OUTLINE

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Business Fluctuations and Forecasting
Week 3 SF Intermediate Economics Professor
McAleese
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• THE BUSINESS CYCLE WILL NOT DISAPPEAR .
• The inevitability of the business cycle, as it
  used to be called, I take for granted. Good
  times bring into existence first, incompetent
  business executives second, wrongful government
  policies and, third, speculators. Working
  together, they ensure the eventual bust.
• J K Galbraith Challenges of the New
  Millennium Finance and Development December
  1999 p 5

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A MORE UPBEAT VIEW .

• It is not enough to assert that since there have
  always been business cycles there always will be
  business cycles. Understanding what causes
  business cycles and how these causes have changed
  suggests that business cycles will not be as
  important in the future as they were in the past.
• S. Weber The end of the business cycle Foreign
  Affairs July 1997

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OUTLINE

• ? What are business fluctuations?
• ? Why do they matter?
• ? What causes them?
• ? What can be done about them?

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BUSINESS FLUCTUATIONS

• Business fluctuations are fluctuations in
  aggregate economic activity that are widely
  diffused throughout the economy and have
  identifiable peaks and troughs
• FLUCTUATIONS ? CYCLES

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Cyclical Variables

• ? Pro-cyclical industrial output, investment
• ? Counter-cyclical unemployment rate,
  bankruptcies and bad debts
• ? A-cyclical health services, staple foods,
  primary education

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FACTS ABOUT FLUCTUATIONS

• ? Negative growth infrequent
• ? Different periodicity
• ? No evidence of systematic long run cycles
• ? Sustained period of growth followed by relative
  or absolute downturn
• ? Industrial countries stay 3 times longer in the
  expansion phase of the cycle then in recession
• ? Even fast growing economies experience cycles
• ? Strong synchronisation (contagion) effects
  few cycles made at home
• ? Fluctuations have decreased in amplitude in
  post-war period

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• SourceM.J. Artis, Z. Kontolemis and D. Osborn,
  Classical Business Cycles for G7 and European
  Countries, Journal of Business

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WHY DO BUSINESS FLUCTUATIONS MATTER?

• ? Growth is generally higher when stability is
  greater. (Zarnovitz)
• ? People prefer a stable growth path to an
  unstable, boom-and-bust growth path.
• Chancellor of the Exchequer, Gordon Brown,
  shortly after taking up office in 1998, declared
  his determination to rid Britain of the
  boom-bust, stop-go cycle

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WHY SHOULD BUSINESS FLUCTUATIONS BE DISLIKED?

• BOOMS
• POSITIVE EFFECTS
• ? Higher incomes and prosperity
• ? Enables government to implement reforms (tax,
  social welfare, deprived communities,
  environment)
• NEGATIVE EFFECTS
• Main problem they dont last!
• Downturn causes more disutility than upturn
  caused utility
• ? Inflation leads to haphazard income effects,
  social unease

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Recessions

• POSITIVE EFFECTS
• ? Structural adjustment and creative destruction
  (Schumpeter)
• NEGATIVE EFFECTS
• ? Unemployment (hysteresis)
• ? Difficulty in re-starting the economy
• ? Adverse effect on innovation

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WHAT CAUSES BUSINESS FLUCTUATIONS?

• Intrinsic instability of the free market
• ? Random external shocks
• ? Policy-induced shocks
• ? Private sector demand shocks
• ? Banking and financial crises

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WHY DO SHOCKS LEAD TO FLUCTUATIONS?

• Keynesian-type explanations based on
• ? Extreme instability of investment
• ? Multiplier
• ? Accelerator
• ? Nominal price and wage rigidities
• Recent explanations emphasise
• ? Contagion effects
• ? Propagation mechanisms

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WHY HAS AMPLITUDE OF CYCLE FALLEN?

• ? Size of government
• ? Tertiary sector (shift in composition of
  output)
• ? Automatic stabilisers
• ? Discretionary fiscal monetary policy
• ? Confidence ?thinking makes it so

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MULTIPLIER-ACCELERATOR MODEL

• Output determined as follows
• Y C I
• C a Y-1 .(a)
• I b (Y-1 - Y-2) I0 (b)
• (I0 is exogenous investment determined by
  animal spirits)
• Combining (a) and (b), we have
• Y (a b) Y-1 b Y-2 I0
• Output is a function of its lagged levels in
  the two periods. Given plausible parameters, a
  cyclical behaviour following a rise in I0 can be
  generated by this model.

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WHAT CAN BE DONE ABOUT BUSINESS FLUCTUATIONS?

• 1. Study and Understand their Causes
• ? Not one but many theories of business
  fluctuations Business cycle theory reminds is
  that we do not understand economic fluctuations
  as well as we would like. Fundamental questions
  about the economy remain open to dispute. Is the
  stickiness of wages and prices key to
  understanding economic fluctuations? Does
  monetary policy have real effects? (Mankiw, p.
  388)
• ? The problem is that fluctuations are often
  caused by random shocks. There are many and
  diverse types of shock and, by definition, all
  are unpredictable.
• ? Effects of these shocks magnified by
  propagation mechanisms such as the multiplier and
  accelerator.
• ? Nominal rigidities in wages and prices explain
  why these real fluctuations may be prolonged.

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• 2. Establish Best Possible Estimates of
  Potential GNP and Derive Reliable, Timely
  Estimates of Current GNP
• ? To derive potential GNP estimates, careful
  modelling of the economy needed. This is an
  on-going exercise.
• 3. Implement counter-cyclical fiscal policy
• ? Dismal record of many governments fiscal
  policy often pro- cyclical instead of
  counter-cyclical.
• ? Solution may be to implement coarse tuning
  rather than fine-tuning policies
• ? Adhere to strict overall guidelines

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• 4. Manage Monetary Policy so that Price Stability
  is the Central Objective
• Bad monetary policy, and inflation, can be
  sources, not cures, of business fluctuations
  because of long and variable lags between
  monetary policy action and its effects on the
  real economy
• 5. . but allow for some counter-cyclical role
• Hence only limited scope for counter-cyclical
  intervention
• 6. Government can also Help by Talking Down
  Booms and Talking Up Recessions
• .but such verbal of symbolic interventions are
  of limited value in practice

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CONCLUSIONS

• Government has on balance diminished the overall
  amplitude of fluctuations.
• ?Bad economic policies have created fluctuations
  in the past
• Policy activism means that the danger of extreme
  collapse and boom is diminished. There has been
  a permanent raising of the floor of the
  business cycle and a lowering of the ceiling.
  Policy is difficult because nobody is quite sure
  when these ceilings and floors are near to being
  reached.
• Danger of really serious Japanese-type downturn
  cannot be ruled out.

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REPEATING HISTORY IS THE WORLD ECONOMY ENTERING
INTO A SERIOUS DOWNTURN?

• THINK ABOUT THIS QUESTION DURING THE NEXT WEEKS
  AND SEE IMF WORLD ECONOMIC OUTLOOK MAY 2001 (NOW
  IN LIBRARY)