Macroeconomics

Lecture 6: Business Cycles

Santosh Kumar Dash
IRMA, Anand
22-12-2023

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Agenda for Today’s Class

• Discuss business cycle

• Theories of business cycle
▪ Keynesian Business Cycle (KBC)
▪ Real Business Cycle (RBC)
▪ New Keynesian Business Cycle (NKBC)

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Introduction to 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.” (Definition by NBER)

• Business cycles have a boom phase or expansion and a bust phase or recession.
While there is no clear definition for the boom phase, recession is a period of
temporary economic decline during which trade and industrial activity are reduced,
generally identified by a fall in GDP in two successive quarters.

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Phases of Business Cycles

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Phases of Business Cycles (Expansion)
• During a period of expansion:
▪ Wages increase
▪ Low unemployment
▪ People are optimistic and spending money
▪ High demand for goods
▪ New businesses start
▪ Easy to get a bank loan
▪ Businesses make profits and stock prices increase

• When the economic cycle peaks:

▪ The economy stops growing (reached the maximum potential)
▪ GDP operates at tad below the theoretical maximum
▪ Businesses can’t produce any more or hire more people
▪ Cycle begins to contract

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Phases of Business Cycles (Contraction)
• During a period of contraction:
▪ Businesses cut back production and layoff people
▪ Unemployment increases
▪ Number of jobs decline
▪ People are pessimistic (negative) and stop spending money
▪ Banks stop lending money

• When the economic cycle reaches a trough:

▪ Economy “bottoms-out” (reaches lowest point)
▪ High unemployment and low spending
▪ Stock prices drop

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Keynesian Business Cycles (KBC)
Introduction
• Keynes has predicted the depression 10 years prior to its occurrence. In the
Keynesian cycle theory, fluctuations in investment driven by fluctuations in
business confidence - summarized by the phrase “animal spirits”- are the main
sources of fluctuations in aggregate demand.
• Keynes sought to explain involuntary unemployment.
• The Keynesian Business Ccycle theory focuses on nominal factors and
Aggregate demand.
• The Keynesian models can explain unemployment and a role for aggregate
demand in determining output and employment.
• A key element in these models is money wage rigidity.
• A fall in AD → Demand for Labor falls

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• However, because of downward wage rigidity, (due to fixed-wage labor
contracts and workers’ backward-looking price expectations), the money
wage will not fall sufficiently in the short run to maintain the initial
employment level.
• Thus, employment and output will fall. Unemployment will rise.

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Some Examples of Sticky Prices

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Real Business Cycle (RBC)
Central Features
• Real business cycle theory has its genesis in the original classical economics.
• The classical economists assume prices to be flexible and that markets always clear. There is
never an over production of goods.
• Say’s law: Supply creates it own demand
• The French economist Jean-Baptiste Say
▪ Say further argued that the law of markets implies that a general glut (the term used in
Say's time for a widespread excess of supply over demand) cannot occur. If there is a
surplus of one good, there must be unmet demand for another: "If certain goods remain
unsold, it is because other goods are not produced.“
• Say's law has been one of the principal doctrines used to support the laissez-faire belief that a
capitalist economy will naturally tend toward full employment and prosperity without
government intervention.

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• The last assumption of classical economics is that saving by the household
sector exactly matches investment expenditures on capital goods by the
business sector.
▪ In other words, while the production of Rs. 100 million of output generates Rs.
100 million of income, the household sector might choose to spend only Rs. 90
million, directing the remaining Rs. 10 million to saving. If so, then supply does
NOT create its own demand. Supply falls Rs.10 million short of creating enough
demand. If this happens, then producers reduce production and lay off workers,
which causes a drop in income and induces a decline in consumption, which then
triggers further reductions in production, employment, income, and
consumption in a contractionary downward spiral.

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 ▪ However, if this Rs. 10 million of saving is matched by an equal amount of
investment, then no drop off in aggregate demand occurs. Such a match between
saving and investment is assured in classical economics through flexible prices.
However, in this case price flexibility applies to interest rates.
▪ If saving does not match investment, then interest rates must adjust to restore
balance. In particular, if saving exceeds investment, then interest rates fall, which
stimulates investment and curtails saving until the two are once again equal.

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• If the markets function well, any unemployed resource should swiftly find
employment somewhere in the economy. Wide spread unemployment is
ruled out by assumption.
• Real business cycle theorists also believe that the business cycle is an
equilibrium phenomenon in the sense that all markets clear. This belief
contrasts with the Keynesian view that the labor market does not clear.
• The Keynesian model includes involuntary unemployment. In RBC models, all
unemployment is voluntary.

• As the name suggest, real business cycles are caused by shocks to real factors
of production.

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• What causes short-run fluctuation in output and employment?
▪ RBC theorists see these fluctuations as “arising from variations in the real
opportunities of the private economy.”
▪ Factors that cause such changes include shocks to technology, variations in
environmental conditions, changes in the real (relative) prices of imported raw
materials (e.g., crude oil), and changes in tax rates.
▪ Fluctuations in output also occur with changes in individuals’ preferences—for
example, a change in the preference for goods relative to leisure.
▪ The RBC theorists argue that these supply-side variables are also the source of
short-run fluctuations in output and employment.

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• This view distinguishes the RBC theorists from:
▪ New classical economists, who regarded unanticipated changes in aggregate
demand, resulting, for instance, from “monetary surprises,” as the main source of
fluctuations in output and employment.
▪ Keynesian models that gives importance to aggregate demand in determining
output and employment in the short run.

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A Simple Real Business Cycle Model
• Real business cycle models view aggregate economic variables as the
outcomes of the decisions made by many individual agents acting to
maximize their utility subject to production possibilities and resource
constraints.
• These models have an explicit and firm foundation in microeconomics.
• A representative agent: Robinson Crusoe.
▪ Robinson’s goal is to maximize his utility in each period of his life. He gets utility
from two sources: consumption and leisure.
▪ Utility function (U): 𝑈𝑡 = 𝑈(𝐶𝑡 , 𝑙𝑒𝑡 )
▸ where C is consumption and le is leisure.

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• Output in the model is generated by the production function:
▪ 𝑌𝑡 = 𝑧𝑡 𝐹(𝐾𝑡 , 𝑁𝑡 )
▪ 𝑧𝑡 represents shocks to the production process.
▪ By shocks we mean events that change the level of output for given levels of
labor and capital.
▪ RBC theorists include a number of factors in this category.
▸ Among the important ones are shocks to technology, environmental factors, changes
in government regulations that affect productivity, and changes in the availability of
raw materials.
• Robinson does not have to consume all the output he produces in each period.
▪ He wants to save for his old age or future generation.

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• 𝑌𝑡 = 𝐶𝑡 + 𝑆𝑡
▪ This indicates that, in addition to a labor–leisure trade-off, the representative
agent faces a trade-off between consumption today and saving for future
consumption.
▪ Saving today will increase consumption in the future because saving is assumed
to be invested to increase the capital stock in the next period:
• 𝐾𝑡+1 = 𝑆𝑡 + 1 − 𝛿 𝐾𝑡 ; 𝛿: depreciation
• In this representative agent framework, the behavior of aggregate output,
employment, consumption, and saving is described in terms of the choices
made by Robinson Crusoe.
• We now consider how those choices are affected by a change in the economic
environment Robinson confronts.
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Effects of a Positive Technology Shock
• Suppose that in a given time period there is a favorable shock to technology.
▪ Which is temporary, lasting only one period;
▪ Assumed to occur exogenously and
▪ Is represented in our model by a rise in the 𝑧𝑡

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• The favorable shock has changed the production possibilities facing
Robinson.
• He responds to this increase in his productivity by working more since MPL is
higher now.
• He has to decide: how much to save and consume
▪ Since it is temporary shock, he will save a portion of increases income to allow
consumption to also be higher throughout the future.
▪ Higher saving → higher investment → higher 𝐾𝑡+1 → 𝑌𝑡+1

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• If the favourable shock lasts for several periods or is permanent?
• Robinson’s responses would have been somewhat different.
▪ S less, C more,
▪ Because of rise in productivity, he might increase his work effort in each period
by less.
▪ Thus, long-lived productivity shocks will also result in changes in output, the
capital stock, and employment that persist for many periods.
• We have focused on shocks to technology because they are central to RBC
theorists’ explanation of economic fluctuations.
• changes in environmental conditions,
• Similarly, changes in variations in tax rates, environmental conditions, and
changes in preferences are additional potential causes of cyclical movements
in output and employment.

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Shocks to RBC

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Macroeconomic Policy in a Real Business
Cycle Model
• In a RBC model, fluctuations arise from individuals’ responses to changes in
the economic environment such as a favourable shock.
• What is the role for macroeconomic policy in a RBC model?

• Monetary Policy
▪ In a RBC model, the real, not monetary factors, are responsible for fluctuations in
output and employment.
▪ Thus, the role of money is to determine the price level.
▸ Changes in the quantity of money result in proportionate changes in the price level
with no change in output or employment.
▪ Thus, monetary policy should focus on controlling the price level.
▪ There is certainly no role for activist monetary stabilization policy

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• Fiscal Policy
▪ Many fiscal policy actions affect output and employment in a RBC model.
▪ The effect will not be caused by an effect on aggregate demand, as in the
Keynesian model, but by supply-side effects.
▪ Changes in tax rates on labor income or the return to capital will affect the
choices of optimizing agents.
▪ Moreover, these effects will be distortionary:
▸ Tax on labor income, for example, will cause an individual to choose too much
leisure in relation to employment (with resulting lower consumption).
▸ Even a lump-sum tax will affect individual behavior by affecting wealth over the
planning horizon.
▪ Thus, the task of fiscal policy in the real business cycle framework is to minimize
these tax distortions.

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 ▪ This opens the door for monetary policy.
▪ An alternative to financing government spending by taxation is to finance it by
printing money.
▪ Policymakers can reduce the distortion due to taxation by financing a portion of
government spending with newly created money.
▪ The term economists use for this practice in which the government gets real
resources through money creation is seigniorage.
▪ However, seigniorage also has costs because the faster the money supply grows,
the higher will be the inflation rate.
▪ Thus, in a real business cycle model, the optimal use of monetary and fiscal
policies is to combine them so as to minimize the total costs from inflation and
tax distortion.

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Critiques of Real Business Cycle Models
• The Importance of Technology Shocks
▪ Are the technology shocks large enough to cause economic fluctuations of the
type and size we observe.
▸ Many technology shocks are likely to be specific to individual industries.
▸ But in a real-world recession, the decline in output is widespread across industries
of diverse structure
▪ Many economists do not accept the RBC explanation of economic fluctuations.
▪ However, they do believe that the sharp rise in the relative price of imported
▪ oil was the central cause of the deep recession in the United States and other
industrialized nations in the mid-1970s.

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Critiques of Real Business Cycle Models
(Cntd…)
• Voluntary Employment Changes:
▪ Individuals moving along their labor supply schedules in response to changes in
their marginal productivity and, therefore, their real wage.
▪ Critics argue that to explain real-world fluctuations in this manner requires an
implausibly high response of labor supply to changes in the real wage—a very
flat labor supply schedule.
▪ Empirical studies show only small responses of hours worked to changes in the
real wage (a steep labor supply schedule).
▪ Data are more consistent with the Keynesian explanation in which workers are
assumed to be thrown off their labor supply schedules; unemployment is
involuntary.

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New Keynesian Business Cycles (NKBC)
• The new classical economists argued persuasively that Keynesian economics
was theoretically inadequate, that macroeconomics must be built on a firm
microeconomic foundation.
• In response, New Keynesian economists (prominently, Mankiw, Romer)
provided a number of features of the wage- and price-setting process explain
such rigidities.
• Sticky Price (Menu Cost) Models
• Efficiency Wage Models
• Insider–outsider Models

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 Thank You

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