3.

Business Cycle Theories (Survey)

History: pre-Keynesian vs. modern theories
Principal: real vs. monetary theories Stability: endogenous instability vs. exogenous shocks (rocking chair)

Price flexibility: new Keynesian vs. new classical Macroeconomics

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monetary endogenous Ralph Hawtrey (1879-1975): Instability of v Knut Wicksell (1851-1926): interest rate spread F.A. von Hayek (1899-1922): excess investment M. Woodford: dynamic stochastic general equilibrium model (DSGE) Milton Friedman: monetary policy Robert Lucas, B.T. McCallum (1980): Price expectations

real E. Lederer, R. Malthus, K. Marx: underconsumption Albert Aftalion (1874-1956), Artur Spiethoff (18731957), Gustav Cassel (1866-1945): Excess investment, accelerator J.R. Hicks, P.A. Samuelson: multiplier/accelerator Goodwin/Pohjola: distribution battle, chaos theory E. Prescott: New classical Macroeconomics Technological shocks, real business cycle (RBC) G.Akerlof, P. Romer: New Keynesian Macroeconomics Sticky prices William St. Jevons (1835-1882): sunspot-theory W.D. Nordhaus (1975): political cycles

exogenous

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Interdependency of Macroeconomics
M * V : P = C+S= underconsumption theories Y = Lnet + Gnet + T monetary/monetaristic theories

= C + I + E + EX - IM Keynesian theories

distribution theories

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Basic idea of monetary theories

HP = Mv = MB * m * v (quantity equation)

v dependent on i and dP/dt)/P => instability m dependent on behavior of banks and households => instability

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Central bank balance

(simplified)

Assets credit claims bonds foreign currency other reserves

Liabilities currency in circulation

monetary base MB

monetary base MB

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Velocity of circulation v in Euro-Zone (1980 2000)

ln [GDPnom/M3]

source: ECB

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Pure monetary theory by Ralph Hawtrey (1928) (I) inventories are sensible to interest rate
Inventory bought at leveraged equity: inventory sold at => Profit before interest 1000.900.100.1100.100.-

Rate of return (i = 11%): 1%

Rate of return ( i = 10%): 10%

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Pure monetary theory by Ralph Hawtrey (1928) (II) inventories are also sensible to inflation
Interest rates decline

Interest rates rise

inventory and commodity demand increase

Inflation

Inflation
rising velocity of money circulation (Hawtrey effect)

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Criticism on Hawtrey`s theory

Inventory less important today

Explanation of cycle is one-sided

Stimulus of initial interest rate decline unclear

However: leverage effect was relevant in recent financial crisis

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Monetary over-investment theory (Knut Wicksell 1922, F.A. von Hayek 1934 )
upswing S inat imon S + d(M/P) imon downswing S + d(M/P) S

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Criticism on Wicksell`s theory

Stimulus of initial interest rate spread unclear

Neglect of real effects (e.g. accelerator) However: interest rate spread was also relevant in recent crisis

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Theories of under-consumption (Lauderdale, Malthus, Lederer)

technical progress and capital accumulation pressure on wages and rising unemployment sales crisis and depression

Critisicm: real wage increase by technical is progress neglected turning points are not sufficiently explained one sided theory, no formal exposition export demand neglected

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Non-monetary theory of excess investment (Aftalion u.a.)

Accelerator effect:
K/GDP = 300/100 d = 10% => D = 30 suppose demand rises at 10% in t1 => I1 = 60 + 100% I2 = 33 -45% => extreme instability Criticism: cause of initial rise in aggregate demand? no formal exposition one sided KuB 3.1 U vanKuB 4 Vorlesung KuB Suntum,
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Aggregate Demand Investment

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Accelerator effect in East German Housing Market

After unification previous adds (1) Demand (110) adds (11) today adds (1,1)

Demand (100)

Housing stock ./. outs (99)

Housing stock ./. outs (99)

Demand (110)

Housing stock ./. outs (108,9)

increase in aggregate demand by 10% => rise in investment by 1100% ! after completed construction of new houses drop in investment
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Orders in East-German Construction Industry Auftragseingang / Werte / Bauhauptgewerbe Ost/ arbeitstglich bereinigt
250

200

150

100

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Monatswerte 12 Per. Gleitender Durchschnitt (Monatswerte)

0
91 Ju l9 1 Ja n 92 Ju l9 2 Ja n 93 Ju l9 3 Ja n 94 Ju l9 4 Ja n 95 Ju l9 5 Ja n 96 Ju l9 6 Ja n 97 Ju l9 7 Ja n 98 Ju l9 8 Ja n 99 Ju l9 9 Ja n 00 Ju l0 0 Ja n 01 Ju l0 1 Ja n 02 Ju l0 2 Ja n 03 Ju l0 3 Ja n 04 Ja n

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Dynamics of the business cycle

GDP

Investment

GDP Investment

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Is there an equilibrium of aggregate demand and investment? (Harrod-Domar 1939): Demand

Y N cY N I (1 s )Y N I 1 N Y I s 1 1 N Y I ( I I t 1 ) s s

Supply
Y A xK Y A dY A x K dK Y A x K Y A x I t 1

wI sx
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Dynamics in Harrod/Domar-model:

lnY

Y* = 1/(1-c)Iaut
ln Y S

ln Y D
t

lnI

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Numerical example I: s = 0,2

x = 0,5

=> g* = 0,2 * 0,5 = 0,1

a) equlibrium: gI = g* = 0,1 lnY

Period: K => YS = xK
I = I t-1 (1 + gI) => YD = I/s ALG = YD/YS

0 200 100
20 100 100%

1 220 110
22 110 100%

2 242 121
24,2 121 100%

ln Y D ln Y S
lnI

I = sY = 0,2*100 = 20 Steady-state: all variables grow at the same rate

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Numerical example II: s = 0,2

x = 0,5

=> g* = 0,2 * 0,5 = 0,1

b) disequilibrium: gI = 0,2 > g* lnY

Period: K => YS = xK I = I t-1 (1 + gI) => YD = I/s ALG = YD/YS 0 200 100 20 100 100% 1 220 110 24 120 109% 2 244 122 28,8 144 118% t

ln Y D
ln Y S

Excess investiment leads to under-utililization of capacities (Domars-Paradoxon)

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Numerical example III: s = 0,2

x = 0,5

=> g* = 0,2 * 0,5 = 0,1

c) disequilibrium: gI = 0,05 < g* lnY

Period:
K => YS = xK I = I t-1 (1 + gI) => YD = I/s ALG = YD/YS

0
200 100 20 100 100%

1
220 110 21 105 95%

2
241 120,5 22,05 110,25 91% t

ln Y S

ln Y D

Lack of investmentleads to excess capacity!

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Criticism of Harrod/Domar

model does not reflect reality s, x bzw. v need not be constant no cycles model is far too simple (no consumption, no public sector, no money, no labor market)

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Learning goals/Questions How do we classify business cycle theories? Which pre-Keynesian theories do we know? To what extent are they still relevant today?

Explain why we cannot forecast GDP for more than two years at best!
Explain the Harrod-Domar condition for a balanced growth!

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