Transcript Porter BJE 1983 A Study of Cartel Stability: The Joint

Economic Fluctuations
Tom Longwell
University of Minnesota
April 19, 2013
Longwell
University of Minnesota
Goal: Explain Why Economic Output
Fluctuates
• The
main goal for today’s lecture is to lay out some theories
for why we observe fluctuations in macro economic variables
• This
is not a settled question, so we will have a few
competing theories
• Any credible theory has to be able to explain unemployment
• We might also like to explain why some countries have
bigger fluctuations than others, and also what determines long
they last
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Example: Argentina
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Example: US
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Measuring Fluctuations
We measure fluctuations by breaking the data of interest
(GDP, employment, etc.) into two components: trend and
cycle
• Trend represents the “long-run average” for the variable
• Cycle represents deviations from the trend
When the cycle is above the trend, we are in a boom, while
the cycle is below the trend when we are in a slump or
recession.
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Trend Example (US)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Cycle Example (US)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Employment
Note that GDP is not the only economic variable which
fluctuates
• Employment tends to tightly track GDP
• So when GDP is in a slump, employment usually is too
• Some variables (leaders) tend to move before GDP
• Building permits and the stock market
• Other variables (laggards) tend to move after GDP
• Average duration of unemployment
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Unemployment Example (US)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Explaining Economic Fluctuations
Now that we have a basic idea what the business cycle
is, we need to try to explain it (No biggie)
We need to
• Explain what economic factors cause it to exist
• Explain why booms and slumps can persist
• Explain why boons and slumps never last forever
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Theories of the Business Cycle
Theories for explaining the business cycle fall into two
main camps:
• Real Business Cycle Theory, or the Neo-Classical
Model
• In an RBC model, the business cycle represents
real changes in the ability of an economy to produce
goods and services
• Keynesian models
• In Keynesian models, the business cycle is
generated by underuse (and sometimes overuse) of
productive capacity
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Real Business Cycle Models
We will focus our analysis on explanation of recessions
In a Real Business Cycle Model, recessions are caused
some fundamental economic object shifts in a bad way
Remember: A recession represents a decrease in the
production of goods and services in an economy
Let’s consider a few examples
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility One: Labor Supply Decreases
Real
Wage
Rate
Recession
Labor Supply?
G
$30
E
$25
Normal
Labor
Supply
Labor
Demand
Employment
If the labor supply decreases, less labor is used, thus
fewer things are produced. Is this convincing?
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility One: Labor Supply Decreases
Real
Wage
Rate
Recession
Labor Supply?
G
$30
E
$25
Normal
Labor
Supply
Labor
Demand
Employment
Not generally convincing, as instances of mass
abandonment of working are rare
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility One: Labor Supply Decreases
The Neo-Classical model has a hard time explaining a
large shift in labor supply
• People generally like stability of employment, not wild
changes in their work habits
• It’s also hard to explain events like the Great
Depression where millions of people wanted to work but
couldn’t find employment as being caused by a labor
supply decrease
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility Two: Labor Demand Decreases
Real
Wage
Rate
Labor
Supply
E
$25
F
20
Normal
Labor
Demand
Recession
Labor
Demand?
Employment
If labor demand decreases, we also get less labor used,
Is this better?
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility Two: Labor Demand Decreases
Real
Wage
Rate
Labor
Supply
E
$25
F
20
Normal
Labor
Demand
Recession
Labor
Demand?
Employment
Sometimes. Can you think of any reasons why employers
might suddenly lower their demand for labor?
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility Two: Labor Demand Decreases
It is sometimes possible to generate a believable story
for a decrease in labor demand
• Robots might be used to replace human workers
• A new technology may be introduced that makes
existing goods or production processes obsolete
• Blacksmiths
• Handloom weavers
If workers need time to retrain following a shift, labor
demand may stay low for some time
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Possibility Three: Total Factor Productivity
Decreases
Here’s a generalization of example two:
• We can model the economy as follows:
• Output = f(labor,capital,technology)
• For example, Y = Z*K.3*L.7
• Z represents our ability to turn capital and labor into
goods and services
• TFP could be lowered temporarily by many things
• Lack of natural resources (Arab Oil Embargo)
• Breakdown of trade agreements (Hawley-Smoot
tariff of 1930 and subsequent retaliation)
• Low TFP means recession (Can’t make stuff easily)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Grading the RBC Model
Ultimately, the RBC models works part of the time
• It does a good job of explaining the 1970s, for example
• It can arguably explain the Great Depression (at least
why it lasted so long)
• It doesn’t do a great job of explaining recent events,
amongst other historical recessions
• FYI: The RBC model rests of a controversial assumption
called efficient markets
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Implications of the RBC Model
There are many public policy implications of the RBC
model, but they generally boil down to one big one:
• The government cannot interfere in the economy to “fix”
the business cycle
• The government can act to aid people who are
harmed by a recession
• Such aid will always come at the cost of long run
economic growth
• Generally speaking, the government should do
nothing and let the situation fix itself
• The RBC model obeys Says’ Law (Supply creates its
own demand)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Problems in the RBC Model
Buried in the RBC model are several problematic
assumptions, first noted by Keynes himself
• Real wage = marginal disutility of working, always
• The real wage is constantly fluctuating due to price
changes
• Evidence that workers care more about nominal wage
• Savings = Investment
• The problem here is people may stick their money
under their mattress
• It’s hard to generate “structural” unemployment
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Keynesian Models
The other class of available models are named after the
British economist John Maynard Keynes
• His big idea is that multiple equilibria are possible in
the economy
• Some will have more output than others (and thus
be better)
• In Keynesian models, the government can often
improve the equilibrium by using deficit spending
• Keynesian models often rely on people repeatedly
behaving irrationally from an economic perspective
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
An Example Keynesian Model
Here is a simple example of a Keynesian model
• The economy starts in a good equilibrium
• Kim Jong Un threatens to turn California into a nuclear
desert
• Investors pull their money from Californian businesses
• These investors are scared, and hoard their money
• California produces fewer goods and services
• People lose their jobs and spend less
• More businesses cut back, as do investors
• Downward spiral
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Keynesian Assumptions
The previous model is making some hidden
assumptions
• The biggest is that desperate workers should lower
their wage demands, and investors their rate-of-return
demands
• Entrepreneurs should then try to take advantage of
these cheap inputs
• In the Keynesian model, some combination of fear and
an inability for prices to adjust prevent this from
happening
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
Grading the Keynesian Model
The Keynesian model usually fits, but it has some problems
• It requires people to not learn from their mistakes
• It is very hard to write down microeconomic models that
generate Keynesian macroeconomic behavior
• While the government may be able to profitably interfere
in theory, doing an intervention ineptly can do more harm
than good, and getting it right is very hard
• The Keynesian model breaks Says’ Law (Probably a plus)
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota
The Lucas Critique of Countercyclical
Spending
Robert Lucas came up with the following:
• To do countercyclical spending, we estimate
Yt+1 = F(Yt,Xt,θ,εt)
• X represents “forcing variables”, things that should affect
the economy and can be chosen, like tax rates or spending
• εt is a random error
• θ are parameters to be estimated
• Lucas noted that changing government policies will
generally change the relationships between Y, X, θ and ε
Longwell
10/28/2008
Tom Longwell
University of Minnesota
University of Minnesota