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Business Fluctuations and Forecasting

Business Fluctuations and Forecasting Week 3 SF Intermediate Economics Professor McAleese THE BUSINESS CYCLE WILL NOT DISAPPEAR ….

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Business Fluctuations and Forecasting

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  1. Business Fluctuations and Forecasting Week 3 SF Intermediate Economics Professor McAleese

  2. 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

  3. 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

  4. OUTLINE  What are business fluctuations?  Why do they matter?  What causes them?  What can be done about them?

  5. 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

  6. Cyclical Variables Pro-cyclical: industrial output, investment Counter-cyclical: unemployment rate, bankruptcies and bad debts A-cyclical: health services, staple foods, primary education

  7. 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

  8. Table 1. Business fluctuations characteristics Source:M.J. Artis, Z. Kontolemis and D. Osborn, “Classical Business Cycles for G7 and European Countries”, Journal of Business

  9. 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 upoffice in 1998, declared his determination to rid Britain of the boom-bust, stop-go cycle

  10. 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 don’t last! • Downturn causes more disutility than upturn caused utility Inflation leads to haphazard income effects, social unease

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

  12. WHAT CAUSES BUSINESS FLUCTUATIONS? Intrinsic instability of the free market Random external shocks Policy-induced shocks Private sector demand shocks Banking and financial crises

  13. 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

  14. 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”

  15. MULTIPLIER-ACCELERATOR MODEL Output determined as follows: Y = C + I C = aY-1……….(a) I = b (Y-1 - Y-2) + I0 (b) (I0is 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.

  16. 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.

  17. 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

  18. 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

  19. 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.

  20. 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)

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