To understand why business cycles happen, and what can be done to prevent/mitigate them, we will examine two models:

• The New Classical or the Real Business Cycle (RBC) Model
• The New Keynesian Model

The New Keynesian model is built on top of the RBC model.

These models are built in the aggregate demand - aggregate supply (AD-AS) framework.

• Long Run Aggregate Supply (LRAS)
• Aggregate Demand (AD)
• Short Run Aggregate Supply (SRAS)

The difference between the two models is that the New Keynesian model includes all three curves but the RBC model does not include SRAS.

The AD-AS framework can be expressed as either be a static model or a dynamic model.

A static model looks at the economy at one point in time.

• This means AD-AS looks at the relationship between Real GDP and the price level.

A dynamic model looks at how the economy is changing over time.

• AS-AD becomes a model of Real GDP growth and inflation.

These notes discuss the dynamic version of AD-AS.

Either way, the graphs look roughly the same!

The Long Run Aggregate Supply (LRAS) curve represents an economy’s maximum growth rate.

Key assumption: if supply or demand shifts in a microeconomic market, the price in that market will adjust immediately.

• If this happens, then the economy will grow at its maximum rate.

Aggregate Demand shows the relationship between spending, inflation, and growth.

We’ve already seen an equation that looks at this relationship: the quantity theory of money.

\(\dot{M}+\dot{V}=\dot{P}+\dot{Y}\), where

• \(\dot{M}\) is the growth rate of the money supply
• \(\dot{V}\) is the growth rate of velocity
• \(\dot{P}\) is inflation
• \(\dot{Y}\) is real GDP growth.

The left side of the quantity theory equation, \(\dot{M}+\dot{V}\), says that spending increases come from:

• There is more money in the economy than before, so \(\dot{M}\) has increased, and/or
• People are spending their money faster than before, so \(\dot{V}\) has increased.

If spending has increased, the right side of the equation tells us what that extra spending is going toward. The two candidates are:

• More goods and services, thus \(\dot{Y}\) has increased, and/or
• Goods and services simply cost more than before, and \(\dot{P}\) has increased

The goal of the AS-AD model is to explain fluctuations in the economy, or why \(\dot{Y}\) moves around.

This means looking at what might cause the equilibrium in our RBC model to move, particularly to the left or the right.

What are the effects of shifting the LRAS and/or AD curve on the macroeconomic equilibrium?

The only causes of the business cycle in the RBC model are productivity shocks.

If the RBC model is correct, then most of what the government does to stave off recessions–fiscal policy to increase \(\dot{V}\) and monetary policy to increase \(\dot{M}\)–has no hope of working.

• This is a result of the model’s assumption – that prices in microeconomic markets adjust very quickly.
• Most economists believe this assumption to be false. While prices may adjust in the long run, they may not in the short run.

Most economists believe prices do not adjust quickly in the short run.

• More importantly, most economists believe that some prices adjust far more quickly than others.

This phenomenon is known as price rigidity or price stickiness.

Both sticky wages and sticky prices can generate situations in which unexpected inflation encourages economic growth.

There are a wide variety of reasons why price may be sticky.

• Long term contracting
• Input and/or output hedging
• Menu costs
• Psychological effects
  • e.g. anchoring bias, status quo bias, price confusion

Wages are likely to be particularly sticky, because many labor contracts are for 1+ years

• While such contracts can include expected inflation, by definition they can’t include unexpected inflation.

This implies that when inflation is higher or lower than expected, companies might expect to see their the prices they sell their outputs at change quicker than the prices they pay for their inputs.

New Classical/Real Business Cycles model implied that AD shocks have no effect on growth.

This is not the case in the New Keynesian model.

• Sticky prices allow the economy to move off the LRAS in the short run

What might cause a change in spending?

Changes in \(\dot{M}\) are typically the result of monetary policy.

Changes to \(\dot{V}\) are likely more varied

It is useful to think about changes in \(\dot{V}\) via changes to the 4 components of GDP:

• \(\dot{C}\), \(\dot{I}\), \(\dot{G}\), \(\dot{NX}\)

In other words, spending might fall because of a drop in private consumption, private investment, government purchases, or a change in the balance of trade.

The New Keynesian Model suggests that positive AD shocks only generate short run boosts to growth.

It also suggests that negative AD shocks will only have temporary reductions in growth.

This is a key difference between New Keynesian and traditional Keynesian theory – traditional Keynesian theory argued a slow growth economy can get “stuck” there.

The key insight of the New Keynesian Model:

• changes in AD cause the business cycle

What causes these changes?

Does the New Keynesian Model help us understand the Great Depression?

The Great Depression(1929-1940) was the worst economic period in the US

• GDP fell by 27%
• Unemployment hit 25%
• The DJIA fell by roughly 90%
• As a world-wide event, gave rise to National Socialism movement in Germany

The Great Depression was made worse by government policies.

The Great Depression began with the stock market crash in October 1929

• Stock Market crashes are negative wealth shocks, which reduce spending.
• The stock market crashed in part because the Fed was reducing the money supply

These two combine to shift the AD left

These events causes consumers to lose confidence in banks and withdraw their money.

Between 1929 and 1933, roughly half of all US banks went bankrupt.

This led to fewer loans, and private investment fell.

Fewer loans, via the money multiplier, reduced the money supply even further.

Most of these issues could have been fixed/lessened by simply increasing the money supply.

Contrast these behaviors with those of the Great Recession (2009-2011).

Like the Great Depression, the Great Recession was brought on by a wealth shock

• housing price collapse (housing bubble)

Unlike during the Great Depression, the Federal Reserve pumped tons of liquidity into the financial sector to try to prevent another depression.

In addition to AD shocks, productivity shocks may have shifted the LRAS to the left.

• Bank failures decimated the financial sector, making it difficult for savers and investors to lend/borrow.
• The Smoot-Hawley Tariff of 1930 was intended to boost demand for US made goods.
  • Instead, the rest of the world responded with retaliatory tariffs.
  • Eliminating internation trade is a big negative productivity shock
• The Dust Bowl: natural disasters are typically negative productivity shocks.

Governments have two major policy tools at their disposal for responding to recessions.

The general goal is to try to speed up the recovery of Aggregate Demand after it shifts to the left.

• Monetary Policy: actions undertaken by the Central Bank to increase \(\dot{M}\)
• Fiscal Policy: actions undertaken by the Congress/President, typically in the form of government stimulus or tax cuts, to increase \(\dot{V}\)

In either case, the goal is to shift the AD curve back to the right.

If the government is going to spend more money, where does that money come from?

1. Increased taxes
2. Selling bonds (borrowing)

Both of these, however, reduce AD further.

This implies that fiscal policy only works if the economy is in a recession.

• Increasing spending in a healthy economy simply cannibalizes the more productive private sector.
• In a recession, resources (capital, workers) are idle, so this is less likely.

Government spending turns into private sector income.

This private sector income turns into private consumption and investment and gives rise to the:

Keynesian Multiplier: If the economy is operating below full employment, an increase in government spending will generate increases in private spending.

The practical effect of the Keynesian Multiplier is that government spending does not need to fully offset any private drops in AD.

Fiscal policy holds the potential to smooth out economic fluctuations.

There are, however, a number of reasons why it may not be effective.

• Crowding out
• Long and variable lags
• Politics trumps economics
• Can’t fix LRAS/productivity shocks with AD.

Crowding Out: Increases in government spending reduce spending in other parts of the economy.

Fiscal stimulus implies either more government spending or reduced taxes.

Either way, the government needs to get more money, either via:

• Raising taxes, or
• Selling bonds (borrowing).

Both can generate crowding out.

Why does raising taxes to finance fiscal policy generate crowding out?

• Answer is straightforward: higher taxes reduce private spending (\(\Downarrow \dot{C}\) or \(\dot{I}\))

Crowding out is only avoided if taxpayers wouldn’t have spent their money.

Borrowing money to finance fiscal policy crowds out private spending as well.

• Why? Because government borrowing pushes up interest rates.
• Rising interest rates reduces investment and purchases of interest sensitive products.

Crowding out is only avoided if there is little saving/borrowing activity in the private sector.

To see why, let’s look at the Market for Loanable Funds.

Does crowding out apply if the government cuts taxes instead of increases government spending?

Yes!

If the government cuts taxes, they increase the budget deficit.

To close that deficit, they need to borrow money, which again leads to rising interest rates and crowding out.

The logic of tax cuts stimulating the economy is twofold:

• Income effect: taxpayers have more money, and thus are likely to spend more.
• Incentive effect: at lower tax rates, people want to work more.

The income effect is only likely to happen if tax cuts are permanent

In 2008, Bush distributed $80 billion in tax rebates, a flat amount of $300 per person.

• Because this didn’t change tax rates, there was no incentive effect.
• Because it was a one-time event, there was little income effect.

If governments cut taxes and borrow money to finance their budget deficit, what should a rational taxpayer do?

Ricardian Equivalence: Rational taxpayers should realize that a budget deficit now is effectively a promise to raise taxes later. If the government cuts taxes now, taxpayers might be better off saving because their tax bills will eventually go up.

The Ricardian Equivalence is an extreme version of crowding out.

Could the government simply print the money it needs? This is the suggestion of Modern Monetary Theory (MMT) economists.

This is perhaps possible for very small amounts of money, maybe a couple percent of GDP.

Beyond that you get inflation or hyperinflation, and crowding out occurs because the purchasing power of money in private hands declines.

The MMT response is to simply combat inflation with taxes, but taxes will be contractionary.

If the economy is self-correcting, poorly timed policy will have limited effect, or even a negative effect.

If the government has poor timing, then the government’s ability to fix problems is undermined.

There are many relevant lags here that can impact policy timing by years!

Inside Lag is the time it takes for the government (or central bank) to respond to an economic shock. Inside lag includes:

• Recognition lag: it takes time to realize there is a problem
• Decision lag; it takes time for the government to come up with a plan, vote on it, etc.
• Implementation lag: it takes time for the plan to actually go into effect

Outside Lag is the time it takes for the implemented policy to actually have an effect.

Monetary policy generally has shorter inside lags than fiscal policy.

Examples:

• Kennedy Tax Cut
  • Kennedy cut taxes by about 30%.
  • Passing the law (inside lag) took 3 years (1961-1964)
  • Effect wasn’t really felt until 1965-1967
• Bush Tax Cuts
  • In response to 2001 recession, Bush pushed a tax cut act
  • Tax cuts were phased in over 3 years
  • By the time the 2003 cuts hit, the economy had mostly recovered.
  • Most rate cuts were on the rich, who spend a smaller proportion of their income.

Some policies designed to explicitly not have lags.

Automatic Stabilizers are policies that automatically kick in during a recession to stimulate AD without requiring congressional/presidential action.

Examples:

• Welfare
• Unemployment insurance

Good economic policy is not necessarily popular politically, and politically appetizing policies are often bad economics.

Partisan politics plays a big role in choosing policy

• Democrats tend to choose stimulus
• Republicans tend to choose tax cuts

Ideally, fiscal policy will:

• increase spending in a down economy, and
• pay off the debt during good times.

In actuality, governments:

• increase spending in a down economy, and
• increase spending during good times.

The result is ever-rising debt

WIth higher debt, a larger share of a governments budget goes toward paying interest.

Countries with high debt have significant risk of default, capital flight, depression, recession, social unrest, etc

Recent and notable examples:

• Argentina
• Cyprus
• Greece
• Latin American debt crisis - La Década Perdida (1980s)

The discussion thus far has implicitly assumed that if the economy is in a recession, it is due to an AD shock.

Not all recessions are AD shocks, some are LRAS shocks.

Stimulating AD in response to an AD shock does little more than drive up inflation.

What are the implications of these potential limitations of fiscal policy?

To be effective, fiscal policy should:

• be in response to an immediate and obvious emergency (to minimize effects of lag)
• not be done in mild contractions (to minimize crowding out)
• not be done in response to productivity shocks (because all you get is inflation)