Lecture 9 - The Business Cycle

The Business Cycle

We graphed GDP (potential and actual) vs. time.

Potential GDP is at full employment and output. Ybar = AF(Kbar, Lbar)

The Business cycle is the regular repetition of the cycle of contraction, recession, recovery and expansion. There's no set amount of time for each of these phases. We want to know: What drives the actual GDP around the potential GDP.

Output gap = Y - Ybar, where Ybar is the potential GDP

Output gap is positive during boom and negative during recession.

How can actual output, Y, be greater than the potential Ybar? Because employment may be greater than the theoretical "potential" by working more hours or if unemployment is lower than the "natural" unemployment. Natural unemployment is the theoretical minimum given that at any point in time some people aren't working because they're changing jobs or just taking some time off for personal reasons.

Business Cycle Indicators

(1) Leading Indicators
(2) Coincident Indicators
(3) Lagging Indicators

(I need some more information about these indicators)

Short Run vs. Long Run

In the long run, prices are flexible and can respond to changes in supply and demand.
In the short run, many prices are stuck at the predetermined level.

Consumer prices do not change immediately after changes in monetary policy from the Fed.

In the short run, prices are stick. (Slow to adjust). Recall the quantity theory of money:
MxVbar = Pbar x Y

If M (money supply) goes up, Y (output) must go up. So monetary policy can be used to affect output activity.

But is the sticky price assumption (in the short run) correct? We will see some data on this.

See the graph: Great Moderation (packet page 6). The business cycle peaks and troughs are much smaller after 1950. Why? Do we have better monetary policy since then? Or perhaps we haven't had severe shocks? Or perhaps pre1950 has less accurate data. (Christian Romer)

See table: Key Characteristics of Recessions in the US (packet page 7). Shows duration and severity of recessions since 1960. Data comes from NBER. The 2001 period is in question whether there was a recession or not.

Unemployment and real personal disposable income and industrial production data indicate that we are now in a recession. See GDP Growth bar graph (pg 9), house-price indices (pg 10, Case-Shiller includes jumbo and sub-prime sales) OFHEO only includes conforming loans (Fannie Mae and Freddie Mac)) and residential investment-GDP ratio graph (pg 11).

Most recessions bottom out with a 2% GDP growth. (is that right? that slide went by way too fast)

When will the recovery happen? U shaped or V shaped or L shaped? Will depend on housing market stabilization/recovery and also how effective fiscal and monetary policies are.

See the table on packet page 8 of the US Economic Outlook.

The AD-AS Model

(1) Aggregate Demand Curve: relationship between P and AD
AD = C + I + G + NX

(i) C = C(Y-t, (y-t)^f, wealth, r)
(ii) I = I(r, Y, Y^f, tax policy)
(iii) NX = NX(ε (minus),Y (minus), Y^foreign(plus))

More on C & I

(1) C - Consumption
In general, disposable personal income is strongly correlated with consumption. But marginal propensity to consume, MPC, may be influenced by age and other factors as well - how much they expect to earn in the future, how much they have now, etc.

Lifecycle hypothesis
forward looking rational consumers will look at all their lifetime potential earnings.
MPC^permanent < MPC^temporary

So, for example, are tax rebates and the "stimulus package" likely to have a big impact? It's $110 billion going to households. In 2001, it was only $38 billion. The 2008 package is temporary. The 2001 rebate was made "permanent" through tax cuts.

With temporary stimulus, we should only expect a 20% MPC. 20% of $110 is $20 billion. This is a 0.8% quarterly increase in the overall consumption, 3.2% annually. This would lead to an increase in Y of 2.2% (Recall that C is 70% of GDP)