EC114 Core Lecture, Week 8

Introduction

• Today: Business cycles (ch. 11).
• Rest of term:
  • Week 9:
    • Thursday: Review of midterm plus Redwood and Juthani guest lectures.
    • Friday: Chapters 12–14: Money, Prices, Monetary and Fiscal Policy.
  • Week 10:
    • Thursday: The budget!
    • Friday: Chapters 17–18: Banking, Debt and (Sovereign) Default.
  • Week 11:
    • Thursday: Claire Macallan from the Bank of England.
    • Friday: Chapters 19–21: Exchange Rates (guaranteed question).
• Unable to cover chapters in full detail.
• Reading all the chapters will be beneficial.

Guest Lecture

• Thanks for attending, for asking questions and making our guest welcome.
• Sam happy for recording to be shared, will also make his speech content available.
• Highly party political but nonetheless, economically competent.
• You do not have to agree with him:
  • But for your essay you do have to explain why you do/don’t…

Essay

• Due Friday March 27 4pm.
• Word limit: 2000, strict (no 10%).
  • Words after 2000th will not be counted (it’s electronic submission).
    • Ability to write succintly and clearly an acquired skill.
  • Footnotes do not count (but no obligation to read footnotes).
  • Tables and figures do not count (but do not abandon them).
  • Harvard style referencing (copy style in academic papers).
• Question Choose one of the guest lectures by Joe Grice, John Redwood and Sam Juthani and answer the following questions:
  1. Summarise the lecture given by each guest.
  2. Identify which economic theories covered in lectures that the lecturers referred to. Was the lecturer in agreement with the theory?
  3. Explain whether you agree with the lecturer.
• All parts equally weighted.

A Little more on Facts and Theories…

• … turns out a journalist at the New York Times finds it important enough to write about:

Fact: Something that is true about a subject and can be tested or proven.

First, the definition of a fact waffles between truth and proof — two obviously different features. Things can be true even if no one can prove them. For example, it could be true that there is life elsewhere in the universe even though no one can prove it. Conversely, many of the things we once “proved” turned out to be false. For example, many people once thought that the earth was flat. It’s a mistake to confuse truth (a feature of the world) with proof (a feature of our mental lives). Furthermore, if proof is required for facts, then facts become person-relative. Something might be a fact for me if I can prove it but not a fact for you if you can’t. In that case, E=MC2 is a fact for a physicist but not for me.

Why do we bother?

• Attendance at classes in week 7 was 44.8%.
  • Each extra class got you extra 4 marks on class test.
• On average it is 58.2%.
  • Best week, week 5, with 69.8%. Wonder why?
• Why should your tutors bother preparing?
  • Why should I bother creating material and prepping the tutors?
• What would actually make you bother?

Classes Next Week: Debate

• Even if David Cameron won’t, we will!
• Contact your group members, get going:
  • Research your arguments, prove your opponents wrong!

The Business Cycle

• Definition: Fluctuations of output around its trend, or potential level.
• Potential/trend: firms producing at their `normal’ amount.
• But overtime and longer shifts can expand output above `normal’ level.
• Above trend: Boom. Significantly below trend: Recession.
• The output gap: The difference between actual GDP and trend.

Output and Trend in Italy

Output and Trend in the UK

## [1] "UKNGDP"

Output Gap, Business Cycle, in Italy

Output Gap, Business Cycle, in the UK Over Two Centuries

Output Gaps Globally

Characteristics of Business Cycles

Measuring the Business Cycle

• We never observe the business cycle — it’s just another economic concept.
• To measure cycle, we need trend output. Methods:
  • Statistical measure: Smooth out GDP fluctuations.
  • Estimate production function using labour and capital data.
  • Use other measures of capacity utilisation.
• Terminology:
  • Boom: Period of particularly strong economic growth (above trend).
  • Peak: The top of the business cycle, the furthest (positive) point from trend.
  • Recession: Period of negative economic growth.
  • Trough: The bottom of the business cycle, the furthest (negative) point from trend.
  • Expansion: Period of growth immediately after a recession.
  • Contraction: Growth slows but is still positive.
  • Depression: Pronounced period of recession or slow growth.
  • Growth recession: Period of slower (below trend) positive growth.

Terms and the Trend, UK 1980–2014

Terms and the Cycle, UK 1980–2014

Dating Business Cycles — Less Arbitrary?

The Great Depression

The Great Depression

The Great Recession

Cycles Across Sectors: Manufacturing and Construction

Okun’s Law: Relationship between Output and Unemployment

Cycles and Co-Movements Across Regions

Cycles and Co-Movements Across Regions

Recent Synchronicity of Cycles

Have Business Cycles Changed?

The Cost of Business Cycles

• In week 1 we noted Lucas: Cost of business cycles trivial relative to trend growth.
• Arguments based on aggregate consumption…
• … but what about sub-groups within that mass?

Recessions Affect the Young…

##… and the Unskilled

Does Uncertainty from Volatility Impact Trend Growth?

Thinking Analytically About Cycles

• Frisch-Slutsky paradigm identified three components of business cycle fluctuations:
  1. Impulse: Impulse or shock. Analogy of stone hitting water.
  2. Propagation: Converts one-time shocks into persistent cyclical fluctuations.
  3. Busines cycle: The resulting persistent cycles.
• What shocks are important?
• How are they propagated?

A Series of Small Impulse/Shock

A Bigger Shock

Real Business Cycle Theory

• Very basic model regarding business cycle:
  • Single representative firm and agent optimising and interacting. No govt.
  • Impulse: Technology (TFP) shocks.
  • Propagation: Time to build machines.
• Implication:
  • Markets always acting efficiency, boom or bust.
  • Government should not try to interfere, as a result.
  • Unemployment voluntary, and recessions caused by negative TFP shocks.
  • Great Depression cast mockingly as the Great Vacation by Paul Krugman.

Real Business Cycle Theory

• But does RBC theory explain the facts?
• Fact: Real wages fluctuate little over the cycle but employment fluctuates a lot.
• Two possible interpretations:
  • Wages (and prices more generally) are sticky, hence big changes in quantities.
  • Individuals very responsive to small changes in (relative) prices.
• RBC: A supply-side explanation of business cycles.

Real Business Cycle Theory

Keynesian Models

• Keynes: Micro models don’t necessarily work at the macro level.
• Essentially: Markets may not restore equilibrium. Government intervention required.
• Insufficient demand can exist at a macroeconomic level sustaining downturns.
• Markets do not function properly: Frictions exist.
  • Labour markets: Sticky wages.
  • Product markets: Monopoly power.
  • Financial markets: Imperfect information.
• Co-ordination failure common theme causing downturns.
• Keynesian models: Demand driven recessions.

AD: Consumption largest part, Investment/trade most volatile

The Aggregate Demand Curve

Vertical Supply?

Positive Supply Curve Can Generate Fluctuations

But do Firms Respond by Adjusting Prices? Flat AS Curve?

Why Don’t Firms Raise Prices? Periodic Reviews…

##…and Often Less Frequent Actual Changes

Flat Short Run, Vertical Long Run?

Supply Shocks Can Causes Cyclical Flucatuations

What Do the Data Tell Us?

Concluding

• Today: Chapter 11, business cycles.
  • Booms, contractions, optimality or otherwise, shock and propagation.