Lecture 9 - The Business Cycle (continued)

See graph (packet page 8) on the Volatility of Investment and the correlation with GDP.

Investment Volatility

(i) Investment accelerator factor
I (gross investment) = ΔK + λK
where
ΔK is net investment
λK is depreciation
Depreciation is usually about 10%

ΔK = α (K*-K_-1)
where
K* = desired level of K
K_-1 = capital at the end of previous period
α = speed adjustment

If Y, output/GDP, falls by 1-2% in a year. Then K* goes down by 1% (huh?), which is worth about $275 billion.

How does that impact investment? It's nearly 15% of I, investment, because I is about $1800 billion.

So, GDP falling by 1% translates to a 15% decline in investment. That explains the wild fluxuation that we see in the Volatility of Investment graph.

(ii) Postponability

In the real world, you can always adjust and adapt to the circumstances. You don't have to do anything. You can always change direction if there are unfavorable conditions.

Story: 5th ave thrived and 6th ave had nothing, until BB&Y moved in. When BB&Y was successful ("Miracle on 6th St."), it was a signal to the market that the business conditions were ripe for success there.

The moral: When there's investment, they invest a lot. When there's little, there's very little.

The Aggregate Demand Curve

See graph in notes i vs M/P.

What shifts the aggregate demand curve?

(i) Fiscal expansion/contraction: T down or G up
(a) G up leads to AD up (since AD = C+I+G+NX)
(b) T down leads to (Y-T) up leads to C up leads to AD up

In the P vs. AD graph, this is an outward shift of the AD curve.

Fiscal contractions do the exact opposite in the inward direction.

(ii) Monetary expansion/contraction

Let's understand the Monetary Transmission Mechanism

Money supply up leads to Ms/P up which shifts the Ms/P vertical to the right and leads to lower interest rates. Under sticky price assumptions, this leads to r down. C, I and NX go up, and AD goes up - an outward shift.

2 addition channels related to monetary policy:
1. Bank-lending channel. Our consumption is tied to how willing banks are to lend. When banks are risk-averse, they tighten their lending policy and raise lending standards. This is supply side - the supply of loans.
2. Balance sheet channel (financial accelerator effect - Bernanke's term). (Warren Buffet: "When the tide is out, we can see who's swimming naked.") There can be financial distress when there are cash flow problems. Consumption spending will be effected by this liquidity problem.

"Jingle Mail" = mailing the bank the key to the house in lieu of continuing to pay the mortgage.

Aggregate Supply

Long Run Aggregate Supply (LRAS) curve.

Key LR assumption is flexible prices. If you have enough time, prices will adjust. Implications: (W/P) vs L graph in notes.

There is downward rigidity to wages. If the market were fully flexible, we would be at equilibrium and at full employment and full output. This is the U of Chicago view - Robert Lucas.

See graph of P vs Y in notes. Ybar is vertical. Add AD curve. With monetary contraction, AD shifts inward and prices decline.

This theory was tested in the early 1980s by Paul Volcker. Inflation fever was eventually broken, but it wasn't so simple.

Short-run aggregate supply curve (SRAS)

This view is supported by Mankiw (which is strange since he supports Republicans who are usually associated with the U of Chicago economists).

Prices are sticky: Pbar. See graph of P vs Y in notes. Pbar is horizontal.
Prices don't change with change in demand. Rather, supply increases if demand increases.

The truth may be somewhere in between, with P not being constant. It probably slopes upward.

Why are prices sticky?
(i) Menu cost. There's some overhead (cost, inconvenience) associated with increasing the prices and changing menus or shelf price or price stickers or cash register programming.
(ii) Long-term relationship with customers. Customers don't like it when prices go up (or down) frequently.
(iii) Contracts. Companies may be contractually bound to a certain price.
(iv) Strategic pricing decision. In highly competitive markets, one company may wait for the other company to make the first move - leading to stalemate.

Frequency of Price Adjustment
10.2% - less than once a year
39.3% - once
15.6% - 2-3 times