WS 2006/07 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 KuB 4 1 U van Suntum, Vorlesung KuB 1

WS 2006/07 monetaryreal endogenous Ralph Hawtrey ( ): Instability of v Knut Wicksell ( ): interest rate spread F.A. von Hayek ( ): excess investment M. Woodford: dynamic stochastic general equilibrium model (DSGE) E. Lederer, R. Malthus, K. Marx: underconsumption Albert Aftalion ( ), Artur Spiethoff ( ), Gustav Cassel ( ): 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 exogenousMilton Friedman: monetary policy Robert Lucas, B.T. McCallum (1980): Price expectations William St. Jevons ( ): sunspot-theory W.D. Nordhaus (1975): political cycles KuB KuB 4 2 U van Suntum, Vorlesung KuB 2

WS 2006/07 Interdependency of Macroeconomics M*V:P=M*V:P= = L net + G net + T = C + I + E + EX - IMC + S = Y underconsumption theories Keynesian theories monetary/monetaristic theories distribution theories KuB KuB 4 3 U van Suntum, Vorlesung KuB 3

WS 2006/07 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 KuB KuB 4 4 U van Suntum, Vorlesung KuB 4

WS 2006/07 Central bank balance (simplified) AssetsLiabilities credit claims bonds foreign currency other currency in circulation reserves monetary base MB KuB KuB 4 5 monetary base MB U van Suntum, Vorlesung KuB 5

WS 2006/07 Velocity of circulation v in Euro-Zone (1980 – 2000) source: ECB ln [GDP nom /M3] KuB KuB 4 6 U van Suntum, Vorlesung KuB 6

WS 2006/07 Pure monetary theory by Ralph Hawtrey (1928) (I) inventories are sensible to interest rate Inventory bought at leveraged equity: inventory sold at => Profit before interest Rate of return ( i = 10%): 10% Rate of return (i = 11%): 1% KuB KuB 4 7 U van Suntum, Vorlesung KuB 7

WS 2006/07 Pure monetary theory by Ralph Hawtrey (1928) (II) KuB KuB 4 8 inventories are also sensible to inflation Interest rates decline inventory and commodity demand increase Inflation rising velocity of money circulation (Hawtrey effect) Inflation Interest rates rise U van Suntum, Vorlesung KuB 8

WS 2006/07 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 KuB KuB 4 9 U van Suntum, Vorlesung KuB 9

WS 2006/07 Monetary over-investment theory (Knut Wicksell 1922, F.A. von Hayek 1934 ) upswingdownswing i nat i mon S I S + d(M/P) S I KuB KuB 4 10 Interest rate spread causal for disparity between investment and consumption goods U van Suntum, Vorlesung KuB 10

WS 2006/07 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 KuB KuB 4 11 U van Suntum, Vorlesung KuB 11

WS 2006/07 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) KuB KuB 4 12 technical progress and capital accumulation pressure on wages and rising unemployment sales crisis and depression U van Suntum, Vorlesung KuB 12

WS 2006/07 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 t 1 => I 1 = 60  + 100% I 2 = 33  -45% => extreme instability Non-monetary theory of excess investment (Aftalion u.a.) Aggregate Demand Investment KuB KuB 4 13 U van Suntum, Vorlesung KuB 13

WS 2006/07 Accelerator effect in East German Housing Market Housing stock./. outs (99) adds (1) Demand (100) Housing stock./. 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 unificationtoday KuB KuB 4 14 U van Suntum, Vorlesung KuB 14

WS 2006/07 KuB KuB 4 15 Orders in East-German Construction Industry U van Suntum, Vorlesung KuB 15

WS 2006/07 Dynamics of the business cycle GDP Investment GDP Investment KuB KuB 4 16 U van Suntum, Vorlesung KuB 16

WS 2006/07 Demand Supply Is there an equilibrium of aggregate demand and investment? (Harrod-Domar 1939): KuB U van Suntum, Vorlesung KuB 17

WS 2006/07 Dynamics in Harrod/Domar-model: t lnI lnY Y* = 1/(1-c)I aut U van Suntum, Vorlesung KuB 18

WS 2006/07 a) equlibrium: g I = g* = 0,1 Numerical example I: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1 Period:012 K => Y S = xK I = I t-1 (1 + g I )202224,2 => Y D = I/s ALG = Y D /Y S 100% Steady-state: all variables grow at the same rate t lnI lnY I = sY = 0,2*100 = 20 U van Suntum, Vorlesung KuB 19

WS 2006/07 b) disequilibrium: g I = 0,2 > g* Numerical example II: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1 Period:012 K => Y S = xK I = I t-1 (1 + g I )202428,8 => Y D = I/s ALG = Y D /Y S 100%109%118% Excess investiment leads to under-utililization of capacities (Domars-Paradoxon) t lnY U van Suntum, Vorlesung KuB 20

WS 2006/07 c) disequilibrium: g I = 0,05 < g* Numerical example III: s = 0,2 x = 0,5 => g* = 0,2 * 0,5 = 0,1 Period:012 K => Y S = xK ,5 I = I t-1 (1 + g I )202122,05 => Y D = I/s ,25 ALG = Y D /Y S 100%95%91% Lack of investmentleads to excess capacity! t lnY U van Suntum, Vorlesung KuB 21

WS 2006/07 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…) U van Suntum, Vorlesung KuB 22

WS 2006/07 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! KuB KuB 4 23 U van Suntum, Vorlesung KuB 23