Chapter 13
Introducing
Advanced
Macroeconomics:
Growth and business
THE ECONOMY
cycles IN THE
SHORT RUN
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WHY UNDERSTANDING BUSINESS CYCLES IS
IMPORTANT
• Recessions bring considerable economic
hardship.
• Thus understanding business cycles is not
only of academic interest.
• It may help the economist to offer advice to
policy makers on reducing business
fluctuations.
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The evolution
of GDP in
some Western
countries
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Unemployment and political extremism in Germany, 1924-1933
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DEFINING BUSINESS CYCLES
“Business cycles are a type of fluctuation found in the aggregate
economic activity of nations that organize their work mainly in business
enterprises: a cycle consists of 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; this sequence of changes is recurrent but not
periodic; in duration business cycles vary from more than one year to ten
or twelve years; they are not divisible into shorter cycles of similar
character with amplitudes approximating their own.”
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DATING BUSINESS CYCLES
The length of the business cycle is measured
from trough to trough.
From the figure on the following slide we see
that:
– Business cycles are far from regular and
periodic.
– Business cycle expansions have tended to
last longer and contractions have on
average been shorter after the Second
World War.
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US business
cycle
expansions
and
contractions
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MEASURING BUSINESS CYCLES
• We need a method for separating the
growth trend from the cyclical
component of a variable like GDP
yt gt ct (2)
where yt is the log of GDP, g t is the
growth trend, and ct the cyclical
component.
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MEASURING BUSINESS CYCLES
• One such method is the Hodrick-
Prescott filter. When detrending an
economic time series, the growth
component is found by minimizing
T
HP yt gt
2
t 1 (3)
T 1
gt 1 gt gt gt 1
2
t 2
with respect to all of the g t .
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Real GDP
and trend
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WHAT HAPPENS DURING BUSINESS CYCLES?
Detrending time series with the HP filter,
we obtain estimates of the g t s, which
can be used to determine our estimates
of the ct s.
We first study the variability in different
economic variables during a ’typical’
business cycle:
1 T
sX xt x
2
(4)
T 1 t 1 ©The McGraw-Hill Companies, 2010
Volatility,
UK and
USA
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Volatility,
Denmark
and Finland
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Volatility,
Belgium
and
Netherlands
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WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 1:
Investment is much more volatile over the
business cycle than GDP. It is the most
volatile component of aggregate demand.
• Stylized business cycle fact 2:
Foreign trade volumes are typically two to
three times as volatile as GDP.
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WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 3:
Employment is considerably less volatile over
the business cycle than GDP, typically 60-80%
as volatile.
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WHAT HAPPENS DURING BUSINESS CYCLES?
We now study whether and to what extent the
cyclical components of the economic variables
move in the same direction as GDP.
x t x ct c
xt , ct t 1 (6)
T T
x x c c
2 2
t t
t 1 t 1
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Correlation,
UK and USA
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Correlation,
Denmark
and Finland
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Correlation,
Belgium
and
Netherlands
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WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 4:
Private consumption, investment and imports
are strongly positively correlated with GDP.
• Stylized business cycle fact 5:
Employment is procyclical and much more
strongly correlated with GDP than real wages
and labour productivity. Labour productivity
tends to be procyclical, whereas real wages
tend to be very weakly correlated with GDP.
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WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 6:
In most countries inflation is positively
correlated with GDP, although the correlation
is not very strong.
• Stylized business cycle fact 7:
Employment is a lagging variable; inflation
and nominal interest rates also tend to be
lagging variables.
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WHAT HAPPENS DURING BUSINESS CYCLES?
Last but not least, we want to study the degree
of persistence in the economic variables. That
is, we compute the coefficient of
autocorrelation
xt , xt n
for different values of n.
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Autocorrelation,
UK and USA
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Autocorrelation,
Denmark and
Finland
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Autocorrelation,
Belgium and
Netherlands
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WHAT HAPPENS DURING BUSINESS CYCLES?
• Stylized business cycle fact 8:
There is considerable persistence in GDP and
about the same degree of persistence in
private consumption.
• Stylized business cycle fact 9:
Employment tends to be even more
persistent than GDP.
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THE PRODUCTION FUNCTION APPROACH
• A way to estimate the output gap which
makes use of the concept of an aggregate
production function:
Yt Bt Kt L1t , 0 1 (7)
• And the following definition of total working
hours:
Lt 1 ut Nt H t (8)
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THE PRODUCTION FUNCTION APPROACH
• Inserting (7) in (8) yields:
1
Yt Bt Kt 1 ut Nt H t t
(9)
• Suppose that the above variables fluctuate
around som long-run trend values. Trend
output can then be written as (capital is fully
utilized):
1
Yt Bt Kt 1 ut Nt H t t
(10)
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THE PRODUCTION FUNCTION APPROACH
• Taking logs on both sides of (9) and (10),
and subtracting one from the other, yields:
yt yt ln Bt ln Bt 1 ln Nt ln Nt
1 ln H t ln H t 1 ln ut ln ut
(11)
• An estimate and decomposition of (11) for
annual US data yields:
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The US output gap and its
components estimated by
the production function
method
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THE PRODUCTION FUNCTION APPROACH
• Stylized business cycle fact 10:
Total labour input varies in a strong procyclical
manner, explaining most of the variation in the
output gap. Total factor productivity, TFP, also varies
procyclically and the cyclical component of TFP
accounts for a large fraction of the total output gap
at business cycle peaks and troughs.
• Stylized business cycle fact 11:
Most of the cyclical variation in total labour input
stems from fluctuations in cyclical unemployment,
but average working hours, and to some extent the
total labour force, also vary procyclically.
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A LOOK AHEAD
• We want to construct an economic model
that may explain short-run fluctuations in
output, employment and inflation.
• In Chapters 14 through 16 we derive the
aggregate demand curve.
• In Chapter 17 the aggregate supply curve is
constructed.
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A LOOK AHEAD
• We set up the AS-AD model in Chapter 18
and try to reproduce some of the presented
stylized facts.
• Chapters 19 through 22 extend the basic
model in order to analyse the problems of
macroeconomic stabilization policy.
• The last three chapters are dedicated to
studying the open economy.
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