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What are Business cycles?
Many leading economists who worked in the first half of the twentieth century regarded the explanation of the recurrent cycles in the economy as ava high priority. Interest in this area died down somewhat in the 1950s and 1960s, both because cycles had ceased to be a major problem, and because the theoretical focus of Keynesian economics was on the determination of the level of income at a specific point in time. Such dynamic theory as there was, was more concerned with the characteristics of stable growth paths than with cycles about such paths. This is not to say that there was no concern with cycles, merely that the dominant view was that the new Keynesian policy tools ensured that cycles need no longer be a problem. This view was reinforced by the apparently self-evident absence of major cycles, which was interpreted by many to mean that these policy tools were highly effective. There is, of course, another interpretation of these events, as we shall see.
An understanding of the nature and causes of business cycles is at the heart of policy controversy between Keynesians and Monetarists. A different explanation was offered by New Classical economists, notably Robert Lucas, which, as we have already seen, is even more damaging to the case for active stabilization policy than the Monetarist arguments. At the center of the problem is the question of whether the private sector of the economy is stable, and whether government intervention makes it more stable or less stable. This distinction was emphasized by Modigliani (1977) in his presidential address to the American Economic Association:
In reality, the distinguishing feature of the Monetarist school and the real issue of disagreement with non-Monetarists is not Monetarism, but rather the role that should probably be assigned to stabilization policies.
Non-Monetarists accept what I regard to be the fundamental practical message of the General Theory: that a private enterprise economy using intangible money needs to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies. Monetarists, by contrast, take the view that there is no serious need to stabilize the economy; that even if there were a need, it could not be done. for stabilization policies would be more likely to increase than to decrease instability, and, at least some Monetarists would, I believe, go so far as to hold that, even in the unlikely event that stabilization policies could on balance prove beneficial, the government should not be trusted with the necessary power.
These issues are now of urgent importance. Most countries have been through two major depressions in the last twenty years (1974-75 and 1981-83, though the precise timing differs from country to country) more serious than any since the 1930s, and the United Kingdom has through a third (1990-93). As a result of this, it should be no surprise that there has been a revival of interest in business cycle theory.
Explain The Theory of Business Cycles
One of the most famous students of the business cycle, Joseph Schumpeter (1939), identified three different amplitudes of the cycle in the previous 150 years. These he named after writers who had noticed them previously. There was a sixty-year wave (Kondratieff), a ten-year cycle (Juglar), and a forty-month cycle (Kitchin). It is the shortest of these which is the one most economists refer to as the business or trade cycle. Subsequent empirical research, particularly that in the United States associated with the National Bureau of Economic Research (NBER), has concluded that business cycles cannot be accurately characterized by periodicity. The time profile is in fact irregular. What does characterize these cycles, however, is a remarkably common pattern of co-movements of aggregate economic series.
The principal among these are the following:
- Output movements across broadly defined sectors move together. (In Mitchell's  terminology they exhibit high conformity, in modern time series language they have high coherence.)
- Production of producer and consumer durables exhibits much greater amplitude than does the production of non-durables.
- Production and prices of agricultural goods and natural resources have lower than average conformity.
- Business profits show high conformity and much greater amplitude than other series.
- Prices generally are procyclical.
- Short-term interest rates are procyclical, long-term rates slightly so.
- Monetary aggregates and velocity measures are pro-cyclical.
Elaborate The Keynesian Approach to Business Cycles
While the literature contains large numbers of attempts to explain cycles (see, for example, R. A. Gordon, 1961, Chapters 12 and 13), attention here is restricted to the main differences between the macro contenders.
Keynesian economics would appear to have no serious difficulty in accounting for these stylized facts. The initial event would be a change in exogenous expenditures such as exports or investments. This would be transmitted through the economy by a combination of the multiplier effect and the accelerator (Samuelson, 1939). The latter reflects the induced effect on investment of the change in output. Upswings or downswings may be explosive but constrained by ceilings (resource constraints) and floors (net investment cannot be negative) as, for example, in Hicks (1950). Alternatively, the dynamics of the economy may themselves be cyclical (Matthews, 1959)-possibly damped cycles, possibly explosive. To illustrate this let us consider a specific case set out by Matthews (1959).
The accelerator derives from the fact that a given capital stock is required to produce a constant level of output. This means net investment (increases in the capital - depreciation is ignored) must be associated with growing output. Assume that there is a lag between changes in output and investment so,
1t = (Yt -1 – Yt-2) (11.1)
The consumption function is the familiar one
Ct = α + βYt (11.2)
The solution for current income when (11.1) and (11.2) are substituted into Y = C + I is
Yt = [v / (1 – β)] (Y, Yt-1 -Yt-2) + α /(1 - β) (11.3)
This is a second-order difference equation, the course of which will depend on the precise values of the parameters (v and β in this case) but it is quite likely that a once-and-for-all change in exogenous expenditures (α) will lead to cycles in Y. Consider Matthews' numerical example which is set out in Table 11.1. Take the values of v and β as 3/5 and 1/2 respectively. Set the initial values of variables as follows: Income (Y)= 100, Capital (K) = 60, Investment (l) = 0, Autonomous Consumption (α) = 50. Then in the third period, α increases to 75 and stays at the new higher level. The immediate impact is a multiplier effect on the income of 50 (1 / (1 - β) = 2).
In the next period, investment starts to rise because income rose in the period before. The investment has a further upward multiplier effect on income, so the next period investment is a bit higher, though only a little. So the rate of increase in income slows down, and this leads to a reduction of investment which itself leads to a downturn of income, etc.
The central elements of this mechanism still seem highly plausible. The model is, of course, highly simplified and would in reality have to include many other structural constraints. Nonetheless, in an IS-LM-type framework augmented by a simple Phillips curve, this model could account for all the stylized facts set out above. Seen as caused by a shifting IS curve, the cycle would evidence positive correlations between output and all prices, profits, interest rates, and velocity. The accelerator is also a very convincing reason why cycles in capital goods industries are of much greater amplitude than in consumer goods industries. However, the analysis also carries the strong implication that government behavior could change all this. In the above example, if government expenditure had been included in the analysis, a reduction of G by 25 in Period 3 would have left income stable. Similarly, a government reaction function of the form G = v (Yt-1-Yt-2) would eliminate the cycle by offsetting the accelerator.
Table 11.1 A multiplier/accelerator model
|Period||α||l||Y||C||K (beginning of period)|
Explain The Monetarist Approach to Business Cycles
The Monetarist approach to the business cycle is rather different from this and is most clearly evident in the work of Milton Friedman and Anna Schwartz (1963a, b). It cannot be claimed that monetary factors were ignored in Keynesian-style explanations - they were not (see Hicks, 1950, Chapter 11; Harrod, 1936, Chapter 3; Matthews, 1959, Chapter 8). Indeed, the trade cycle had been described by one of Keynes' contemporaries, R. G.
Hawtrey, as a purely monetary phenomenon' (though Hawtrey could hardly be described as a Keynesian). What was different about the work of Friedman and Schwartz (apart from the detailed empirical evidence they produced to support their case) was the emphatic insistence on the importance of the money stock, rather than on credit conditions and interest rates in general. Most stories would have tightening credit associated with the slowdown and easy credit associated with the upturn. Friedman and Schwartz argued that changes in money were the dominant cause of cycles and that changes were predominantly exogenous. The following statements are the main findings of Friedman and Schwartz (1963a):
There is unquestionably a close relation between the variability of the stock of money and the variability of income. This relation has persisted over some nine decades and appears no different at the end of the period than at the beginning.
There is a one-to-one relation between monetary changes and changes in money income and prices. Changes in money income and prices have, in every case, been accompanied by a change in the rate of growth of the money stock, in the same direction and of appreciable magnitude, and there are no comparable disturbances in the rate of growth of the money stock unaccompanied by changes in money income and prices.
The changes in the stock of money cannot consistently be explained by the contemporary changes in money income and prices. The changes in the stock of money can generally be attributed to specific historical circumstances that are not in turn attributable to contemporary changes in money income and prices. Hence, if the consistent relation between money and income is not a pure coincidence it must reflect an influence running from money to business.
Our survey of experience leads us to conjecture that longer-period changes in money income produced by a changed secular rate of growth of the money stock are reflected mainly in different price behavior rather than in different rates of growth of output; whereas the shorter-period changes in the rate of growth of the money stock are capable of exerting a sizable influence on the rate of growth of output as well.
Even if the above statements are accepted, we still do not have a reason to believe that a step change in the rate of growth of the money stock will generate anything but an (ultimate) step change in the rate of inflation and a one-off temporary effect on the level of real output. How does this provide the basis for a theory of business cycles? The answer provided by Friedman and Schwartz is that the transmission mechanism contains forces that will produce overshooting. The principal of these is associated with the fact that the demand for real money balances depends upon the rate of inflation (this is the opportunity cost of holding money relative to goods). Suppose there is a step increase in the rate of growth of money. In equilibrium, there will be a similar step increase in the rate of inflation. However, as a result of the higher inflation, demand for real money balances will fall. This means that the price level must be higher relative to the nominal money stock than it was initially. Therefore, during the transition to the new equilibrium, the rate of inflation must overshoot its steady-state value. This temporary overshooting of inflation will lead people to run down their real money balances too far. As they build them up again the inflation rate must be below its equilibrium level, etc. The rundown of the money balances phase will. of course, be associated with upturns in business activity and vice versa for the build-up of money balances.
In purely mechanical terms there are obvious similarities between this explanation of cycles and the accelerator mechanism. In one case the dynamics resulting from the fact that the stock demand for one variable (money) depends upon the rate of change of another (prices). In the other case, a flow demand (investment - itself the change in the stock of capital) depends on the rate of change of another variable (income). In both cases, the time paths of endogenous variables may be described by difference or differential equations which, depending upon the parameters of the system, may generate cycles once disturbed. In terms of their implications for policy, however, the Keynesian and Monetarist explanations are very different.
The main policy difference derives from a disagreement over the source of disturbances. For Keynesians, the shocks come from changes in autonomous expenditures, such as exports, or shifts in private expenditures, such as investment. This reflects the intrinsic instabilities of the market economy and it is the job of the government to try to spot these movements and offset them by changes in its own behavior. For Monetarists the shocks are primarily changes in the rate of growth of money and, at least in the modern world, control of the money stock is the responsibility of central monetary authorities. The shocks, therefore, are primarily due to control failures on the part of the government or governmental agencies. Hence, the conclusion is that the discretionary powers of these authorities should be reduced and they should be made to adhere to a more or less rigid growth rule for the money stock.
Even if shocks are identified as being from other sources, monetary policy should not be used as a tool of stabilization policy because it is too clumsy. In Friedman's well-worn phrase, the impact of monetary policy is subject to 'long and variable lags'. As a result, a policy that is intended to be stabilizing may, in reality, be destabilizing. A stimulus, for example, intended to help the economy out of depression may add fuel to a subsequent boom because its effects are felt with a lag. The variability of such lags makes the stabilization role of monetary policy severely limited.
How Does the New Classical Approach Relate to Business Cycles?
The New Classical approach to business cycles contains elements of both the accelerator mechanism (as, indeed, could the Monetarist story, though it is not emphasized) and monetary shocks. However, in one respect the New Classical economists have made a major break with the post-World War Two macroeconomic tradition. This is their insistence on developing an equilibrium theory of the business cycle. The reason for this insistence is the problem posed by the Lucas Critique rather than the inability of earlier theories to explain the general pattern of past cycles.
The ability of a model to imitate actual behavior... has almost nothing to do with its ability to make accurate conditional forecasts, to answer questions of the form: how would behavior have differed had certain policies been different in specified ways?... Any disequilibrium model, constructed by simply codifying the decision rules which agents have found useful to use over some previous sample period, without explaining why these rules were used, will be of no use in predicting the consequences of nontrivial policy changes.
Before the 1930s economists did not recognize a need for a special branch of economics, with its own special postulates, designed to explain the business cycle. Keynes founded that sub-discipline called
'macroeconomics', because he thought explaining the characteristics of business cycles was impossible within the discipline imposed by classical economic theory, a discipline imposed by its insistence on adherence to the two postulates (a) that markets clear and (b) that agents act in their own self-interest. The outstanding facts that seemed impossible to reconcile with these two postulates were the length and severity of business depressions and the large-scale unemployment they entailed...
The research line being pursued by some of us involves the attempt to discover a particular econometrically testable equilibrium theory of the business cycle, one that can serve as the foundation for quantitative analysis of macroeconomic policy. There is no denying that this approach is counter-revolutionary, for it presupposes that Keynes and his followers were wrong to give up on the possibility that an equilibrium theory could account for the business cycle.
It should be immediately obvious that to have an equilibrium theory of cycles requires a different concept of equilibrium from that normally used in textbook economics. Equilibrium is not, in this sense, a state of rest. Rather, it means that at each point in time actors respond optimally to the prices they perceive (which are being perpetually disturbed) and that markets should clear, given the supply and demand responses by actors to their perceptions of prices. In other words, the economy will be describable by a stable statistical process, rather than by displaying constant values of all variables. The idea of optimizing individuals should not be alien to economists. However, the statement that markets are perpetually clear at first sight seems outrageous. We shall see that it is not so outrageous and amounts to little more than an analytical device. It should not be interpreted as a statement about the real world, though unfortunately it often is. For example, it does not deny the existence of registered unemployed.
The central mechanism that generates the cycle is the (surprise) supply relationship that was described in Chapter 4. When applied to the explanation of business cycles (Lucas, 1975, 1977), the story contains elements of both speculative supply behavior (Lucas and Rapping, 1969) and signal extraction (Lucas 1972, 1973). Consider an individual self-employed producer. The producer has to decide each period how much to work and therefore produce, as well as deciding how much to invest (that is, increase the capital stock). Both these decisions are made on the basis of one piece of current information the price of the output. They learn about everything else going on in the economy with a lag except that, as before, they do know the probability distribution of real and nominal shocks.
Let us suppose that our actor observes a rise in the current price of the output. How should she react? As before, it depends on the extent to which this is regarded to be a shift of (real) relative prices in her favor, as opposed to a rise in the general price level. To the extent that this is perceived as real, one also has to decide whether it is temporary or permanent. If it is temporary, the actor should work harder now and take leisure later when the return to the effort will be lower. If it is permanent, it will pay to increase capacity by investing. The claim is that since all these decisions have to be made on the basis of a single price signal, the optimal response will be a weighted average. The weights depend on the relative variances of real and nominal shocks as before. The price rise will be associated with both a higher current output and a higher level of investment. This relation between output and investment can be thought of as an accelerator, though it will be damped as compared to the Keynesian accelerator. The investment will only respond to output changes perceived to be permanent. We return to this idea of intertemporal substitution - below.
Two important problems remain. Why do random shocks generate cycles of considerable duration? Why are the cycles evident in the aggregate rather than simply averaging out across the economy? For the
New Classical business cyclist persistence is a serious problem, but not insuperable. There is no necessary inconsistency between the randomness of shocks and the fact that output and employment changes are auto-correlated. Two factors in combination are used by Lucas (1975) to explain the duration of cycles. One is the lag in receipt of information; the other is the durability of capital goods. The role of lagged information has been discussed above. Obviously, the longer the information lag the longer will be the full-adjustment period. This would not matter so much if decisions were costlessly reversible. However, once changes are made in the capital stock this is no longer true because the capital formation is assumed to be irreversible. Mistakes made in one period will continue to affect output in future periods - hence the persistence of effects resulting from a random shock.
Why, then, is there a tendency for all sectors to expand and contract together? Lucas' answer is that the nature of the shock cannot be a random shift between markets or, indeed, any kind of disturbance that will wash out in the aggregate. Nor can it be an aggregate supply shock because this would lead to a negative correlation between price and output, which is not the typical pattern of business cycles. The strongest candidate is an aggregate monetary disturbance since this is the most likely to affect the price signals in all markets simultaneously. It should go without saying that this monetary disturbance has been unanticipated.
However, even a fully anticipated change in the rate of monetary expansion will have real effects if prices are not perfectly flexible for the same reasons as there is overshooting in the Monetarist business cycle. If there is a step increase in the rate of monetary growth this will lead to a corresponding step increase in the inflation rate. Demand for real money balances will fall. This can only be achieved at a higher relative price level. If the increased growth rate of money is fully anticipated, the price level will jump up at the initial point in time. Similarly, an anticipated lowering of the rate of monetary growth will both lower the inflation rate and cause an immediate downward jump in the price level. Friedman and Schwartz implicitly assume that prices are sticky so that some of the adjustment pressure is felt on output. It is hard to believe that prices are so flexible that there would not be real effects in any real economy. However flexible prices are, it is hard to believe that the price level could jump downwards overnight in an immediate response to the announcement of a tighter monetary policy. This, of course, reinforces the case for monetary causes of business cycles, but it would not meet with the approval of New Classical economists because of the arbitrary presumption in favor of price stickiness. However, the assumption of a jump in prices is also problematic because at the point in time at which the jump takes place the return to nominal assets is either plus infinity or minus infinity. If this jump is anticipated, the model will be explosive. New Classical economists handle this problem by assuming it away. The economy is simply assumed to jump to the new stable (saddle) path. Whether a real-world economy could jump in this way depends on what price we are discussing. While it does not seem sensible to construct models where, say, the aggregate price level jumps, it is not at all implausible in financial markets.
It is this assumption that prices adjust continuously to clear markets that have been the economics among economists. While markets do exist in which prices are determined to clear the market at the time (such as commodity markets and foreign exchange markets), most goods and services are traded in what Hicks (1974) calls 'fix-price markets' and Okun (1981) calls 'customer markets'. Certainly, the rhetoric of New Classical economics is inconsistent with arbitrary stickiness in prices. However, in reality, the disagreement is more apparent than real. It is an issue of semantics rather than economics, This is because as we have just seen New Classical economists have to introduce imperfections and rigidities of some kind in order to explain real-world data. The effect of this is to introduce auto-correlation into activity series (such as GDP) so that the series becomes describable by a difference or differential equation as above. Once in this form, the theory is observationally equivalent (Sargent, 1976) to a large number of other theories including versions of the ones outlined above. There may be no way of discriminating between them from the data alone.
In behavioral terms, this has an obvious interpretation. The price-stickiness view of markets has some actors in the marketplace frustrated because they cannot buy or sell at the going price. The price does not adjust immediately to reflect this excess demand or supply. We would commonly say that the market does not clear. In the New Classical set-up, the price does clear the market made up of the actors who actually express the demands or supplies actively at a point in time in the marketplace, but it does not reflect the demands and supplies of actors who are delayed in their response because of poor information or being locked into the wrong location or equipment because of past mistakes. In the first view, for example, the unemployed worker is knocking at the factory gate, yet the employer does not reduce wages immediately to make it profitable to employ him. In the second view, there are no workers left outside the factory gate today. All who turned up today struck a wage bargain with the employer such that all get employed today. However, there are other workers who would work at that wage agreed upon today. It is just that they will not get there until after they hear about it and then have time to move house and arrange transport, etc. Either way, there is a slow adjustment and it is surely a matter of taste which way the problem is specified. The former conforms to many of our (perhaps Keynesian) prejudices whereas the latter may well offer methodological advantages. These are that the reasons for the slow adjustment have to be explicitly stated and, as a result, can be formally modeled. It does, however, seem unnecessarily narrow to rule out, a priori, some form of price stickiness which might be justified by optimizing models such as that discussed in the implicit contracts’ literature.
The implications of the New Classical approach are, of course, even more, cautionary for stabilization policy than was the Monetarist approach. Here, though, the strictures are much stronger. It is not the problem of long and varied lags. Rather, it is the fact that any systematic policy will come to be anticipated by actors. This argument is set out in detail in Chapter 4. A stabilization policy would be beneficial if the authorities had information or were able to react quicker than private actors.