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# Introducing Advanced Macroeconomics:

## Growth and business cycles

Chapter 13
THE ECONOMY IN THE SHORT RUN

## WHY UNDERSTANDING BUSINESS CYCLES IS IMPORTANT

Recessions bring considerable economic hardship. Thus understanding business cycles is not only of academic interest. It may help the economist to offer advice to policy makers on reducing business fluctuations.

## DEFINING 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.

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DATING BUSINESS CYCLES The length of the business cycle is measured from trough to trough. From the figure on the following slide we see that: Business cycles are far from regular and periodic. Business cycle expansions have tended to last longer and contractions have on average been shorter after the Second World War.
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## MEASURING BUSINESS CYCLES

We need a method for separating the growth trend from the cyclical component of a variable like GDP

y t = g t + ct

(2)

where yt is the log of GDP, g t is the growth trend, and ct the cyclical component.

## MEASURING BUSINESS CYCLES

One such method is the HodrickPrescott filter. When detrending an economic time series, the growth component is found by minimizing

HP =

(y
t =1

gt ) +
2 2

(3)

( g t +1 g t ) ( g t g t 1 )
t=2

T 1

## with respect to all of the g t .

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## WHAT HAPPENS DURING BUSINESS CYCLES?

Detrending time series with the HP filter, we obtain estimates of the gt s, which can be used to determine our estimates of the ct s. We first study the variability in different economic variables during a typical business cycle:

sX =

1 T 2 ( xt x ) T 1 t =1

(4)
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## WHAT HAPPENS DURING BUSINESS CYCLES?

Stylized business cycle fact 1: Investment is much more volatile over the business cycle than GDP. It is the most volatile component of aggregate demand. Stylized business cycle fact 2: Foreign trade volumes are typically two to three times as volatile as GDP.

## WHAT HAPPENS DURING BUSINESS CYCLES?

Stylized business cycle fact 3: Employment is considerably less volatile over the business cycle than GDP, typically 60-80% as volatile.

## WHAT HAPPENS DURING BUSINESS CYCLES?

We now study whether and to what extent the cyclical components of the economic variables move in the same direction as GDP.
T

( xt , ct ) =

(x
t =1

x )( ct c )
(6)
2

(x
t =1

x)

(c
t =1

c)

## WHAT HAPPENS DURING BUSINESS CYCLES?

Stylized business cycle fact 4: Private consumption, investment and imports are strongly positively correlated with GDP. Stylized business cycle fact 5: Employment is procyclical and much more strongly correlated with GDP than real wages and labour productivity. Labour productivity tends to be procyclical, whereas real wages tend to be very weakly correlated with GDP.
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## WHAT HAPPENS DURING BUSINESS CYCLES?

Stylized business cycle fact 6: In most countries inflation is positively correlated with GDP, although the correlation is not very strong. Stylized business cycle fact 7: Employment is a lagging variable; inflation and nominal interest rates also tend to be lagging variables.

## WHAT HAPPENS DURING BUSINESS CYCLES?

Last but not least, we want to study the degree of persistence in the economic variables. That is, we compute the coefficient of autocorrelation

( xt , xt n )
for different values of n.

## WHAT HAPPENS DURING BUSINESS CYCLES?

Stylized business cycle fact 8: There is considerable persistence in GDP and about the same degree of persistence in private consumption. Stylized business cycle fact 9: Employment tends to be even more persistent than GDP.

## THE PRODUCTION FUNCTION APPROACH

A way to estimate the output gap which makes use of the concept of an aggregate production function:

Yt = Bt K t L

1 t

0 < <1

(7)

## And the following definition of total working hours:

Lt = (1 u t ) N t H t

(8)

## Inserting (7) in (8) yields:

Yt = Bt K t (1 u t ) N t H t t

(9)

Suppose that the above variables fluctuate around som long-run trend values. Trend output can then be written as (capital is fully utilized):

Yt = Bt K t (1 u t ) N t H t t

(10)

## THE PRODUCTION FUNCTION APPROACH

Taking logs on both sides of (9) and (10), and subtracting one from the other, yields:

+ (1 ) ( ln H t ln H t ) (1 )( ln u t ln u t )
(11) An estimate and decomposition of (11) for annual US data yields:
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yt yt ln Bt ln Bt + (1 ) ( ln N t ln N t )

The US output gap and its components estimated by the production function method

## THE PRODUCTION FUNCTION APPROACH

Stylized business cycle fact 10: Total labour input varies in a strong procyclical manner, explaining most of the variation in the output gap. Total factor productivity, TFP, also varies procyclically and the cyclical component of TFP accounts for a large fraction of the total output gap at business cycle peaks and troughs. Stylized business cycle fact 11: Most of the cyclical variation in total labour input stems from fluctuations in cyclical unemployment, but average working hours, and to some extent the total labour force, also vary procyclically.
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