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2 The Global Macroeconomy (Subject) / R14: Business Cycles (Lesson)
- Business cycle = Fluctuations of output above and below the trend level The business cycle is the continual process whereby the economy enjoys an expansion, endures a recession, and then again experiences an expansion Output gap = Measure of the business cycle (explain how monetary policy operates) output gap is large and negative: GDP is far below its potential level and factors of production are not being used intensively. output gap is positive and large, GDP exceeds potential output by a large margin. This can only be the case if factors of production are being used intensively, so that overtime is high and machines are operating a full shift. If overtime costs more than normal working hours, so costs will increase -> pressure on prices If firms are already at full capacity when they receive additional orders, these orders cannot easily be met, so the firm will start to increase prices to choke off demand In these circumstances, inflation is likely to be rising
- Measuring the Business Cycle Different economies will experience different shocks, and the magnitude and duration of business cycles may vary, but such fluctuations are inevitable. - dshock might be increase in oil price or interest rates Recession: two successive quarters of negative growth Growth recession: the growth is less than the economy’s long-run trend rate Depression: bad recession—one that is both long-lasting and in which output declines substantially, downturn lasts so long that the economy seems unable to recover on its ownwithout a dramatic policy intervention. Differences across sectors: Most volatile: Construction, Manufacturing Most stable: service sector wage growth displays little volatility over the business cycle and a much lower correlation with GDP than other economic variables Trying to explain why wages show such a weak cyclical pattern when unemploymentand employment are so strongly cyclical When GDP growth is strong, unemploymentfalls, but when the economy moves into recession, unemployment starts torise (and employment falls). The labor market is normally a lagging indicator of thebusiness cycle—it usually takes around six months for a rise in the rate of GDP growthto have an affect on employment or unemployment
- Inflation over the past 350 years Over the last 350 years, inflation was on average low but it was also volatile: average annual inflation was 1.5% with a standard deviation of approximately 6.5%, Inflation is often volatile, and that it can get into two digits for prolonged periods even in developed countries Nothing inherent to advanced economies that guarantees low and stable inflation Central banking (characterised by flexible exchange rates, independent central banks, and an inflation-targeting framework) has delivered two decades of low and stable inflation These 350 years can be divided into six sub-periods: (i) the Gold Standard period (1717-1913) (ii) the two world wars and the interwar period (1914-1945) (iii) Bretton Woods period (1946-1973) (iv) Post Bretton Woods until the European Monetary System (EMS) crisis (1974-1993) (v) Great Moderation (1994-2008) (vi) Post-global financial crisis period (2008-2016) Gold Standard: Low I, High V, Deflation War & Interwar: High inflation 4%, high volatility, prices fell rapidly when gold standard Bretton Woods: High I, Low V, unsustainable exchange Rates Post-Bretton Wood: Very High I, High V, no deflation____1993 Great Moderation: Moderate Post-global financial crisis: sudden drop in inflation (average inflation went from 2%to 1.2%) and a mild increase in volatility
- The challenge in 2010 headline inflation = includes most volatile as food and energy core inflation = excludes food and energy High inflation volatility around 2008-09 was due to the joint effect of One of the largest commodity shocks in history (the Goldman Sachs commodity price index went from 490 in mid-2007 to 860 in mid-2008 Immediate aftermath of the epicentre of the crisis in September 2008 that saw big swings in currencies. Advanced Econ: Strong difference between Headline & Core - Headline post 2000 largely due to volatility in food and energy, core slight decline Emerging countries: No difference between Headline & Core - higher average inflation and higher volatility
- The Phillips curve view “clean little secret” of the study of inflation and central banking inflation seemed to be negatively correlated with unemployment Phillips curve relates inflation to some measure of economic activity and to expected inflation, which is sometimes modelled using past inflation through an implicit assumption of backward-looking expectations. After 2008, the unemployment rate rose very sharply in each, albeit starting from quite different points and rising at different paces. The unemployment rate kept on rising, peaking at the end of 2009 in the US, the UK, and Japan. While in the US, the unemployment rate reached 10%, in the UK employment did not rise as much and in Japan it remained below 5.5%. In the Eurozone, unemployment kept rising until mid-2013 and surpassed 12%. the simple Phillips curve would haveled one to expect a significant deflation after 2010. Real activity was clearlydepressed, and with the sharp decline in inflation in 2008-10, backward-lookingexpectations of inflation should have been very low as well
- The interest rate view Fisher equation = expected inflation is equal to the difference between the safe nominal interest rate and the real interest rate for investments of equal maturity.
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