Transcript Document

MBA34
Managerial Excellence – 1° Term
Business cycles and stabilization policies Class 17
The firm and its environment
Copyright SDA Bocconi 2004
Francesco Giavazzi
1
Class outline
 Definitions
 Facts
 Scope for stabilization policies
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Definition: business cycles
Actual GDP data mix up two parts, permanent and
transient
 Permanent GDP = potential GDP or output
 Lecture 1, 2 and 3 on growth are about growth of
potential GDP
 Transient part is business cycle component of GDP.
Expansions and recessions around path of potential
GDP
Same for unemployment. Actual rate of unemployment
fluctuates
around
the
Natural
Rate
of
Unemployment (NRU)
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Definition: the “output gap”
Output gap - a synthetic measure of fluctuations
= (GDP-GDPpotential) / GDPpotential
 If output gap positive, economy overheated,
inflation mounting
 if output gap negative, economy working at less than
full capacity, inflation cooling down
When economy in recession, “output gap” gets smaller.
It may still be positive though. See next
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Output gaps in practice
4
3
2
1
0
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
-1
-2
-3
Euro area
USA
Output gaps in the US and the Euro area move together.
But swings in the US economy usually come before (1 year)
and are sharper than those in the EU
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Computing the output gap
on the flip side of your business card
Euro area
2005
2006
2007
2008
Actual GDP
growth
1.7
2.9
2.6
1.7
Potential
GDP growth
2.1
2.0
2.1
2.0
Output gap
-1.6
-2.0
-1.1
-0.6
Output gapt  output gapt-1+
(actual growtht – potential growtht)
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Definition: Okun’s law
Over the cycle: GDP and unemployment co-vary
negatively. Need rule of thumb to translate U rate
above or below its natural rate in terms of output
gap. Okun’s law is such rule of thumb
Okun’s law: Any extra % point of actual
unemployment corresponds to 2 % points of output
gap (1:2 relation)
An empirical regularity. With a rationale
 GDP fluctuates more than U. Why?
 As GDP falls, labor hoarding; as GDP rises, overtime
 In both cases, changes in U lag behind changes in GDP
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Reminder: what is a “recession”
Business cycle: alternating expansions and recessions.
What is a “recession”?
Oft-cited definition: GDP growth <0 over two
consecutive quarters
 Not very useful: sequence of quarterly GDP growth of -
2%, +0.01%, -2%, +0.01 would not be a recession,
although the yearly number would be sharply negative
Common practice -- business cycle dating committees
look at broad set of variables (GDP, industrial
production, total employment, retail sales)
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Business cycle facts
Expansions last longer than recessions a
Recessions are sharper than expansions b
GDP is less volatile in rich countries
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Real GDP volatility: Germany vs. Peru
25
20
10
5
0
2000Q1
1998Q1
1996Q1
1994Q1
1992Q1
1990Q1
1988Q1
1986Q1
1984Q1
1982Q1
-5
1980Q1
Annual Percentage Growth
15
-10
-15
-20
-25
-30
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Business cycle and stabilization policies
What can govt do to affect the level of GDP over
the cycle?
Can Govts stabilize growth of actual GDP?
Answer: to some extent yes, but at a cost
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What can Govts do in a recession?
Governments want high GDP and low inflation
In a recession GDP is low. Inflation low or high,
depending on what caused the recession in the first
instance
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When recession caused by demand,
low GDP and low inflation
LRAS
Price Level
AD
Government
responds by
increasing demand
AS
Increase G
Decrease T
Increase M
P0
P1
Y1
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Y0
Real GDP
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When recession caused by supply,
low GDP and high inflation
LRAS
Price Level
AD
If Gov’t responds by
increasing demand
AS
Maxi
increase in
price, GDP
back to
potential
P0
Y0
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Real GDP
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How to read supply and demand shocks
in the data: the US in the 1990s
US
economy
1991-93
1994-96
1997-00
2001-02
GDP
growth
2.4
3.2
4.2
1.3
inflation
3.2
2.7
2.6
1.7
1990s: GDP up & inflation down, symptom of positive
supply shock
2001-02: both GDP & inflation down, symptom of
negative demand shock
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Back to main question -what can Govts do in a recession?
Plausibly, in the short run, only AD can be shifted
Through fiscal policy (G or T) or monetary policy
(discount rate). In both cases AD shifts to the
right
Results? GDP but P as well


To have GDP, inflation to be tolerated
Hence, at most, only one goal at a time
By raising AD in recession (and reducing it in
booms), stabilizing effect of policy on GDP
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More extensive use of stabilization (“Keynesian”)
policies may explain lengthened expansions and
shortened contractions after WWII
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Arguments against stabilization policies
• Uncertainty
• Policy Lags
• Problems with Fiscal Policy (Ricardian
Equivalence)
Longer discussion postponed to classes on
fiscal and monetary policy
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Can Govts accelerate GDP growth indefinitely
by raising AD?
Suppose GDP at its potential and U = natural rate. But
elections very close and Govt badly wants higher
GDP now
Idea: expand AD (e.g. cut taxes)

AD to the right, P up. GDP up & U down
Great? Only temporarily, at most
GDP gains don’t’ last, for workers raise wage claims
upwards. Then real labor costs up, GDP down, U
up. Back to long-run equilibrium (same GDP but
inflation higher).
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The Phillips curve
GDP-inflation dilemma can be rephrased in terms of
inflation and unemployment
 As GDP up, U temporarily down and inflation up
 As GDP down, U temporarily up and inflation
down
 The negative relation between inflation and
unemployment is the “Phillips curve” (PC)
 as with GDP and inflation, the inflationunemployment dilemma is there in the short run
(SR-PC), not in the long run (vertical LR-PC)
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Conclusions on business cycles and
stabilization policies
Business cycles are costly
 Govts can do something to smooth recessions, but
stabilizing GDP is not a free lunch. It comes at the
cost of higher inflation
 Govts can’t make the economy grow indefinitely
faster by AD policies only
 AS policies needed too
 encouraging technical change and K accumulation is key
for long-run growth
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Expansions last longer than recessions a
Luxembourg
Recessions
Expansions
Ireland
Netherlands
Belgium
Spain
Italy
UK
France
Germany
Japan
Canada
USA
0
50
100
Duration in Months
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Recessions are sharper b
Luxembourg
Ireland
Netherlands
Belgium
Spain
Italy
UK
France
Decline in Contraction
Germany
Growth in Expansion
Japan
Canada
USA
0
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0.5
1
1.5
2
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