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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 real

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)

• E. Lederer, R. Malthus, K. Marx: underconsumption

• Albert Aftalion (1874-1956), Artur Spiethoff (1873-1957), 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

exogenous •Milton Friedman:

monetary policy

• Robert Lucas, B.T. McCallum (1980):

Price expectations

• William St. Jevons (1835-1882):

sunspot-theory

•W.D. Nordhaus (1975):

political cycles

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Interdependency of Macroeconomics

M*V:P=

=Lnet

+Gnet

+T

= C + I + E + EX - IMC + S = Y

underconsumptiontheories

Keynesian theories

monetary/monetaristic 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 Liabilities

• credit claims• bonds• foreign currency• other

• currency in circulation

• reserves

monetary base MB

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monetary base MB

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

source: ECB

ln [GDPnom/M3]

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Pure monetary theory by Ralph Hawtrey (1928) (I)

• inventories are sensible to interest rate

Inventory bought at 1000.-•leveraged 900.-•equity: 100.-inventory sold at 1100.-=> Profit before interest 100.-

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

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

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Pure monetary theory by Ralph Hawtrey (1928) (II)

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• inventories are also sensible to inflation

Interest rates decline

inventory and commodity demand increase

Inflation

rising velocity ofmoney circulation(Hawtrey effect)

Inflation

Interest rates rise

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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 downswing

inat

imon

imon

S

I

S + d(M/P)

S + d(M/P)

S

I

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Interest rate spread causal for disparity between investment and consumption goods

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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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Critisicm:

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

Theories of under-consumption

(Lauderdale, Malthus, Lederer)

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• technical progress and capital accumulation

• pressure on wages and rising unemployment

• sales crisis and depression

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Criticism:• cause of initial rise in aggregate demand?• no formal exposition• one sided

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

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

Aggregate Demand

Investment

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Accelerator effect in East German Housing Market

Housing stock

./.outs(99)

adds(1)

Demand(100)

Housingstock

./.outs(99)

adds(11)

Demand(110)

• increase in aggregate demand by 10% => rise in investment by 1100% !• after completed construction of new houses drop in investment

Demand(110)

Housing stock

./.outs

(108,9)

adds(1,1)

previous

After unification today

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Auftragseingang / Werte / Bauhauptgewerbe Ost/ arbeitstäglich bereinigt

0

50

100

150

200

250

Monatswerte

12 Per. Gleitender Durchschnitt (Monatswerte)

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Orders in East-German Construction Industry

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Dynamics of the business cycle

GDP

Investment

GDP

Investment

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Demand Supply

)(11

1

)1(

1

tN

N

N

NN

IIs

Is

Y

Is

Y

IYs

IcYY

1

tA

A

AA

A

IxY

KxY

dK

dY

K

Yx

KxY

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

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xswI

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Dynamics in Harrod/Domar-model:

t

SYln

lnI

lnY

DYln

Y* = 1/(1-c)Iaut

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

Numerical example I: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1

Period: 0 1 2

K 200 220 242

=> YS = xK 100 110 121

I = I t-1 (1 + gI) 20 22 24,2

=> YD = I/s 100 110 121

ALG = YD/YS 100% 100% 100%

Steady-state: all variables grow at the same rate

t

SD YY lnln

lnI

lnY

I = sY = 0,2*100 = 20

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

Numerical example II: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1

Period: 0 1 2

K 200 220 244

=> YS = xK 100 110 122

I = I t-1 (1 + gI) 20 24 28,8

=> YD = I/s 100 120 144

ALG = YD/YS 100% 109% 118%

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

t

lnY

SYln

DYln

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

Numerical example III: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1

Period: 0 1 2

K 200 220 241

=> YS = xK 100 110 120,5

I = I t-1 (1 + gI) 20 21 22,05

=> YD = I/s 100 105 110,25

ALG = YD/YS 100% 95% 91%

Lack of investmentleads to excess capacity!

t

DYln

lnY

SYln

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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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