Transcript Chapter 15

Chapter 15
Business Cycles
Business Cycles are Now Less
Frequent
• From 1789 through 1982, a recession
occurred about once every four years.
• Since then, there have been only 2 mild
recessions, in 1990-91 and 2001. During
the 2001 recession, final sales – i.e., GDP
minus inventory investment – did not
actually decline.
Measuring the Business Cycle
• The actual starting and ending dates of each
business cycle are determined by the Dating
Committee of the National Bureau of Economic
Research.
• These dates are based on the behavior of the
indexes of leading, coincident, and lagging
indicators.
• Sometimes the Committee takes a long time to
make up its mind. For example, even though
the 2001 recession ended in November of that
year, this was not “officially” announced until July
2003, some 20 months later.
Index of Leading Indicators
• The index of leading indicators consists of economic
data series that usually turn up or down several months
before general economic conditions change.
• The major problem with this index is that it provides too
many false signals, indicating that a recession is
imminent when in fact no turning point is about to occur.
• The stock market is often mentioned as an important
leading indicator. Yet after the economy recovered in
late 2001, the stock market fell almost steadily during the
first three quarters of 2002.
Index of Coincident Indicators
• This index measures where the economy is right
now. It consists of four components: payroll
employment, real business sales, industrial
production, and real personal income excluding
transfer payments.
• Although not widely followed, this is a very
useful index for pinpointing where the economy
is right now. It is more accurate than real GDP,
and is also available on a monthly rather than a
quarterly basis.
Index of Lagging Indicators
• This index is supposed to provide
verification that the economy has in fact
entered a recession or recovery.
However, even here the index did not work
very well, failing to alert the Dating
Committee that the recession had ended
in late 2001. As a result, this index is
seldom mentioned any more.
What Determines a Recession?
• In general, the answer is a decline in real GDP
and production and a rise in the unemployment
rate. However, sometimes these changes are
small enough that the result is a pause in the
expansion but not an actual downturn.
• There is no “dictionary definition” for a
recession, but generally, the unemployment rate
must rise at least 2% and industrial production
must decline for two consecutive quarters. It
was once thought that real GDP also had to
decline for two consecutive quarters, but that did
not occur in several recessions.
Recessions – Recurring but not
Regular
• The timing of business cycle recessions is quite
erratic. There were no recessions from 1961 to
1969, then four of them occurred in the next 12
years. That was followed by only 2 recession in
the next 20 years.
• The causes of recessions are somewhat
different, but once the downturn has started, a
recurring pattern of economic activity does
occur.
What Causes Recessions?
• Previously we noted that since 1969, every
recession has been preceded by an inverted
yield curve, and that there have been no other
times that the yield curve became inverted. But
what causes the yield curve to become inverted?
• It would be a serious mistake to say that
monetary policy causes recessions. If anything,
monetary policy has mitigated the severity of
recessions in the post World War II period.
What Causes an Inverted Yield
Curve?
• Often, the rate of inflation rises, and the Fed
tightens in order to keep inflation from spiraling
even further.
• Even if inflation does not rise, though, interest
rates may rise because of an overheated
economy or a bubble in the stock market.
• The 2001 recession was caused more by excess
capacity rather than the inverted yield curve per
se, because credit was not restricted.
Nonetheless, the yield curve remained an
accurate indicator of the upcoming recession.
Non-monetary factors causing
recessions
• Besides monetary tightening reflecting
overheating, or explicit restraints on credit
through legislation, what other factors cause
business cycle recessions?
• End of wartime spending
• Excessive fiscal restraint
• Energy or other supply shocks
• Excess capacity
• Strikes or other major disturbances
• International developments
Impulse and Propagation
• The impulse, or initial shock causing a
recession, may be due to a large variety of
figures, as shown on the previous slide.
• However, once the downturn is under way,
a recurring pattern of economic reactions
generally occur. Thus even if the impulse
is quite different, the propagation – as the
downturn spreads through the economy –
is usually quite similar.
The Lower Turning Point
• We have suggested several reasons for why
recessions start. Why do recoveries start?
• Monetary easing: lower interest rates and
greater availability of credit
• Fiscal stimulus: usually but not always
• Workoff of excess capacity, and decline in
excessive inventory stocks.
• Weaker dollar may stimulate net exports in the
short run.
Length of Recent Recessions
• It usually takes the Fed about three months to
recognize a recession and start easing, and
about six months before that change in policy
takes effect. Thus most recessions – including
the 2001 downturn – last about 9 months.
• Two postwar recessions have been six months
longer, because the Fed initially failed to ease –
or started to ease but then reversed course
when inflation accelerated and tightened again.
Other than that, there have been no exceptions
in the U.S. economy in the postwar period.
Suppose Everything Went Wrong
• But suppose after a recession was underway,
the Fed tightened, credit was restricted, taxes
were raised and government spending was cut,
and foreign trade plunged because tariffs were
raised. Under those circumstances, the
recession might continue indefinitely and
intensify into a depression.
• That is what happened to the U.S. economy
from 1929 to 1933. Presumably no
administration would make those kinds of
mistakes any more.
Old and New Business Cycle
Theory
• From 1959 through 1990, the U.S. economy
went through 6 recessions that all showed the
same pattern. Inflation increased, productivity
growth slackened, the Fed tightened, the yield
curve inverted, credit was restricted, and real
GDP declined.
• The 2001 recession was quite different. The
core inflation rate did not rise at all and
productivity growth accelerated. Yet a recession
still occurred – and the bursting of the stock
market bubble was not the major impact,
because most of that happened later.
Business Cycle Theory, Slide 2
• We have already mentioned excess capacity as
one of the major reasons for the 2001 recession.
This is not a new theory. In fact it is a very old
theory, one that was common before the Great
Depression of the 1930s.
• It all goes back to the fundamental identity I = S.
No matter what theory is used, a recession
occurs when ex ante I falls below ex ante S and
the decline in interest rates is not sufficient to
close the gap.
Business Cycle Theory, Slide 3
• Why would ex ante I fall? The fundamental relationship
remains the comparison between the cost of capital and
the marginal productivity of capital (mpk). When the
former is higher than the latter, investment declines.
• Usually that imbalance occurs because interest rates
rise. But suppose they do not. In that case, investment
would keep rising. Eventually the capital stock would
increase so much that the mpk would decline, and it
would no longer pay to invest because of excess
capacity. When that occurs, a recession would start
even if interest rates and the cost of capital had not risen
at all.
Business Cycle Theory, Slide 4
• That cycle would caused primarily by a
technological boom, which would initially
boost the mpk relative to the cost of capital
and would keep capital spending rising
rapidly much longer than would ordinarily
be the case. Hence the expansion phase
of the cycle would be longer than usual.
That is what happened in the 1990s.
Real Business Cycle Theory
• The fact that some business cycles are caused
by shifts in technological progress is one of the
key elements in what is known as Real Business
Cycle Theory.
• In general, RBC says that most cycles are
caused by various shocks, including shifts in
technology, but also due to energy shocks, wars,
international disturbances, and strikes and other
major domestic disruptions. RBC says that
changes in monetary and fiscal policy play only
a secondary role in causing business cycles.
Fed Does Not Usually Cause
Recessions
• Sometimes this point is confusing because it seems that
recessions invariably occur shortly after the Fed has
tightened.
• However, most economists no longer think – if indeed
they ever thought – that the Fed causes business cycles.
It reacts to other factors that cause business cycles,
namely an imbalance between the cost of capital and the
MPK. The expansion invariably comes to an end when
the former exceeds the latter, whether that is due to a
rise in interest rates or a decline in the MPK due to
excess capacity. The Fed does not cause business
cycles; usually it reduces them.
Fiscal Policy Usually Reduces
Rather than Magnifies Recessions
• The same comment can generally be made
about fiscal policy. Automatic stabilizers help
reduce the length and severity of recessions.
• Also, discretionary fiscal stimulus often occurs
during recessions, although given the length of
time required to pass legislation, sometimes the
stimulus does not occur until after the recession
has ended.
• Of course, fiscal policy can cause recessions,
especially when market forces are subverted by
wage and price controls or other interferences
with market-clearing mechanisms.
Errors Have Been Made
• It is, of course, possible, for fiscal and monetary
policy to contain errors that lengthen and
deepen recessions. That happened in the
1930s, and to a lesser extent occurred in 1968
and 1973.
• Since the end of World War II, though, fiscal and
monetary policy in the U.S. have generally
worked to ameliorate, rather than exacerbate,
business cycle downturns.
Business Cycles: Endogenous or
Exogenous?
• Without monetary and fiscal stabilizers, regular cyclical
fluctuations in the difference between the cost of capital
and the MPK would probably cause recessions on a
fairly regular basis.
• In an optimal world, monetary and fiscal policy could
regulate the economy well enough that any imbalances
would remain minor.
• However, even if policy makers were unusually capable,
that still does not take account of expectations. Suppose
“everyone” believed the business cycle had been
conquered and there would never be any more
recessions. Many consumers and businesses would
leverage their positions, leading to a runaway stock
market. Eventually, the excessive optimism would turn
on itself, and a recession would develop anyhow.