle expansions has been
57 months, while recessions have on average lasted 10 months. By contrast, the average
recession lasted about 22 months before the war.
3. The business cycle fluctuation in a macroeconomic time series may be measured as the
deviation of the actual time series from its long·term trer d. The trend may be estimated by
means of the HP filter which allows for smooth changes in the underlying (growth) trend in a
series.
4. The volatility of the cyclical component in a macroeconomic time series may be measured by
its standard deviation. By this measure, investment is a lot more vo latile over the business
cycle than GOP, whereas employment is considerably less volatile.
5. The co-movements in different economic variables over the business cycle may be measured
by their coefficients of correlation with GOP. Private investment, consumption and imports all
have a strong positive correlation with GOP. Employment also displays a clear positive corre·
lation with GOP, but it is a lagging variable, being more strongly correlated with the GOP of
the two previous quarters than with current GOP. Labour productivity tends to vary positively
with GOP, and so does inflation in most countries, although the latter correlation is not very
strong. The nominal short·term interest rate tends to go up in the two quarters following a rise
in GOP, reflecting a tightening of monetary policy.
6. The degree of persistence in a macroeconomic variable may be measured by its coefficients
of correlation with its own lagged values, the so-called coefficients of autocorrelation. There
is considerable persistence in GOP and private consumption, and even more persistence in
employment. This means that once these variables start to move in one direction, they will
continue to move in the same direction for a while, unless they are disturbed by new
significant shocks.
7. The output gap is the percentage difference between actual GOP and trend GOP. The output
gap may be estimated by means of the production function method which allows a decom·
position of the gap into contributions from cyclical variations in unemployment, average working hours, the total labour force, and total factor productivity (TFP). Such a decomposition
shows that fluctuations in TFP - capturing cyclical swings in work intensity and capacity
utilization as well as an uneven pace of technical progress - account for a relatively large
share of the fluctuations in output at business cycle peaks and troughs. The largest part of the
cyclical variation in labour input comes from fluctuations in cyclical unemployment, but
average working hours (and to a minor extent the labour force) also tend to vary positively with
the output gap, reflecting that labour supply tends to increase when there is more work to do.
8. The method of detrending an economic time series by means of the HP filter should be used
with care, because (i) the HP filter gives imprecise estimates of the trend at the end-points of
the time series; (ii) the filter relies on an arbitrary choice of the ,1, -parameter which determines
the smoothness of the estimated trend, and (iii) the HP filter cannot capture structural breaks
in the data series. For these and other reasons there is considerable uncertainty associated
with the measurement of business cycles.
Building blocks of the short run model
the previous chapter showed that private investment is often the most volatile
component of aggregate demand and that it is highly correlated with total output.
Understanding the forces driving private investment is therefore crucial lor understanding
business cycles. In this chapter we present a theory of business investment as
well as a theory of h ousing investment. This will give us an opportunity to study two of the
most important asset markets in the economy: the stock market and the market lor
owner-occupied housing. As we shall see, there is a systematic link between stock prices
and business investment, and a similar systematic impact of housing prices on housing
investment. To w1derstand investment. we must therefore study how asset prices are
formed.
A glance at Fig. 15.1 should make clear why we are interested in asset prices. The
figure is constructed from data for the 16 most important industrial corm tries and shows
the link between the evolution of housing prices and stock prices and the evolution of the
output gap. There is a close relationship betwem asset price.fluctuations and output .fluctuations
and a clear tendency .for stock price movements to lead movements in output. Thus the llgure
suggests that an increase in stock prices or in housing prices will trigger an increase in
economic activity, whereas a signillcant drop in asset prices may be a signal of a future
economic downturn. As we will show in this chapter and the next one, Fig. 15.1 reflects
that higher asset prices tend to stimulate private consumption and investment. In particular,
the present chapter will explain why higher stock prices tend to be followed by
higher business investment, and why higher housing prices provide a boost to housing
investment.
The basic idea underlying our theory of investment may be most easily illustrated by
looking at the housing market. At any point in time there is a certain market price lor
houses of a given size and quality. This price may well exceed the cost of constructing a
new house of similar size and quality (the replacement cost). The more the market price
exceeds the replacement cost. the more prolltable it will be for construction firms to build
and sell new houses. Hence we will observe a higher level of housing investment the
greater the discrepancy between the market price and the replacement cost of housing.
Note that the market price can deviate from the replacement cost for a long time. since it
takes time for new construction to produce a significant increase in the existing housing
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