Macroeconomic Forces Chapter 2

1. Macroeconomic ForcesChapter 2

2. Characteristics of the Business Cycle 1. Fluctuations in aggregate business activity 2. Characteristic of a market driven economy 3. Regular sequence of changes from expansion, downturn, contraction, recovery 4. Not periodic in duration, intensity, or scope. 5. Expansion and contraction occur in many phases of economic activity in both the real and financial sectors. 6. Cycles cannot be further subdivided into shorter cycles with similar characteristics

3. Duration of expansion, contraction, and full cycle • NBER reference dates: http://www.nber.org/cycles.html/ • Macroeconomic data: http://rfe.wustl.edu/Data/USMacro/index.html • Diffusion of industrial production

4. Past Business Cycles • The 1970-75 Cycle (The Great Recession) • Longest and most severe post-WWII recession (16 months, 3.6% decline in real GDP, and 13% decline in industrial production) • Causes of recession included both demand factors and supply factors: a. Inflation due to relatively easy monetary policy prior to 1973 b. Poor crop that drove up food prices c. Rapid increase in energy prices due to OPEC cartel d. Excessive inventory buildup and real estate speculation • Endogenous forces set the stage for recovery as inflation slowed and inventories were “worked down.” Consumer debt was repaid and adjustments were made to higher energy prices.

5. The 1980 and 1981-82 Recessions: • Higher rates of inflation and lower “real” interest rates had maintained spending for housing and consumer durables until 1979. In late 1979 the Fed switched to monetary aggregates as a monetary policy target with resulting overnight increases in nominal interest rates. Private borrowing fell over 50% during the second quarter of 1980. • In early July the Fed eased credit and interest rates fell resulting in renewed expansion over the 12 months from August 1980. Inflation remained in double-digit levels. • The Fed again turned restrictive in and, together with high rates of inflation, pushed nominal interest rates upward to about 20 percent. Housing and consumer durable demand fell by over 10 percent. • Cooling inflation and tax cuts enacted in 1981 led to economic recovery that continued from 1982 to 1990 (92 months).

6. The 1990-91 Recession: • The official business cycle peak of July 1990 was not recognized until 9 months later and, in fact, real GDP did not fall until the fourth quarter of 1990. Iraq’s invasion of Kuwait occurred August 1990 and public debate centered upon the impact of US involvement on domestic economic conditions. • Higher debt loads by households and business and financial industry imbalances were a fundamental reason for the economic downturn. The invasion of Kuwait was probably a contributing factor. • The economic recovery was slow relative to prior periods and, in fact, the unemployment rate increased because economic growth in the last three quarters of 1991 was 1.4, 1.8, and 0.3 percent, respectively.

7. The 2001 recession • Probably began in the second half of 2000 as industrial production declined in response to overinvestment in late 1990s • Business investment in capital spending decreased and remained soft during recovery • A relatively mild recession due to the resiliency of household spending and relatively strong housing demand. • Labor markets reflect slow employment demand relative to output (“jobless recovery’)

8. Five Lessons from 2001 Cycle • Structural imbalances take time to resolve, especially in the capital goods sector. • Uncertainty matters for economic decisions by business and households. • September 11, 2001 terrorist attack • Corporate financial reporting scandal • Iraq war • Aggregate monetary policy can mitigate recession • Tax cuts and government spending boost economic activity • Strong productivity growth raises standards of living but require much faster growth in order to raise employment

9. Indicator forecasting • Strengths and weaknesses of indicator method • Useful in identifying reference dates with composite measures • May confirm strength of recovery or downturn • May give false signals

10. Econometric models • Structural equations in early models did not link sufficiently to the financial sector (simple Keynesian with lags) • Financial sector added in second generation models with greater disaggregated detail. • Aggregate supply added after Great Recession. • Macro models serve as a “driver” for industry and firm level projections that may be purchased from commercial vendors.