Sources of Business Cycle - Report Example

Introduction Two economists, Long and Plosser came up with the term real business cycle which is used to explain the cycles generated by random changes in technology (McGrattan, 2006). Real business cycles (RBC) are recurrent fluctuations in an economy’s income, products, and factor inputs (especially labor) that are due to non-monetary sources (McGrattan, 2006). As a result of these fluctuations, individuals consciously change their consumption and labor supply (Mankiw, 1989). The RBC theory brought forward two innovations, the first one theoretical and the second one being technical .Under the theoretical innovation, RBC theorists acknowledged the fluctuations in aggregate demand and employment but they deemed such shocks to be socially optimal responses to exogenous shocks such as changes in productivity. Under the technical innovation, RBC models were developed with the aid of a method called calibration. (Quiggin, 2009). Sources of Business Cycle In 1986, Edward Prsescott, argued in an article that business cycles in USA, after the World War II resulted from the random changes in the business sector productivity. He justified his argument by proving that upswings in economic activity resulted from an above average growth rate of productivity while downswings resulted from a below average growth rate of productivity. In doing so, Prescott openly challenged the then prevalent notion that business cycles were triggered by monetary and financial disturbances (Chatterjee, 1999). There are numerous ways of measuring total output and one such way is to measure the total value added in all the domestic firms. The total output tends to change when productivity of workers changes or the effectiveness of the equipments used increases. Thus an increase in the effectiveness of workers and equipment leads to the value-added and is known as total factor productivity (TFP). TFP increases majorly as a result of improvements in technology and increase in worker productivity. TFP can also change when the price of an imported raw material changes or when new products are developed through investments in Research and Development (R&D) or when natural calamities destroy agricultural output (Chatterjee, 1999). When the TFP increases, it signals to the firms that they can benefit immensely from hiring more labor and installing more equipment. To make good use of such opportunities, firms invest heavily in buildings, equipment and hire a lot of workers. Additional income is generated in the economy and the overall output rises and people tend to consume more. These favorable trends in macroeconomic variables such as consumption and investment are used by RBC theorists to explain a boom (Chatterjee, 1999). There are other sources of fluctuations in the RBC, such as changes in taxes and government spending, tastes, government regulation (such as laws to protect the environment and minimise wastage by factories), terms of trade and energy prices. When government spending increases such as expenditure on infrastructure and transfer payments, firms are encouraged to set up production plants and increase economic activity, and consumption of households also increases. Investment, government spending and consumption are the elements of aggregate demand and they are directly related to output: an increase in these elements results in an increase in the overall output of an economy. The graph below shows this as an outward shift of the aggregate demand (AD) curve from AD to AD1, with the corresponding increase in output from Q to Q1 (McGrattan, 2006). In RBC theory, technological distrubances are discussed at length because the fluctuations caused by technological disturbances resemble the actual economic fluctuations a lot. According to Kydland and Prescott’s model, when households respond optimally to changes in technology, fluctuations occur (McGrattan, 2006). In a traditional business cycle, consumption and leisure move in opposite directions: when one increases, the other decreases. During the boom period, consumption rises and leisure falls, vice versa for a recessionary period. Consumption and leisure are both normal goods, hence the deduction that both move in the same direction is likely. Overcoming this likely deduction and explaining the inverse relationship between consumption and leisure becomes difficult for RBC theorists then. RBC theorists have to explain that real wage is procyclical and in recession people prefer leisure because the cost of leisure relative to goods (that is real wage) falls during recession (Mankiw, 1989). If the demand shocks are responsible for fluctuations and the production function is constant, it would be extremely tough to convince that real wage is procyclical. It is natural to assume that marginal product of labor and the real wage would rise in recession when the labor input is high but if the production function is constant, there would be diminishing marginal returns to labor and real wage would become countercyclical. Thus it becomes binding on RBC theorists to discuss that there are fluctuations in the rate of technological change. The standard of technology is low during a recession, the marginal product of labor and the real wage are also low as a result. When workers see very few chances of earning more in recessionary times, they prefer consuming less and availing more leisure time. A very important result of a change in the rate of growth of technology is that the aggregate supply (AS) cuve shifts accordingly because aggregate supply has a positive relationship with technology. The graph below shows an outward shift of the AS curve (when the rate of technology growth rises) and an inward shift (when the rate of technology growth falls). (Mankiw, 1989). Apart from the technological disturbances, the RBC theory stresses upon the intertemporal substitution of goods and leisure, time and again. An increase in government purchases, induces an increase in demand for goods. To maintain equilibrium in the goods market, real interest rates rise and thus consumption and investment fall. Another effect of a high real interest rate is that it makes individuals reallocate leisure across time. For instances, in such a scenario of high real interest rates, workers find working today more lucrative than working in the future. As a result, there is an economy wide increase in labor supply and equilibrium employment and output also tend to rise (Mankiw, 1989). Proponents of the RBC theory believe that analyzing the macroeconomy becomes easier if it is assumed that there is perfect competition in all markets. Also the technology parameter, ‘A’ is added to the aggregate production function f(n,k) which then becomes A.f(n.k), where ‘n’ is the quantity of labor and ‘k’ is the quantity of capital. The technology parameter ‘A’ is part of the Solow Residual and since RBC theory gives immense importance to technological shock, it is incorporated in the production function. The marginal product with capital is given by A.fk(n.k) and the marginal product of labor is given by A.fn(n.k) and these functions help in deriving the demand funcions for labor and capital. The functions fn(n.k) and fk(n.k) are the first derivatives of the production function ‘f’ with respect to n (labor) and capital (k). A change in ‘A’ shifts the demand functions for labor and capital. In case of an increase in A, the output function becomes steeper as a response for any given quanity of labor and capital. When the output function becomes steeper, it means that the marginal product is rising. The following graphs represent this situation better: Theoretically speaking, the demand for labor and capital rises when there is an increase in technology. Firms demand labor more, in case of a positive technology shock and employment tends to rise as a result. Similarly a positive technological shock also increases the demand for capital and firms start investing in capital. However there is another dimension to this: when firms intall more machinery (capital), they do not require labor for a aparticular task which can be done more efficiently by machines. So firms literally substitute workers with machines and a lot of workers are made redundant as a result of this (Chugh, 2008). Main Conclusions of RBC theorists The Walrasian equilibrium is a traditional equilibrium where price and quantity play a part in equating supply and demand in all markets in an economy. In discussing the Walrasium equilibrium, great emphasis is laid on output and price and ‘money’ is ignored. Money, like products has the two components, supply and demand. If proper money demand and supply functions are defined, then money can easily be incorporated in the conventional product market (where only product demand, supply, output and prices are studied) and the classical dichotomy can be achieved. As per the classical dichotomy, there two types of variable: real and nominal. Examples of real variables are employment, output, relative prices and the real interest rates and the Walrasian system determines them. Examples of nominal variables include price level, nominal wage and the nominal interest rate and they are determined in the money market. RBC theorists uphold the classical dichotomy and deem the monetary policy irrelevant. As per the RBC theory, money supply and price level do not account for the fluctuations in output and employment, both of which are real variables (Mankiw, 1989). Another important conclusion of the RBC theory is the comovement of various sectors of the economy. This phenomenon of comovement was first discussed in the research paper of Long and Plosser: they explained it through a multisector model. Comovement can be between employment in different industries. Christiano and Fitzgerald showed that the comovement in the US economy between hours worked in the major sectors and aggregate private hours was 80%. Comovement is not restricted to hours worked only, it is also observed in other economic variables such as gross output, value added, materials and energy use.These comovements across sectors bring an important point to surface: that aggregate shocks rather than sector-specific shocks are responsible for the business cycles. However comovements are not readily generated and it has been experienced that generating comovement across industries that produce consumer and capital goods is difficult. This is because investment is more responsive than consumption to a technological shock. When there is a technological shock and investment increases, labor will move from the consumer goods industry to the capital goods one and hence hours worked in the consumer goods industry will fall (Rebelo, 2005). Importance of Price Stickiness RBC theorists are said to do ‘price-free’ analysis as they bypass price stickyness and argue that prices are flexible (Summers, 1986). Both the prices and wages are assumed to be flexible under the RBC theory. Price flexibility means that prices can be and are reset quite often (Chugh, 2008). The RBC theory has received its share of criticism. RBC theory implies that after an aggregate technology shock, aggregate labor, real interest rate and investment rise sharply because of intertemporal substitutions and instantaneous market clearing. It was found by Gali and Basu that aggregate technology shocks in the USA were found to be contractionary to labor, real interest rate and investment in the short run, which is quite the opposite of what the RBC theory proposes. This discovery led to two conclusions: (1) that aggregate technology shocks are not the only sources of business cycles as labor and technology are procyclical and (2) in the short run, supply is not that responsive to technology shocks which indicates the presence of sticky prices. These discrepancies have made some experts conclude that the RBC theory is dead. But the discovery of Gali and Basu is not enough to conclude that technology is of trivial importance or that prices are sticky (Wang and Wen, 2007). Conclusion As compared to Keynesian, Monetarists or Neo-classical schools of thought, Real Business Cycle Theory is relatively new. In comparison to the Keynesian and new classical theories, the RBC theory accepts the classical dichotomy and also considers money supply as a variable irrelevant to business cycles (Mankiw, 1989). The RBC theory cannot be criticized fully as it has given rise to a lot of important concepts such the implications of a technological shock and price flexibility. The RBC has opened up more macroeconomic possibilities for economic experts, and had the RBC theory not been there, our thinking would have been restricted to the traditional business cycle. Bibliography Chatterjee, S. (1999) Real Business Cycles: A legacy of Countercyclical Policies, Business Review Journal of the Federal Reserve Bank of Philadelphia, pp. 17-26. Chugh, S.K. (2008) Real Business Cycle Theory, Spring, [Online], Available: http://www.skchugh.com/images/Chapter13.pdf. Mankiw, N.G. (1989) Real Business Cycles: A New Keynesian Perspective, Journal of Economic Perspectives, vol. 3, no. 3, pp. 79-90. McGrattan, E.R. (2006) Real business cycles, Staff Report, February, pp. 1-3. Moffat, M. http://economics.about.com, [Online], Available: http://economics.about.com/cs/studentresources/f/business_cycle.htm [2 November 2011]. Quiggin, J. (2009) Refuted Economic Doctrines #9: Real Business Cycle Theory, 25 June. Rebelo, S. (2005) Real Business Cycle Models: Past, Present and Future, Scandinavian Journal of Economics, vol. 107, pp. 217-238. Simpson, S. Macroeconomics: The Business Cyclw, [Online], Available: http://www.investopedia.com/university/macroeconomics/macroeconomics7.asp#axzz1dxzNSCs1. Summers, L.H. (1986) Some Skeptical Observations of the Real Business Cycle Theory, Quarterly Review of Federal Reserve Bank of Minneapolis, vol. 1043, Fall, pp. 23-27. Wang, P. and Wen, Y. (2007) A Defence of RBC: Understanding the puzzling effects of technology shocks, The Quarterly Journal of Economics, April, pp. 1-2. Watson, M.W. (1988) Sources of Business Cycle Fluctuations, NBER MAcroeconomics Annual, MAY, p. 1. Read More