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ECON 202: Macroeconomics I Lecture 9 - Business Cycle Facts and Introduction John Grigsby February 2, 2017 Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 1 / 28 So far, weve been concerned with growth long run trends 11.5

SLIDE 1

ECON 202: Macroeconomics I Lecture 9 - Business Cycle Facts and Introduction

John Grigsby February 2, 2017

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 1 / 28

SLIDE 2

So far, we’ve been concerned with growth – long run trends

8.5 9 9.5 10 10.5 11 11.5 Log GDP per Capita (Chained 2009 USD)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 2 / 28

SLIDE 3

Now we will study fluctuations around trend

What is a business cycle?

Business Cycles are a type of fluctuation found in the aggregate economic activity

f nations that organize their work mainly in business enterprises. A cycle consists
f 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 Burns and Mitchell (1946)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 3 / 28

SLIDE 4

What do business cycles look like?

P indicates peak, T shows trough. Taken from http://www.fperri.net/TEACHING/bocconi/20205/LEC10.pdf

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 4 / 28

SLIDE 5

We see this in GDP growth rates

myf.red/g/cxNC

5 10 15 20 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 fred.stlouisfed.org

Source: U.S. Bureau of Economic Analysis

Real Gross Domestic Product Percent Change from Preceding Period

Long periods of positive growth followed by negative growth.

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 5 / 28

SLIDE 6

Observations regarding GDP cycle

myf.red/g/cxNC

5 10 15 20 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 fred.stlouisfed.org

Source: U.S. Bureau of Economic Analysis

Real Gross Domestic Product Percent Change from Preceding Period

1 Cycles recurrent but not periodic 2 Less volatile today than pre-80s. 3 Cycle length varies from 1.5 years to ≈ 20 years Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 6 / 28

SLIDE 7

Some key definitions (1)

Definition: Recession A recession is defined as a period with 2+ consecutive quarters of negative growth in output (Okun). NBER defines recussion to be recurring period of substantial decline in output, income, employment, and trade across a variety of sectors. See http://www.nber.org/cycles/main.html for more. Definition: Cyclicality A variable is said to be Pro-Cyclical, Counter-Cyclical, or A-cyclical if it moves together with, opposite to, or independently of GDP, respectively.

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 7 / 28

SLIDE 8

Some key definitions (2)

Definition: Lags, Leads, and Coincidence A variable is said to be Lagging, Leading, or Coincident if it moves after, before, or at the same time as GDP, respectively. Definition: Durable Goods A good is durable if it is not meant for immediate consumption and may be consumed over time. Non-durable goods are the opposite. Durable examples: cars, household appliances; things that depreciate slowly Non-durable examples: Food, Gasoline; things that depreciate quickly

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 8 / 28

SLIDE 9

Quiz: what do you think is pro-, counter-, and a-cyclical?

Direction Timing Consumption Pro-Cyclical Coincident Industrial Production Pro-Cyclical Coincident Business Fixed Investment Pro-Cyclical Coincident Residential Investment Pro-Cyclical Leading Inventories Pro-Cyclical Leading Government Spending Pro-Cyclical Varies Imports Pro-Cyclical Leading Exports Pro-Cyclical Lagging Net Exports Counter-Cyclical Leading

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 9 / 28

SLIDE 10

Quiz: what do you think is pro-, counter-, and a-cyclical?

Direction Timing Consumption Pro-Cyclical Coincident Industrial Production Pro-Cyclical Coincident Business Fixed Investment Pro-Cyclical Coincident Residential Investment Pro-Cyclical Leading Inventories Pro-Cyclical Leading Government Spending Pro-Cyclical Varies Imports Pro-Cyclical Leading Exports Pro-Cyclical Lagging Net Exports Counter-Cyclical Leading

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 9 / 28

SLIDE 11

Quiz: what do you think is pro-, counter-, and a-cyclical?

Direction Timing Consumption Pro-Cyclical Coincident Industrial Production Pro-Cyclical Coincident Business Fixed Investment Pro-Cyclical Coincident Residential Investment Pro-Cyclical Leading Inventories Pro-Cyclical Leading Government Spending Pro-Cyclical Varies Imports Pro-Cyclical Leading Exports Pro-Cyclical Lagging Net Exports Counter-Cyclical Leading

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 9 / 28

SLIDE 12

Quiz: what do you think is pro-, counter-, and a-cyclical?

Direction Timing Consumption Pro-Cyclical Coincident Industrial Production Pro-Cyclical Coincident Business Fixed Investment Pro-Cyclical Coincident Residential Investment Pro-Cyclical Leading Inventories Pro-Cyclical Leading Government Spending Pro-Cyclical Varies Imports Pro-Cyclical Leading Exports Pro-Cyclical Lagging Net Exports Counter-Cyclical Leading

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 9 / 28

SLIDE 13

Quiz: what do you think is pro-, counter-, and a-cyclical?

Direction Timing Consumption Pro-Cyclical Coincident Industrial Production Pro-Cyclical Coincident Business Fixed Investment Pro-Cyclical Coincident Residential Investment Pro-Cyclical Leading Inventories Pro-Cyclical Leading Government Spending Pro-Cyclical Varies Imports Pro-Cyclical Leading Exports Pro-Cyclical Lagging Net Exports Counter-Cyclical Leading

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 9 / 28

SLIDE 14

Round 2: Labor market, stock prices, inflation

Direction Timing Employment Pro-Cyclical Coincident Unemployment Rate Counter-Cyclical Lagging Labor Productivity Pro-Cyclical Leading Real Wage Pro-Cyclical Varies Money growth Pro-Cyclical Leading Inflation Pro-Cyclical Lagging Stock prices Pro-Cyclical Leading Nominal Interest rates Pro-Cyclical Lagging Real interest rates Acyclical –

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 10 / 28

SLIDE 15

Round 2: Labor market, stock prices, inflation

Direction Timing Employment Pro-Cyclical Coincident Unemployment Rate Counter-Cyclical Lagging Labor Productivity Pro-Cyclical Leading Real Wage Pro-Cyclical Varies Money growth Pro-Cyclical Leading Inflation Pro-Cyclical Lagging Stock prices Pro-Cyclical Leading Nominal Interest rates Pro-Cyclical Lagging Real interest rates Acyclical –

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 10 / 28

SLIDE 16

Round 2: Labor market, stock prices, inflation

Direction Timing Employment Pro-Cyclical Coincident Unemployment Rate Counter-Cyclical Lagging Labor Productivity Pro-Cyclical Leading Real Wage Pro-Cyclical Varies Money growth Pro-Cyclical Leading Inflation Pro-Cyclical Lagging Stock prices Pro-Cyclical Leading Nominal Interest rates Pro-Cyclical Lagging Real interest rates Acyclical –

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 10 / 28

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Round 2: Labor market, stock prices, inflation

Direction Timing Employment Pro-Cyclical Coincident Unemployment Rate Counter-Cyclical Lagging Labor Productivity Pro-Cyclical Leading Real Wage Pro-Cyclical Varies Money growth Pro-Cyclical Leading Inflation Pro-Cyclical Lagging Stock prices Pro-Cyclical Leading Nominal Interest rates Pro-Cyclical Lagging Real interest rates Acyclical –

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 10 / 28

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Round 2: Labor market, stock prices, inflation

Direction Timing Employment Pro-Cyclical Coincident Unemployment Rate Counter-Cyclical Lagging Labor Productivity Pro-Cyclical Leading Real Wage Pro-Cyclical Varies Money growth Pro-Cyclical Leading Inflation Pro-Cyclical Lagging Stock prices Pro-Cyclical Leading Nominal Interest rates Pro-Cyclical Lagging Real interest rates Acyclical –

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 10 / 28

SLIDE 19

What is least cyclical? Non-Durable Consumption Growth

15.0
10.0
5.0

0.0 5.0 10.0 15.0 20.0 25.0 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Percent Change

Non-Durable Consumption not too volatile

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 11 / 28

SLIDE 20

Durable Consumption Much More Volatile

15.0
10.0
5.0

0.0 5.0 10.0 15.0 20.0 25.0 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Percent Change

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 12 / 28

SLIDE 21

And Residential Investment Even More Volatile

15.0
10.0
5.0

0.0 5.0 10.0 15.0 20.0 25.0 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Percent Change

Note that recessions are different: 2001 had small drop in residential investment, but 2008 had a huge drop.

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 13 / 28

SLIDE 22

While Non-Residential Investment Also Volatile

10.0
5.0

0.0 5.0 10.0 15.0 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Percent Change

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 14 / 28

SLIDE 23

To Summarize (All Series Detrended by HP Filter)

Source: http://www3.nd.edu/~esims1/stylized_facts.pdf Investment 2.76 times as volatile as GDP Hours worked, consumption, investment, and TFP very cyclical All variables above highly persistent

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 15 / 28

SLIDE 24

Lower Income Countries more Volatile

Source: http://www.fperri.net/TEACHING/bocconi/20205/LEC10.pdf

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 16 / 28

SLIDE 25

Causes and Consequences of Country Differences

Why? Still under debate Institutions/Corruption/Conflict? Climate? (What is economic cost of global warming?) Less ability to save and smooth? More commodity-driven/less diversified economy, so more subject to sector-specific global shocks (Thanks Michael!) Consequences Poor individuals less able to save ⇒ If bad shock hits, no way to consumption smooth ⇒ May lead to abject poverty ⇒ Which in turn can lead to populist governments and bad politics

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 17 / 28

SLIDE 26

Major Questions of Business Cycle Theory

1 What causes business cycles?

Is it persistent shocks? Or is it from our response to temporary shocks?

2 Why do different goods categories have different responses? 3 What kinds of policies can smooth cycles? Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 18 / 28

SLIDE 27

A brief note on prediction

Economists at policy institutions and banks often try to predict onset of business cycles with leading indicators Logic If falls in labor productivity always preceed falls in output, we can predict that output will fall, say, 2 quarters after an observed drop in labor productivity.

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 19 / 28

SLIDE 28

A brief note on prediction

Economists at policy institutions and banks often try to predict onset of business cycles with leading indicators Logic If falls in labor productivity always preceed falls in output, we can predict that output will fall, say, 2 quarters after an observed drop in labor productivity. Common leading indicators include

1 Weekly hours 2 Initial claims for unemployment insurance 3 Manufacturer new orders 4 Housing permits/starts 5 Index of Consumer Expectations Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 19 / 28

SLIDE 29

A word of caution

Lucas Critique Without knowing the underlying mechanisms behind these statistical relationships, subject to mistakes if rules of the game change. For example, residential investment fell a lot in 2008, but did not in 2001. We need theory of business cycles

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 20 / 28

SLIDE 30

The predictive power of the yield curve

4.00
3.00
2.00
1.00

0.00 1.00 2.00 3.00 4.00 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 Spread between 10 year and 1 year Treasury Yields

“Yield on t-year Treasury Bond” means interest rate demanded to lend $1 to the government for t years

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 21 / 28

SLIDE 31

Why might the yield curve be predictive?

Let iLt be the interest rate (yield) on a 10-year treasury in period t, and let iSt be the yield on a 1-year treasury in period t. Then iLT ≈ 1 10iSt + 1 10Et[iSt+1] + . . . + Et[iSt+10] Why? If iLt were much larger than the above, then should buy long-term bond and sell short-term bond because get higher return for it (no-arbitrage).

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 22 / 28

SLIDE 32

Why might the yield curve be predictive?

Let iLt be the interest rate (yield) on a 10-year treasury in period t, and let iSt be the yield on a 1-year treasury in period t. Then iLT ≈ 1 10iSt + 1 10Et[iSt+1] + . . . + Et[iSt+10] Why? If iLt were much larger than the above, then should buy long-term bond and sell short-term bond because get higher return for it (no-arbitrage). Suppose that above holds and iLt >> iSt. Then Investors must expect future rates to be higher. Rates tend to be higher in good times because Fed raises rates to cool inflation (more on this later/in ECON 203) So must expect good times in future. But if reverse is true iLt < iSt, then expect bad times in future. This is called an “inverted yield curve”

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 22 / 28

SLIDE 33

How to think about differences in Cyclicalilty?

Differences in Income Elasticities Definition: Engel curves An Engel curve plots the amount consumed of a product as you increase income

0.5 1 1.5 2 2.5 3 3.5 1 2 3 4 5 Consumption on Good Type i Income

Engel Curves by Consumption Type

Non-Durable Goods Durable Goods

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 23 / 28

SLIDE 34

Income Elasticities and Business Cycle Volatility

Definition: Income Elasticity A good i’s income elasticity is defined to be the percent change in consumption of i for a 1 percent change in income. That is ηi = %∆xi %∆Y

1 Suppose that output falls so that we become poorer 2 The amount that consumption of goods fall depends on the good’s

income elasticity

3 More income elastic goods fall more 4 Non-durable consumption tends to be a necessity (ηi < 1): we always

need to eat.

5 Durable consumption may be a luxury (ηi > 1): we can put off

purchasing a new car

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 24 / 28

SLIDE 35

Transmission Mechanisms

Income elasticity explanation is nice, but inconsistent with permanent income hypothesis.

⇒ Why wouldn’t we just consumption smooth if shocks truly temporary?

Need mechanism to make temporary shock permanent. Possibilities

Pass-through to investment (Real Business Cycle Theory)

Financial constraints: shocks require deleveraging

Adjustment costs force large drops in anticipation of future shocks

Businesses/workers do not enter during recessions ⇒ missing generation of ideas/human capital growth

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 25 / 28

SLIDE 36

Transmission Mechanisms

Income elasticity explanation is nice, but inconsistent with permanent income hypothesis.

⇒ Why wouldn’t we just consumption smooth if shocks truly temporary?

Need mechanism to make temporary shock permanent. Possibilities

Pass-through to investment (Real Business Cycle Theory)

Financial constraints: shocks require deleveraging

Adjustment costs force large drops in anticipation of future shocks

Businesses/workers do not enter during recessions ⇒ missing generation of ideas/human capital growth

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 25 / 28

SLIDE 37

Unemployment Rate Clearly Pro-Cyclical

2 4 6 8 10 12 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Unemployment Rate (%)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 26 / 28

SLIDE 38

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 39

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

2 Return to working is lower, so households supply less labor Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 40

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

2 Return to working is lower, so households supply less labor 3 That reduces income in the economy by more than if productivity

shock were only change

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 41

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

2 Return to working is lower, so households supply less labor 3 That reduces income in the economy by more than if productivity

shock were only change

4 Smaller pie today + consumption smoothing ⇒ less capital

acquisition

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 42

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

2 Return to working is lower, so households supply less labor 3 That reduces income in the economy by more than if productivity

shock were only change

4 Smaller pie today + consumption smoothing ⇒ less capital

acquisition

5 End up with smaller capital stock in period 1, so less

utput/consumption in period 1

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 43

Real Business Cycle (RBC) in words

Developed by Kydland and Prescott (1982) [won them the Nobel Prize]

1 There is a temporary fundamental shock in period 0 (e.g. productivity

shock)

2 Return to working is lower, so households supply less labor 3 That reduces income in the economy by more than if productivity

shock were only change

4 Smaller pie today + consumption smoothing ⇒ less capital

acquisition

5 End up with smaller capital stock in period 1, so less

utput/consumption in period 1

6 Thus temporary shock spills over into future periods Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 27 / 28

SLIDE 44

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 45

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 46

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Adjustments to new technology requires learning

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 47

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Adjustments to new technology requires learning

“Forgetting” how to do something (maybe from firm exit/retirement)

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 48

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Adjustments to new technology requires learning

“Forgetting” how to do something (maybe from firm exit/retirement)

Wartime destruction

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 49

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Adjustments to new technology requires learning

“Forgetting” how to do something (maybe from firm exit/retirement)

Wartime destruction

Strikes

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 50

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?

Weather (particularly for agriculture)

Adjustments to new technology requires learning

“Forgetting” how to do something (maybe from firm exit/retirement)

Wartime destruction

Strikes

Shifts in regulation/laws/institutions

Grigsby Lecture 9 - Business Cycle Facts February 2, 2017 28 / 28

SLIDE 51

Short-Run Productivity Shocks: What are they?

Much of our theory revolves around a production function of the form Y = AF(K, L) so that output Y is a function of capital K and labor L, multiplied by a productivity parameter A Easy to think about long run growth in A from technology/education But what could be an exogenous temporary downward shock in A?