BUSINESS CYCLES AND GROWTHChap. 21, 22, 23, 27 & 29.

LONG TERM PROSPERITYChap. 21 496-498. Chap. 23 541-543, 549-551

Living Standards• Headline measure of living standards is GDP per Capita

• How to compare across countries since GDP data is collected in national currencies.

• Must convert them into a single measure. • Could use exchange rates,

but this is volatile and biased.

_GDP

PC GDPPOP

$ __ US PC GDP

PC GDPE

Exchange Rate Conversion Method

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

10000

20000

30000

40000

50000

60000

GDP per Capita, US$

Hong Kong SAR, China Singapore

Axi

s M

eth

od

GDP in Intl$

GDP per capita, PPP (current international $)2005

Hong Kong SAR, China $35,677.92China $4,114.57India $2,299.76Indonesia $3,216.81Malaysia $11,754.53Korea, Rep. $22,783.27Thailand $6,750.94Singapore $45,374.24

• PPP’s are used to construct comparable measures of GDP for multiple countries by converting them into international dollars.

$ __ US j

jj

PC GDPPC GDP

PPP

Per capita GDP in international dollars is headline way of comparing living standards.

World Development Indicators

• Conceptually PPP is the cost of the goods purchased by consumers in their country relative to the cost of those same goods in US$ terms.

PPP XrateClassification Name 20051101 Food and non-alcoholic beverages 8.81547906 7.781102 Alcoholic beverages and tobacco 10.1680743 7.781103 Clothing and footwear 6.11435997 7.781104 Housing, water, electricity, gas and other fuels 9.09847987 7.781105 Furnishings, household equipment and household maintenance 7.61334163 7.781106 Health 2.9312812 7.781107 Transport 9.40016616 7.781108 Communication 6.83789147 7.781109 Recreation and culture 5.24897067 7.781110 Education 3.25951882 7.781111 Restaurants and hotels 8.98215569 7.781112 Miscellaneous goods and services 5.61784877 7.781501 Machinery and equipment 7.5934365 7.781502 Construction 4.15019416 7.78

International Comparison Project

World Development Indicators

0 10000 20000 30000 40000 50000 60000 70000 800000

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

PPP conversion factor (GDP) to market exchange rate ra-tio

GDP per Capita (PPP, 2005)

PP

P/S

World Development Indicators

Developing countries tend to be relatively cheap with PPP’s being lower than exchange rates.

Use real GDP growth rates to construct path of constant price International $GDP for comparisons of production levels across time and space.

GDP per Capita, PPP

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Con

stan

t 200

5 In

tern

atio

nal $

Singapore Hong Kong

0

10,000

20,000

30,000

40,000

50,000

60,000

France; 35,847

United States; 52,737

South Korea; 33,908

Brazil; 10,254

GDP per Capita, in 2013 EKS$

2013

US

$

GDP per Capita vs. Productivity• Per Capita GDP can be broken down into two parts:

GDPper

Capita=

ProductivityGDPper

Engaged Person

Employment RateEngaged Person

perCapita

X

Bosnia and Herzegovina Djibouti Armenia Hungary Gambia Russia Sweden Luxembourg0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

Employment per Capita, 2011

Fra

ctio

n o

f P

op

ula

tio

n

Most differences due to Worker Productivity

Congo - Kinshasa Comoros Kyrgyzstan India Sri Lanka Jordan Serbia Russia South Korea Spain Kuwait0

20000

40000

60000

80000

100000

120000

140000

160000

180000

GDP per Worker, 2011

2005

In

tl $

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

France; 87,561

United States; 114,914

South Korea; 66,438

Brazil; 19,833

GDP per Person Employed, in 2013 EKS$

2013

US

$

Determinants of Output per Worker• Physical Capital• Human Capital• Hours per Worker• Technology Frontier

Capital Accumulation• Capital Formation – Stock of equipment, machines, structures. • Incremental increase in capital is investment less some measure

of depreciation

• Capital Productivity: Capital investment is a central part of advancing productivity in developing economy but displays diminishing returns.

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

0

50000

100000

150000

200000

250000

300000

350000

Capital stock at current PPPs (in mil. 2005US$) per persons engaged

Brazil

France

South Korea

United States

2005

In

tl.

$

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

Capital Productivity

Brazil France South Korea United States

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 20100.00

2.00

4.00

6.00

8.00

10.00

12.00

Korea: Average Years of Schooling, 25+

Nethe

rland

s

Norway

Luxe

mbo

urg

Belgium

Trinida

d an

d Tob

ago

United

King

dom

Austri

a

Finlan

d

New Z

ealan

d

United

Sta

tes

Canad

a

Barba

dos

Slovak

ia

Czech

Rep

ublic

Cypru

sBra

zil

Turke

y

Eston

iaIs

rael

Portu

gal

Colom

bia

Jam

aica

Greec

e

Mex

ico

Taiwan

Singap

ore

0

500

1000

1500

2000

2500

Hours Worked per Worker, 2011

Ho

urs

BUSINESS CYCLES AND THE DYNAMICS OF GDPChap. 21 497, Chap. 22 514-521,

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

r0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

2,000,000

GDP (constant dollars)M

illi

on

200

9 H

K$

Hong Kong Census & Statistics

Two Impressions1. GDP Volume is growing over time.

2. Growth is variable. Sometimes fast, sometimes flat, sometimes negative.

Decompose the series into two parts which capture each of these phenomena.

1.Potential GDP

2.Output Gap

GDP and Productivity

t

tt t

tAPL

YY Employment

Employment

• GDP is output per worker times number of workers.

Unemployment Rates

• The population resides in 1 of 3 categories• Not in the Labor Force: Not working and not actively seeking work

• Labor Force• Employed: Currently working.• Unemployed: Not working but seeking work.

Unemployment Rate

100%Unemployed

UREmployed Unemployed

Natural Rate of Unemployment• Always people losing or leaving jobs and looking for new ones. Always people joining the labor force.

• In natural state of labor market, people looking for jobs will match the number of people who find jobs.

• uN = Natural Rate: Rate at which there is neither excess demand nor supply in labor market. (mostly stable). Natural Unemployment 2007

2

3

4

5

6

7

8

9

10

Australia UnitedKingdom

UnitedStates

Japan Korea Spain France Germany

%

Potential Employment and Output• Potential employment is the level of employment when

unemployment equals the natural rate.

• Potential output is GDP when employment equals potential employment

(1 )P NREMPLOYMENT LABOR FORCE u

P Pt tY APL EMPLOYMENT

HK GDP vs. Estimate of HK Potential GDP

120,000

160,000

200,000

240,000

280,000

320,000

360,000

400,000

440,000

480,000

86 88 90 92 94 96 98 00 02 04 06 08 10 12

2010$ GDP Potential Output

Hong Kong Census & Statistics

Recessions and Expansions

• The path of the economy is often divided into periods called recessions and periods caused expansions.

• No precise definition of “recession” or “expansion” exists, sometimes as consecutive quarters of growth.

• Business cycles are defined by the Output Gap,

• Sometimes the period from peak of the output gap to the trough is a recession and the period when the output gap is increasing is an expansion.

US Business Cycle Dates

Pt t tOutput Gap Y Y

-30,000

-20,000

-10,000

0

10,000

20,000

30,000

86 88 90 92 94 96 98 00 02 04 06 08 10 12

HK Output Gap

Recession Expansion

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

-40,000

-30,000

-20,000

-10,000

0

10,000

20,000

30,000

40,000

86 88 90 92 94 96 98 00 02 04 06 08 10 12

Dividend Yield Hang Seng IndexOutput Gap

Cyclical Behavior of Asset Prices

Output and Unemployment

0

2

4

6

8

10

-30,000

-20,000

-10,000

0

10,000

20,000

30,000

86 88 90 92 94 96 98 00 02 04 06 08 10 12

Unemployment Rate Output Gap

BUSINESS CYCLESChap. 25. 608-609; Chap. 27, 29• Focus on explaining fluctuations in real GDP, Y,

and the GDP Deflator, P. • Framework reminiscent of the supply and demand

model.

Global Financial Crisis

Q1-20

05

Q2-20

05

Q3-20

05

Q4-20

05

Q1-20

06

Q2-20

06

Q3-20

06

Q4-20

06

Q1-20

07

Q2-20

07

Q3-20

07

Q4-20

07

Q1-20

08

Q2-20

08

Q3-20

08

Q4-20

08

Q1-20

09

Q2-20

09

Q3-20

09

Q4-20

09

Q1-20

10

Q2-20

10

Q3-20

10

Q4-20

10

Q1-20

11

Q2-20

11

Q3-20

11

Q4-20

11

Q1-20

12

Q2-20

12

Q3-20

1290

92

94

96

98

100

102

104

106

108

110

Constant $ GDP (Index 2005 = 100)

Japan United Kingdom United States Euro area (17 countries)

Statistics OECD

• Why did output fall globally, why so much, and why has it lasted so long?

HK Contraction and Recovery

3841

2 -1

033m

/yyy

y

3850

4 -1

033m

/yyy

y

3859

6 -1

033m

/yyy

y

3868

7 -1

033m

/yyy

y

3877

7 -1

033m

/yyy

y

3886

9 -1

033m

/yyy

y

3896

1 -1

033m

/yyy

y

3905

2 -1

033m

/yyy

y

3914

2 -1

033m

/yyy

y

3923

4 -1

033m

/yyy

y

3932

6 -1

033m

/yyy

y

3941

7 -1

033m

/yyy

y

3950

8 -1

033m

/yyy

y

3960

0 -1

033m

/yyy

y

3969

2 -1

033m

/yyy

y

3978

3 -1

033m

/yyy

y

3987

3 -1

033m

/yyy

y

3996

5 -1

033m

/yyy

y

4005

7 -1

033m

/yyy

y

4014

8 -1

033m

/yyy

y

4023

8 -1

033m

/yyy

y

4033

0 -1

033m

/yyy

y

4042

2 -1

033m

/yyy

y

4051

3 -1

033m

/yyy

y

4060

3 -1

033m

/yyy

y

4069

5 -1

033m

/yyy

y

4078

7 -1

033m

/yyy

y

4087

8 -1

033m

/yyy

y

4096

9 -1

033m

/yyy

y

4106

1 -1

033m

/yyy

y

4115

3 -1

033m

/yyy

y90

95

100

105

110

115

120

125

130

HK Constant Dollar GDP (2005 = 100)

Hong Kong Census & Statistics

SUPPLY

Two Aspects of Potential Output

• Potential Output is unrelated to the price level but is determined by capital infrastructure, efficiency of labor markets, population, technological know-how. • Output increases above potential only if unemployment falls below natural level;

• if unemployment rises above natural level, output will be below potential.

Potential output and labor market.

• Potential output can be viewed as a level consistent with equilibrium in labor market.• Wages hit a level so workers want to work as many

hours as firms want to hire.

• When output is above potential output, low unemployment and the search for workers will push up wages.

• When output is below potential, high unemployment and the surplus of workers will push down wages.

P

Y

Potential Output

Upward Pressure on Wages

Downward Pressure on Wages

YP

Unemployment below natural rate

Unemployment above natural rate

Why does SRAS Slope Up?Take wages as given in Short Run

• Money wages paid to workers adjust dynamically over time through negotiation.

• At a given wage, a rise in the price level reduces the cost of labor relative to value of goods produced making hiring labor to produce goods more attractive.

• At a given wage rate, higher prices induce higher production → in the short run, supply is positively associated with output.

P

Y

SRAS

Short Run Aggregate Supply CurveYP

1. Shift in Potential Output• Advance in Technology Frontier, PP& E, or expansion in potential labor force (population, demographics).

• Shifts SRAS w/ potential output.

2. Shifts in SRASWhen dollar cost of labor (or prices of

energy) shift, changes in costs are passed on into prices.

Wages and other cost shifters shift SRAS at a given level potential output.

P

Y

SRAS

1. Expansion in Output PotentialYP YP '

SRAS'

Normal for technological progress to increase potential output.

P

Y

SRAS

2. Increase in Wages

YP SRAS'

DEMAND

Two Views• Demand: The quantity of real GDP desired for purchase

at any level of the GDP deflator.

• Monetarist View: Demand can be described by liquidity/money

• Keynesian View: Demand best Viewed as Elements of Expenditure

Quantity Theory

• Simplest monetary theory is the Quantity Theory of Money.• Purchasing power of money is equal to the quantity of money (Mt)

times the speed of circulation (V, # of transactions)• Purchasing power means # of goods (Yt) multiplied by price per

good (Pt)

Pt * Yt = Moneyt * Velocity

P

Y

AD

Aggregate Demand Curve

Holding money & velocity constant

MONEY SUPPLY THE STOCK OF THE MEDIUM OF EXCHANGE.

Types of Financial Assets

M1 Currency in Hands of the Public [C] + Demand Deposits [D]

M2 M1 + Savings Deposits + “Small” Time Deposits + [Liquid Money Market Instruments inc/ “Small” NCD’s]

M3 M2 + LTD [“Large” Time Deposits and NCD’s]

Japan’s Money Supply

0

2000

4000

6000

8000

10000

12000

2003

/04

2003

/10

2004

/04

2004

/10

2005

/04

2005

/10

2006

/04

2006

/10

2007

/04

2007

/10

2008

/04

2008

/10

2009

/04

2009

/10

2010

/04

2010

/10

2011

/04

Bill

ion

Yen

M3 M2 M1

Monetary Aggregates in HK

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

8,000,000

Jan

-85

Jan

-87

Jan

-89

Jan

-91

Jan

-93

Jan

-95

Jan

-97

Jan

-99

Jan

-01

Jan

-03

Jan

-05

Jan

-07

Jan

-09

HK

$ M

illio

n

M1 M2 M3

HKMA Monthly Statistical Bulletin

Expenditure: C + I + G + NX

• Wealth Effect – Real value of liquid/monetary assets rises as prices fall. This adds to wealth of households stimulating consumption.

• Competitiveness Effect – Holding exchange rate constant, a lower price level makes domestic exports more attractive and foreign imports less stimulating net exports.

Prices and Spending

For now, hold interest rate and exchange rate constant.

Keynesian View: Expenditure constrained not by liquidity but by behavior of purchasers of goods.

P

Y

AD

Aggregate Demand Curve

Wealth Effect, Competitiveness Effect

AS-AD MODEL

Equilibrium

• Equilibrium in the competitive market occurs when the price is set at a level (P*) such that the amount that consumers want to buy is equal to the amount that sellers want to sell (Y*). Excess Supply If P were above equilibrium, sellers would want to sell

more goods than buyers would want to buy. Competition between sellers would force prices down.

Excess Demand If P were below equilibrium, customers would want to buy more goods than people would want to sell. Competition between buyers would force prices up.

P

Y

SRAS

Equilibrium GDP and Price Level

AD

P*

Y*

P

Y

SRAS

Output below potential: Recessionary Gap. YP

AD

P*

1

Y*

GAP

P

Y

SRAS

Output above potential: Inflationary Gap. YP

AD

P*2

Y*

GAP

Self Correction Process

• Business cycles have a natural end. • In short run, Y* may be greater than or less than potential output. However, in that case surplus or shortage of workers in labor markets will be putting downward or upward pressure on wages.

• Pressure on wage costs will shift the supply curve until equilibrium output is equal to potential output.

P

Y

AS

Movement to Long Term Equilibrium

AD

YP

2

1W↓

AS1

AS2

W↑

Cyclical Fluctuations

• Period-by-period, different important events will impact the economy. We will think of these events as primarily driving the demand side of the economy (shifting the AD curve) or primarily driving the supply side (shifting the supply side).

• The strength of these will determine the correspondence between movements in output and inflation.

P

Y

SRAS

Demand side shocks cause output and prices to move together.

AD1

P*

Y*

AD2

Y**

P**

1

2

Excess Supply

P

Y

SRAS

Output below potential. Downward pressure on wages. Cost of production falls and AS shifts down

YP

AD2

Y***

P***

1

2

SRAS2

Wages fall

3 As costs fall, competitive prices fall, there is a movement along the AD curve.

P

Y

SRAS3

Wages will keep falling until the surplus of labor is absorbed – when prices fall enough that demand reaches potential output

YP

AD2

4

SRAS2

Wages keep falling

3

What shifts the AD curve?

Shift Outward In AD Shift Inward In AD

Increasing Optimism Increasing Pessimism

Increasing Value of Assets Falling Value of Assets

Increasing Foreign GDP Decreasing Foreign GDP

Expansionary Monetary Policy Contractionary Monetary Policy

Expansionary Fiscal Policy Spending Hikes Tax Cuts

Contractionary Fiscal Policy Spending Cuts Tax Hikes

P

Y

SRAS

YP SRAS'

AD

Supply Shocks – Shocks to resource prices or labor relations may shift supply curve.

1

2Higher Prices, Negative Output GapStagflation

AS-AD and Expected inflation

• Potential GDP generally increases at a consistent rate.

• On average, aggregate quantity of liquid assets tends to increase faster than potential GDP.

• Workers wages will tend to rise to match increases in the cost of living.

• AD does not always rise evenly with GDP.

Rule of Thumb

Z X Yt t t t t tZ X Y g g g

• Rule of Thumb The growth rate of product is approximately equal to the sum of the growth rates of the elements of a product.

1

1

Z t tt

t

Z Zg

Z

Money and Inflation

M Y Pt t t t tg g g

• Assuming stable velocity

• Inflation occurs when money growth speeds ahead of output growth. The unbounded creation of fiat money leads to inflation which ultimately will make the money worthless.

Money & Inflation: 1975-1994

Inflation & Money OECD Countries

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

0.2

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18

Average Money Growth

Ave

rag

e In

flat

ion

Rat

e

Dynamics of Stable Policy• If the economy’s potential output shifts out by a constant

amount on an annual basis….• ….and velocity is constant….• ….then policy-makers can keep inflation and the output

gap stable by increasing demand smoothly with potential output.

• Target inflation becomes expectation.

P

Y

SRASt

Dynamic AS-AD Model: Stability

ADt

Yt*

YtP YP

t+1

ADt+1

SRASt+1

Y*t+1

Pt*

P*t+1

Demand expansion matches supply expansionAverage Inflation

Ch. 29, 711-712

P

Y

ASt

Dynamic AS-AD Model: Inflation Acceleration

ADt

Yt*

YtP

YPt+1

ADt+1

ASt+1

Y*t+1

Pt*

P*t+1

Gap

Demand expands faster than expected

Expected Inflation

Positive Output Gap

Inflation rises more than usual

Actual Inflation

Inflation Acceleration: πt – πt-1

UK 1992-2008

-4

-3

-2

-1

0

1

2

-4 -3 -2 -1 0 1 2 3

Output Gap

Infl

atio

n A

ccel

erat

on

P

Y

ASt

Dynamic AS-AD Model: Recession, Inflation Deceleration

ADt

Yt*

YtP

YPt+1

ADt+1

ASt+1

Y*t+1

Pt*

P*t+1Expected Inflation

Gap

Demand expands slower than expected

Negative Output Gap

Inflation rises less than usual

Actual Inflation

Expenditure SideDeclining Consumption and Investment in most affected countries (mostly those that received inflows prior to the crisis).

Declining net exports for surplus countries.

Q1-20

05

Q3-20

05

Q1-20

06

Q3-20

06

Q1-20

07

Q3-20

07

Q1-20

08

Q3-20

08

Q1-20

09

Q3-20

09

Q1-20

10

Q3-20

10

Q1-20

11

Q3-20

11

Q1-20

12

Q3-20

12

-0.50%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

YoY Inflation GDP Deflator

United Kingdom United States Euro area (17 countries)

• Link

Learning Outcomes

Students should be able to:• Define the terminology of business cycles. • Calculate unemployment rate with labor data.• Calculate the output gap with GDP and potential GDP

data.

Learning Outcomes

Students should be able to• Explain how various events will shift the aggregate supply

or demand curves.• Construct an aggregate supply and demand model of

business cycles and use it to explain equilibrium outcomes.

• Describe the short-term and long-term dynamics of business cycles.