SSBNYU Average Duration of Business Cycles in The Us 1854 to 1982 Excel Worksheet

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Business Finance

Stern School of Business at NYU


1) Review Chapters 1, 2 and 3 in Zarnowitz (1992)

Choose #2 OR #3 below

2) Replicate and update Tables 2.1 in Zarnowitz (1992) with the new data since the 1980s. (pages 23-24).

3) Replicate and update Tables 2.2 in Zarnowitz (1992) with the new data since the 1980s. (pages 23-24). For table 2.2, you will need to download data for GDP (instead of GNP), nonfarm payroll employment, and unemployment rate.

Use the same format for the tables, add new rows for information covering 1980 to 2019. Not all of the data you download will go back to 1875, download as long a history as possible. Can you verify and validate the information in the tables with the data you downloaded for the period before the 1980s? Use data for GDP instead of GNP. You can find the business cycle chronology back to 1959 for the US in the table on the last page of this document:

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The Economy of the United States July 2018 1 © 2018 The Conference Board, Inc. | U.S. Business Cycles and the Leading and Coincident Economic Indexes Peak: 60:4 Trough: 61:2 120 110 100 69:12 70:11 73:11 75:3 80:1 81:7 80:7 82:11 90:7 91:3 01:3 01:11 07:12 09:6 The Conference Board Leading Economic Index® (LEI) for the U.S. The Conference Board Coincident Economic Index® (CEI) for the U.S. 90 80 Index (2016=100) 70 60 50 40 30 Source: The Conference Board Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. 20 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 For more information: 2 © 2018 The Conference Board, Inc. | 2015 U.S. Leading Economic Index Vs. Real GDP (1959 – Present) Peak: 60:2 69:4 73:4 80:1 81:3 90:3 01:1 07:4 Trough: 61:1 70:4 75:1 80:3 82:4 91:1 01:4 09:2 120 The Conference Board Leading Economic Index® for the U.S. (left scale) GDP* (right scale) 110 20,000 100 18,000 90 16,000 80 14,000 70 12,000 60 10,000 50 8,000 40 6,000 30 Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. 20 1960 1965 1970 1975 1980 1985 1990 4,000 Source: The Confrence Board, *BEA 2,000 1995 2000 2005 2010 2015 For more information: 3 © 2018 The Conference Board, Inc. | Bill. 2009$ Index (2016=100) 22,000 U.S. Leading Economic Index (1959 – Present) Peak: 60:4 Trough: 61:2 69:12 73:11 70:11 75:3 20 80:1 81:7 80:7 82:11 01:3 01:11 90:7 91:3 07:12 09:06 The Conference Board Leading Economic Index® for the U.S. 15 10 Percent change (AR) 5 0 -5 -10 -15 6-month growth 12-month growth -20 -25 Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. Source: The Conference Board -30 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 For more information: 4 © 2018 The Conference Board, Inc. | 2015 Close-up on the Leading Economic Index (1995 - Present) 01:3 01:11 Peak: Trough: 07:12 09:6 15 The Conference Board Leading Economic Index® for the U.S. 10 5 Percent change (AR) 0 -5 -10 -15 3-month growth 6-month growth 12-month growth -20 -25 -30 Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. Source: The Conference Board -35 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 For more information: 5 © 2018 The Conference Board, Inc. | 2018 U.S. Coincident Economic Index (1959 - Present) Peak: 60:4 Trough: 61:2 69:12 70:11 10 73:11 75:3 80:1 81:7 80:7 82:11 01:3 01:11 90:7 91:3 07:12 09:06 The Conference Board Coincident Economic Index® for the U.S. 8 6 Percent change (AR) 4 2 0 -2 -4 6-month growth 12-month growth -6 -8 Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. Source: The Conference Board -10 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 For more information: 6 © 2018 The Conference Board, Inc. | 2015 Close-up on the Coincident Economic Index (1995 Present) Peak: Trough: 01:3 01:11 07:12 09:6 8 The Conference Board Coincident Economic Index® for the U.S. 6 4 Percent change (AR) 2 0 -2 -4 3-month growth 6-month growth 12-month growth -6 -8 -10 Note: Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee. Source: The Conference Board -12 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 For more information: 7 © 2018 The Conference Board, Inc. | 2018 U.S. Real GDP (1960 - Present) 60:2 69:4 73:4 Trough: 61:1 70:4 75:1 Peak: 12 80:1 81:3 80:3 82:4 90:3 01:1 07:4 91:1 01:4 09:2 US GDP 10 2-quarter growth 4-quarter growth 8 Percent change (AR) 6 4 2 0 -2 -4 -6 Note: Shaded areas represent recessions as determined by Source: BEA the NBER Business Cycle Dating Committee. -8 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 For more information: 8 © 2018 The Conference Board, Inc. | 2015 Close-up on Real GDP(1995 - Present) Peak: 01:1 07:4 Trough: 01:4 09:2 8 US GDP 6 Percent change (AR) 4 2 0 -2 1-quarter growth 2-quarter growth 4-quarter growth -4 -6 -8 Note: Shaded areas represent recessions as determined by Source: BEA the NBER Business Cycle Dating Committee. -10 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 For more information: 9 © 2018 The Conference Board, Inc. | 2018 Business Cycle Reference Dates North America U.S. Mexico Euro Area France Spain Latin America Asia-Pacific Europe Germany U.K. Australia Japan Korea Feb-73 Mar-79 China India Brazil Mar-91 Oct-97 Sep-08 Dec-00 Oct-02 Jul-08 Dates at Business Cycle Peaks 1940s Feb-45 Nov-48 1950s Jul-53 Aug-57 1960s Apr-60 Dec-69 1970s Nov-73 1980s Jan-80 Jul-81 Jul-90 Nov-81 Nov-85 Nov-94 Mar-01 Dec-07 Oct-00 Jun-08 1990s 2000s May-66 2010s Feb-92 Feb-08 Jul-11 Aug-74 May-73 Feb-80 Oct-82 Jan-92 Mar-80 Feb-92 Aug-02 Feb-08 Feb-08 Feb-11 Jun-10 Feb-91 May-95 Feb-01 Feb-08 Dec-60 Jun-73 Nov-79 Sep-74 May-82 May-90 Jun-90 May-08 Sep-88 Feb-92 Mar-97 Feb-01 Feb-08 Aug-97 Jan-08 Sep-10 Feb-12 Mar-14 Dates at Business Cycle Troughs 1940s Oct-45 Oct-49 1950s May-54 Apr-58 Feb-61 1960s 1970s 1980s 1990s 2000s 2010s Apr-67 Nov-70 Mar-75 Jul-80 Nov-82 Mar-91 Jun-83 Jan-87 Jul-95 Nov-01 Jun-09 Mar-02 May-09 Jul-93 May-61 May-75 Oct-75 Aug-75 Jan-75 Aug-81 Nov-84 Dec-93 Nov-82 Dec-81 Mar-83 Jul-93 Mar-96 Aug-03 Apr-09 Dec-91 Jun-91 Apr-93 Aug-09 May-03 Aug-09 May-09 Feb-13 Jan-13 Mar-13 Jun-09 Apr-75 May-80 Aug-93 Feb-99 Jan-02 Mar-09 Apr-11 Sep-12 Jul-98 Dec-08 Feb-90 Nov-91 Feb-99 Jan-09 Sep-01 Jun-03 Jan-09 Dec-16 Source: NBER; IBRE/FGV; The Conference Board Notes: U.S. and Brazil business cycle chronologies are determined by the NBER and CODACE Business Cycle Dating Committees, respectively; all other business cycle reference dates are determined by The Conference Board using a business cycle dating algorithm (see Bry and Boschan (1971) and Harding and Pagan (2002)). 10 © 2018 The Conference Board, Inc. | This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Business Cycles: Theory, History, Indicators, and Forecasting Volume Author/Editor: Victor Zarnowitz Volume Publisher: University of Chicago Press Volume ISBN: 0-226-97890-7 Volume URL: Conference Date: n/a Publication Date: January 1992 Chapter Title: Recent Work on Business Cycles in Historical Perspective Chapter Author: Victor Zarnowitz Chapter URL: Chapter pages in book: (p. 20 - 76) 2 2.1 Recent Work on Business Cycles in Historical Perspective Introduction Interest in business cycles is itself subject to a wavelike movement, waxing during and after periods of turbulence and depression, waning in periods of substantial stability and continuing growth. I At time, confidence in government institutions and actions persuaded many that cyclical instability had ceased to be a serious problem. Thus in the early heyday of the Federal Reserve System, 1922-29, monetary policies were expected to help maintain prosperity. In the 1960s, the late heyday of Keynesian economics, fiscal finetuning evoked similar hopes. The present is another time of disillusionment-now extending to both types of stabilization policy. The sequence of serious worldwide recessions in the last decade soon refuted the perennially attractive idea that business cycles had become obsolete. Beyond that, the credibility of both Keynesian and monetarist explanations has diminished. Once again, the apparent failure of old solutions prompts the profession to pay more attention to the continued existence of business cycles. Reprinted from the Journal ofEconomic Literature 23 (June 1985): 523-80. The author thanks Alan Blinder, William Fellner, Stanley Fischer, Milton Friedman, Robert Gordon, Robert Hall, Bert Hickman, Wilhelm Krelle, David Laidler, Ronald McKinnon, John Taylor, and two anonymous referees for many helpful suggestions and criticisms of the first outline and earlier drafts of this paper. Also gratefully acknowledged is the financial and intellectual support received from the National Bureau of Economic Research and the Graduate School of Business of the University of Chicago. Naturally, responsibility for the expressed opinions and any remaining errors is exclusively the author's. 1. This is well illustrated in the early literature, which focused on the episodes of commercial crises, but it is also reflected in the timing of later, classical studies of the nature and causes of business cycles at large. There is little doubt about the impetus provided in this context by the major depressions of the late 1830s, 1870s, 1890s, 1907-8, 1920-21, and most strikingly the 1930s. 20 21 Recent Work on Business Cycles in Historical Perspective The rediscovery of an important subject is always welcome, even if long overdue. However, much of the recent work has neglected the long history of both the phenomena of major economic fluctuations and their interpretations, concentrating instead on contemporary theoretical and policy controversies, mainly in the United States. An overview of selected literature will attempt to demonstrate that this myopia is costly and needs to be corrected. The study of business cycles is almost coextensive with short-term macrodynamics and it has a large interface with the economics of growth, money, inflation, and expectations. The literature is huge; its level of difficulty is in general high. This survey attempts to provide a historical background and outline the evolution of thought leading to the recent developments in theory and related evidence. The coverage is extensive, yet of necessity much is left out, including theories that are largely concerned with unemployment and inflation, much less with business cycles directly. 2 In particular, no attempt can be made here to discuss in any detail the statistical and historical work on the observed regularities and idiosyncrasies of business cycles and their possible long-term changes. This empirical literature is rich and important: it deserves a separate review. After all, it is the "stylized facts" which it provides that ought to be explained by the theory. Those main facts are summarized in section 2.2, but with a minimum of references and commentary. Section 2.3 discusses the main elements of older theories, before and after the Great Depression, and proceeds to more recent models driven by changes in investment, credit, and price-cost-profit relations. Most of these theories and models are primarily endogenous and deterministic. Exogenous factors and stochastic elements are introduced early in section 2.4. The sections that follow deal, first, with the monetarist interpretation of business cycles, then with the newer equilibrium models with price misperceptions and intertemporal substitution. The route leads generally from "adaptive" to "rational" expectations. The approach is generally monetarist in the sense of relying on monetary shocks, but the emphasis shifts from nominal demand changes and lagged price adjustments to informational lags and supply reactions. Various problems and complications arise, revealed in large part by intensive testing and criticism. This leads to new attempts to explain the persistence of cyclical movements, the role of uncertainty and financial instability, real shocks, gradual price adjustments, etc. Conclusions are drawn in the last section, which stresses the need for a realistic synthesis. 2. Two sets of writings should be mentioned in this context, namely, the theories of the new radical economists and those embodied in some of the recent "disequilibrium" models. For summaries or surveys, see Sherman 1976; Malinvaud 1977; and Drazen 1980. Also, the early mathematical models and the more recent theories of the "political business cycle". receive little attention in the present paper; monographs surveying this literature are Rau 1974; Gapinski 1982; and Mullineux 1984. 22 Chapter 1\vo 2.2 Stylized Facts 2.2.1 The Overall Aspects and Varying Dimensions of Business Cycles The term "business cycle," is a misnomer insofar as no unique periodicities are involved, but its wide acceptance reflects the recognition of important regularities of long standing. The observed fluctuations vary greatly in amplitude and scope as well as duration, yet they also have much in common. First, they are national, indeed often international, in scope, showing up in a multitude of processes, not just in total output, employment, and unemployment. Second, they are persistent-lasting, as a rule several years, that is, long enough to permit the development of cumulative movements in the downward as well as upward direction. This is well established by the historical chronologies of business cycles in the United States, Great Britain, France, and Germany, a product of a long series of studies by the National Bureau of Economic Research (Bums and Mitchell 1946; Moore 1961, 1983; Moore and Zarnowitz 1986; see also chapter 5). For all their differences, business expansions and contractions consist of patterns of recurrent, serially correlated and cross-correlated movements in many economic (and even other) activities. Seasonal movements, which are periodic but often variable in size and pattern, may obscure the cyclical developments from an observer of current changes in individual time series. The same applies to short, erratic movements, which are similarly ubiquitous. But, looking back across monthly or quarterly data representing many different variables, business cycles can be clearly distinguished from the other fluctuations in that they are as a rule larger, longer, and more widely diffused. They dominate changes in the economy over spans of several years, in contrast to the seasonal and other variations which spend themselves over spans of a year or less. They reflect, and interact with, long growth trends which dominate developments across decades. Peacetime expansions in the United States averaged about 3 years in the last half-century, 2 years in the earlier periods containing 10 cycles each (table 2.1). Each of the wartime expansions was much longer. Contractions have averaged close to 1 year since 1933, almost twice as long in the earlier periods. This suggests a strong shift toward longer and more variable expansions and shorter and more uniform contractions since the Great Contraction of the early 1930s. However, the NBER dates for the early business cycles are based on limited information and may overstate the length of some of the recessions (see note to the table). The mean duration of full peacetime cycles has remained approximately stable at 4 years. The individual phase and cycle durations show considerable variability over time, as shown by the standard deviations in table 2.1. However, when the relatively rare outliers are discounted, fairly clear central tendencies emerge. Thus the ranges of 1.5-3 years, 1-2 years, and 2.5-5 years account for three 23 Recent Work on Business Cycles in Historical Perspective Average Duration of Business Cycles in the United States, 1854-1982 Table 2.1 Average Measures of Phase and Cycle Durations Period (years, T to T) 1854-97 1897-1933 1933-82 1933-82, excl. wars 1854-1982 1854-1982, excl. wars No. of Business Cycles Covered Mean S.D. Mean S.D. Mean S.D. (1) (2) (3) (4) (5) (6) (7) 10 10 10 7 30 25 27 23 49 37 33 27 9 10 27 15 20 11 24 20 17 10 3 4 12 13 51 43 60 48 51 46 24 10 26 14 22 16 Expansion Contraction II 11 18 19 Full Cycle (T to T) Note: All means and standard deviations (S.D.) are rounded to full months. Expansions are measured from troughs (T) to peaks (P), contractions from P to T, the full cycles from T to T. Figures in line 4 exclude the expansions during World War II, the Korean War, and the Vietnam War and the immediately following contractions. Figures in line 6 exclude also the expansions during the Civil War and World War I and the immediately followng contractions. For references and underlying detail see Moore and Zamowitz 1986. It should be noted that the data available for identifying and measuring the historical business cycles are fragmentary and often weak. Much of the evidence relates to cyclically sensitive sectors and processes. Hence some of the early fluctuations may have involved only slowdowns rather than absolute declines in total output and employment. If so, the averages in lines 1 and 2 should be somewhat larger for expansions and smaller for contractions. This would only moderately reduce the contrast with the entries in line 3 and would not significantly alter the overall conclusions drawn in the text (see chapter 7). fourths or more of the peacetime expansions, contractions, and full cycles in the United States, respectively. The amplitudes of cyclical expansions vary as much as their durations, with which they tend to be well correlated. The rates of change (velocities) and diffusion show less variability across the cycles. Table 2.2 provides some evidence in support of these generalizations. In the 20 years between the two world wars three major depressions occurred, including the uniquely deep one of 1929-33. Since then no general declines of comparable magnitude have occurred, notwithstanding the gravity of recent conditions of rising and high unemployment in some countries, such as the United Kingdom. On the whole recessions have become not only much shorter but also shallower and less diffused. Table 2.3, using a sampling of measures for the U.S. business contractions of 1920-82, illustrates the contrasting dimensions of major depressions versus other declines and the much smaller but consistent differences between the "severe" and "mild" recessions. 2.2.2 Main Features of Cyclical Behavior Most industries and sectors of the economy participate in the general business cycles with substantial regularity (i.e., they exhibit high conformity or 24 Chapter lWo Table 2.2 Selected Characteristics of Seven Expansions, United States, 1949-82 (1) Smallest Value (2) Mean (3) Standard Deviation (4) 106 49.2 6.4 12 4.4 3.5 46 21.1 4.7 30 14.7 1.0 -5.3 -0.6 -2.7 1.5 73 89 Largest Value Statistic Line Real GNP: Duration (months) Total increases (%) Rate of increase (% per year) Unemployment rate: Total decline (% points) Nonfarm employment: Percent of industries expanding 1 2 3 4 5 100 9 Source: Moore and Zamowitz 1986, table 6. Note: The entries in col. 1 refer to the expansion of 2/1961-12/1969 (lines 1-3) and 10/1948-7/ 1953 (lines 4 and 5). The entries in col. 2 refer to the expansion of 7/1980-7/1981. The entries in col. 3 and 4 cover all seven expansions. Line 5 shows the maximum percentage of nonagricultural industries with rising employment, based on changes over 6-month spans. Table 2.3 Line 2 3 4 5 6 Average Duration, Depth, and Diffusion of Thirteen Contractions, United States, 1920-82 Statistic Average duration (months) Percentage decline: Real GNP Industrial production Nonfarm employment Unemployment rate: Total increase (% points) Nonfarm employment: Percent of industries contracting Great Two Major Six Severe Four Mild Depression Depressions Recessions Recessions (2) (3) (4) (1) 43 16 12 10 -32.6 -53.4 -31.6 -13.4 -32.4 -10.6 -3.3 -13.1 -3.8 -1.7 -7.8 -1.7 21.7 9.6 3.8 2.3 100 97 88 77 Source: Moore and Zamowitz 1986, table 7. Note: The contraction of 8/1929-3/1933 is referred to as the Great Depression; the contractions of 1/1920-7/1921 and 5/1937-611938 are the major depressions. The dates of the six severe recessions are 5/1923-711924, 11/1948-10/1949, 711953-5/1954, 8/1957-4/1958, 11/1973-3/ 1975, and 7/1981-11/1982. The dates of the four mild recessions are 1011926-11/1927,4119602/1961, 12/1969-11/1970; and 111980-7/1980. coherence), but some do not (e.g., agriculture, which depends heavily on the weather, and production of naturally scarce resources). 3 Durable producer and consumer goods tend to have high conformity and large amplitudes of cyclical movements in production, employment, and inventories. The amplitudes are 3. This section is based primarily on studies of U. S. economic history, but many of the qualitative features of cyclical behavior summarized here are found as well in the data for other major industrialized countries with private enterprise and free markets: Mitchell 1913, 1927; Schumpe- 25 Recent Work on Business Cycles in Historical Perspective much smaller for nondurable goods, and still smaller for most of the (nonstorable) services. Manufacturers' sales move with greater amplitudes than wholesalers' sales, and the latter with greater amplitudes than retailers' sales. In many industries, particularly manufacturing of durables, production is, in large measure, guided by advance orders, which show large fluctuations followed, with variable lags, by much smaller fluctuations in outputs and shipments. The resulting changes in backlogs of unfilled orders and average delivery lags are themselves procyclical. Private investment expenditures, although much smaller in the aggregate than consumer spending, have much larger cycles in percentage terms. Aggregate production typically fluctuates more widely than aggregate sales, which implies a procyclical behavior of inventory investment. Business profits show very high conformity and much greater amplitude of cyclical movements than wages and salaries, dividends, net interest, and rental income. The level of industrial prices tends to have wider fluctuations than the levels of retail prices and wages. Virtually all U. S. business contractions before World War II were associated with declines in wholesale prices. 4 However, the last recession to be accompanied by a significant deflation was that of 1948-49. Since then the price level never fell cyclically, but each of the seven U. S. recessions of 1953-82 resulted in a temporary reduction of the rate at which prices rose, that is, in some disinflation. But, in contrast to the general price indexes for consumer and producer goods, prices of industrial commodities and raw materials traded in organized auction markets continued to show high sensitivity to business cycles, often turning down early in slowdowns as well as contractions. Narrowly and broadly defined monetary aggregates usually experience only reduced growth rates, not absolute declines, in connection with ordinary recessions. Only in cycles with severe contractions do substantial downward movements interrupt the pronounced upward trends in these series. The income velocity of money (i.e., ratio of income to the stock of currency and commercial bank deposits held by the public) tends to move procyclically (up in expansions and down in contractions), allowing for its long trends (downward before World War II, then upward for some time). Short-term interest rates display high positive conformity and generally large amplitudes of movements relative to their average level in each cycle. However, when measured in basis points, cyclical changes in these series are typically small when the interest-rate levels are low. Long-term rates usually ter 1939; Frickey 1942; Burns and Mitchell 1946; Abramovitz 1950; Mitchell 1951; Gayer, Rostow, and Schwartz 1953; Matthews, 1959; Moore 1961,1983; R. A. Gordon 1961; M. Friedman and Schwartz 1963a; Hultgren 1965; Zamowitz 1972a, 1973; Zamowitz and Moore 1984; P. Klein and Moore 1985. 4. This is true both for the periods of long-term inflationary trends (1843-64, 1896-1920) and for those of long-term deflationary trends (1864-96, 1920-32). 26 Chapter 1\vo lag behind the short-term rates and have much lower conformity and much smaller amplitudes. The relative movements in both short-term market rates and bond yields increased significantly in the recent past compared with their historical averages. Near cyclical peaks, short rates tend to come close to or exceed the long rates; near cyclical troughs, they tend to be much lower. Along with these conformity and amplitude characteristics, the recurring features of business cycles include an array of timing sequences. Months before total employment, output, and real income turn down, activities marking the early stages of investment process begin to decline. These include the formation of new business enterprises, corporate appropriations for capital expenditure, contracts for commercial and industrial construction, new orders of machinery and equipment, and new bond and equity issues. Investment realizations-construction put in place, deliveries and installations of equipment-keep increasing long after the decline in these investment commitments as work continues on the backlog of orders accumulated during the busiest stages of expansion. Indeed, business expenditures for new plant and equipment often peak when the overall economic contraction is already well under way. At business cycle troughs, with lower levels of capacity utilization, the delivery lags are generally shorter, but investment commitments still tend to lead and expenditures coincide or lag. Long before the downturn in total sales, profits per unit of sales decline. Total profits (a product of margins times sales) also lead, but by shorter intervals. Stock prices move early as well, reflecting expected changes in corporate earnings. Bond prices tend to tum earlier yet (bond yields are generally lagging). Labor productivity (output per hour) fluctuates procyclically around a secularly rising trend, generally with leads. Money wages often rise less than prices in recoveries and more than prices in late expansion stages. This combines with the marked and persistent productivity changes to induce a procyclical and lagging movement in labor costs per unit of output. Net changes in consumer installment credit and in mortgage credit outstanding have similar procyclical, leading behavior patterns. So has the net change in bank loans to business, but here the leads tend to be shorter and less consistent. Compared with the overall credit flows, the rates of growth in monetary aggregates show, in general, lower cyclical conformities and amplitudes and more random variations. They have historically led at business cycle turns by highly variable but mostly long intervals. Indeed, these leads are often so long as to produce strong elements of inverted behavior in the monetary growth rates: that is, extended declines during expansions and rises during short recessions. Consumers' "sentiment," that is, anticipations concerning their economic and financial fortunes, also has a predominantly leading pattern. Recent recessions in the United States have been preceded, more often than not, by downturns, and recoveries by upturns, in consumer buying plans and actual ex- 27 Recent Work on Business Cycles in Historical Perspective penditures on automobiles, housing, and related durable goods. Residential construction commitments, such as new-building permits and housing starts, have particularly long leads at peaks and often also at troughs of the business cycle. Here the gestation periods are fairly short so that the expenditures themselves show sizable leads. Change in business inventories not only conforms positively to cycles in general economic activity but is highly sensitive and volatile, often leading, albeit by variable and, on the average, short intervals. Total manufacturing and trade inventories, on the other hand, are dominated by long trends and tend to lag. Inventory investment plays a very important role in short and mild cycles, whereas fluctuations in fixed investment acquire a greater weight in the longer and larger cycles. Table 2.4 provides a conspectus of the timing relationships found to be typical of business cycles. 2.2.3 Some International Aspects and Recent Developments Business cycles have tended to be shorter in the United States than in Europe (e.g., the 1854-1938 period witnessed 21 U.S. cycles averaging 4 years and only 16 British cycles averaging 5V3 years). However, before World War II, more than 60% of the cyclical turning points can be matched for all four countries covered by the NBER chronologies, and only 10% cannot be matched at all (Moore and Zarnowitz 1986). After World War II, an era of great reconstruction in Western Europe and Japan set in, which witnessed, first, a restoration of sound currencies and free markets, then rapid growth. For some time cyclical setbacks in these countries assumed the form of retardations of growth rather than absolute declines. However, these slowdowns and the intervening speedup phases continued to show a high degree of international diffusion. Then growth slackened and the "classical" business cycles (with absolute declines in total output and employment) reappeared everywhere in the 1970s. The tendency for these cycles to be roughly synchronized across the major trading countries became visible again, even without allowances for discrepancies in the longer growth trends. 5 In a large economy dominated by production for domestic markets, business cycles are likely to be induced primarily by internal mechanisms (e.g., fluctuations in spending on durable goods endogenously and elastically financed) but they are then transmitted abroad through the movements in imports that are a positive function of production and income. For small and, particularly, less developed countries, fluctuations in exports usually call the tune. Of course, foreign influences can be critical, at times, for even the largest and relatively least open economy. This is well illustrated by the adverse effects on the United States of the OPEC oil price boosts in 1973-74 and 5. These events rekindled interest in business cycles of larger dimensions and essentially endogenous nature; see Volcker 1978. 28 Table 2.4 Chapter Two lYpical Leads and Lags among Major Economic Indicators Leading Lagging Roughly Coincident I. Investment in Fixed Capital and Inventories New building permits; housing Backlog of capital Production of business starts; residential fixed inappropriations, mfg. * equipment vestment Business expenditures for new Machinery and equipment New business formation plant and equipment* sales* New capital appropriations, Mfg. and trade inventories mfg. *; contracts and orders for plant and equipment Change in business inventories II. Consumption, Trade, Orders, and Deliveries Production of consumer New orders for consumer goods goods and materials Mfg. and trade sales Change in unfilled orders, durable goods* Vendor performance (speed of deliveries) Index of consumer sentiment Average workweek; overtime hours (mfg.) Accession rate; layoff rate (mfg.) New unemployment insurance claims Productivity (output per hour) Rate of capacity utilization (mfg. mtls.) III. Employment, Production, and Income Nonagricultural employment Average duration of Unemployment rate unemployment GNP; personal income Long-term unemployment Industrial production, total IV. Prices, Costs, and Profits Unit labor costs Labor share in national income Bond prices* Stock prices* Sensitive materials prices* Profit margins Total corporate profits; net cash flows Monetary growth rates* Change in liquid assets* Change in consumer credit* Total private borrowing* Real money supply V. Money, Credit, and Interest Velocity of money Short-term interest rates* Bond yields* Consumer credit outstanding* Commercial and industrial loans outstanding Note: Series marked * are in nominal terms (some have the same average timing properties when deflated). All other series are in real terms (constant dollars, physical units) or related indexes and ratio numbers. The selection is based on U.S. indicators published in Business Conditions Digest, a monthly report by the Bureau of Economic Analysis, U.S. Department of Commerce. The timing relations among corresponding series for other countries are in many respects similar (Moore 1983, ch. 6). Abbreviations: mfg. = manufacturing; mtls. = materials. 29 Recent Work on Business Cycles in Historical Perspective 1979-80 through increased costs and prices (leftward shifts in the aggregate supply schedule) and reduced real disposable income (hence, presumably also, some leftward shifts in the aggregate demand schedule). Such worldwide supply shocks, although clearly of major importance in the context of contemporary problems of productivity, growth, and development, are new and rare phenomena whose role in business cycles generally is modest but in danger of being overemphasized. 6 The more persistent effects come from changes on the demand side. Thus the volume, prices, and value of U.S. exports show fluctuations that correspond well to cycles in the dollar value of imports by the outside world (Mintz 1967). The demand changes are powerfully reinforced when the links among the major countries convert their independent cyclical tendencies into fluctuations that are roughly synchronized. These links result not only from international trade (current-account transactions in goods and services) but also from international lending and investment (capital-account transactions in assets). The latter factor became particularly important in recent times when asset markets became highly integrated worldwide. Interest rates (adjusted for the anticipated exchange-rate movements) are now linked across the open economies, and capital flows are extremely sensitive to the risk-adjusted differentials in expected rates of return. Partly because of the increased capital mobility, the shift from fixed to flexible exchange rates in the early 1970s provided much less insulation against foreign disturbances than was hoped for, and also much less autonomy for effective national macroeconomic policies. The price levels adjusted for exchange rates (i. e., the "real exchange rates") show large and persistent movements over time: the purchasing power parity does not hold over time spans relevant for the study of business cycles. The recent fluctuations in real economic activity show a very considerable degree of international convergence, which presumably reflects not only the exposure to common disturbances but also the increased interdependence among (openness of) nations (Whitman 1976; P. A. Klein 1976; Moore 1983, ch. 6). In the 1960s, when it appeared that business contractions in Europe and Japan were being replaced by mere retardations, there was a revival of interest in cycles defined in terms of deviations from long trends rather than levels of economic aggregates. For lack of a better term, the alternations of above-trend and below-trend growth phases came to be called growth cycles. These short fluctuations are defined by the consensus of detrended indicators just as business cycles are defined by the consensus of the same time series with no allowance for their long-term trends. The trends are estimated only to be eliminated from each series separately. Growth cycles in this sense are thus sharply dif6. James Hamilton (1983), writes about the role of changes in crude oil prices in the U.S. recessions after World War II. It should be noted that many recessions are preceded by upward cost pressures and supply restrictions associated with the boom-and-slowdown sequence of middle and late expansion stages. On the developments during 1973-76, see Zamowitz and Moore, 1977. 30 Chapter Two ferent from, and should not be confused with, any fluctuations in the longterm growth rates themselves. They also need to be clearly distinguished from business cycles. Most persistent and pervasive economic slowdowns begin with much reduced but still positive growth rates and then develop into actual declines-recessions. Thus the high-growth phase typically coincides with the business cycle recovery and middle-expansion, and the low-growth phase with late expansion and contraction. But some slowdowns stay in the range of positive growth rates and result in renewed expansion, not recession. Thus growth cycles are more numerous than business cycles and more symmetrical, being measured from rising trends. One can imagine a lengthy period of low, positive growth that would be associated with as much deterioration in business conditions and rise in unemployment as a short and moderate recession-and more. But it is also possible for a slowdown mainly to reduce inflationary excess demand created in the preceding boom, without causing much surplus capacity and real hardship. The policy implications of such a deceleration in economic growth are entirely different from those of a recession, which always depresses real incomes and spending, outputs, and employment. In actual experience, those decelerations in growth that have not led to absolute declines in aggregate economic activity (in recent U.S. history: 195152, 1962-64, and 1966-67) occupy an intermediate position between the two hypothetical cases considered above. Their adverse effects were felt primarily in areas of particular sensitivity, notably as declines in housing activity and stock prices. Unemployment would cease falling rather than rise substantially, and profits would weaken rather than tumble. Thus the overall impact of each of these slowdowns on economic activity was definitely less than even the mildest of recent recessions. Some economists focus on the nature and sources of expansions and contractions, that is, on the business cycles. Others, by abstracting from the longrun trend, actually address growth cycle phenomena while aiming at an analysis of business cycles; that is, they fail to differentiate between the two categories. The latter treatment, frequently implicit in the theoretical literature of recent years, may not be a good practice. General business contractions need to be distinguished from periods of low but positive growth. However, mild recessions and severe depressions are also quite different. Also, many important regularities described in the previous section are observed, to a large extent, in the context of growth cycles as well. Thus, when the series that tend to lead at business cycle turns are adjusted for their own long trends, the resulting detrended series are generally found to be leading at growth cycle turns. An analogous statement can be made for the roughly coincident and lagging indicators. Systematic differences among the series with respect to their conformity and amplitude characteristics are likewise largely retained after the necessary transformations. 31 2.3 2.3.1 Recent Work on Business Cycles in Historical Perspective Theories of Self-Sustaining Cycles Disparities and Common Elements in Some Early Theories The classics of business cycle literature made lasting contributions to the description and analysis of the motion of industrialized market economies. They addressed the cumulative processes of inflationary expansions and deflationary contractions induced by bank credit fluctuations constrained by the availability of reserves under the gold standard (Hawtrey 1913). The role of discrepancies between the market and the "natural" interest rates in this process was much explored following Knut Wicksell ([ 1898] 1936). At belowequilibrium market rates, excessive bank credit creation produces overinvestment in capital-goods industries and imposes "forced saving" on those whose incomes lag behind inflation (Hayek 1933). But banks will have to curtail the supply of credit, and individuals will tend to restore their old consumption standards. As the demand and resources shift back to consumer-goods industries, undersaving-real capital shortage and losses to the producers of capital goods-results, causing a decline in these industries which cannot be compensated elsewhere in the short run. A deflationary downturn cannot be avoided. Here the monetary changes are linked to real "vertical maladjustments": that is, imbalances between production of capital and consumer goods or between aggregates of investment plans and savings decisions (Tugan-Baranovskii [1894] 1913; Spiethoff [1925] 1953). Other writers worked out the importance of long gestation and life periods of capital goods and developed some cyclical aspects of the acceleration principle (Aftalion 1913; 1. M. Clark 1917,1934). Schumpeter (1939) saw economic growth itself as a cyclical process, reflecting technological progress and spurts of innovations-opening up and temporary exhaustion of opportunities for new, profitable investment. Related factors include the failure of foresight, intersectoral shifts, and changes in relative prices. Thus, under uncertainty, interdependent expectations of business people generate widespread errors of optimism in expansions and pessimism in contractions (Pigou 1927). Unpredictable shifts in demand or supply lead to "horizontal maladjustments"-say, overinvestment in a particular sector, which involves indivisible and durable fixed capital, high costs of adjustments, and temporary but cumulative depressant effects (Robertson [1915] 1948). Unit costs of labor and production tend to rise relative to output prices before and after the downturn, and they tend to fall before and after the upturn, reflecting changes in capacity utilization and productivity; as a result, business profits show large fluctuations, which help explain the cyclical movements in investment and output (Mitchell 1913, 1927). This capsule summary can merely illustrate the broad range of views held by these early students of business cycles. It is clear that there are important disagreements among their theories, particularly with respect to the relative 32 Chapter Two importance of monetary and real factors, long a major point of contention. But the dominant tone is one of awareness that what matters most is the interaction of changes in money and credit with changes in economic activity, particularly those connected with business investment. Most of the writers considered business cycles to be caused and conditioned by a number of factors and circumstances, and so their theories typically overlap and vary mainly in the emphasis accorded the different elements (Haberler [1937] 1964). Not surprisingly, there is much in these individual theories that is unsatisfactory, unduly restrictive, or out-of-date. Here we must abstract from the detail and note that it is the high degree of consensus and achievement that is much more remarkable from the present point of view. The first aspect of essential agreement is that the theories are mainly endogenous. That is, they purposely concentrate on internal dynamics of the system (interrelations and lagged reactions among its components). The authors generally held that contemporary industrial economies are, as a result of such dynamics, subject to recurrent fluctuations with major regularities that can be explained economically. They believed that "the cyclical movement has a strong tendency to persist, even where there are no outstanding extraneous influences at work which can plausibly be held responsible." Hence they viewed the role of the exogenous forces as secondary, even though acknowledging that the latter continually act "as the originators or disturbers of endogenous processes, with power to accelerate, retard, interrupt, or reverse the endogenous movement of the economic system." 7 Second, these economists all basically adhered to the standard economic theory of their times, which is what Keynes later labeled the "classical school"; indeed, the latter is well personified by some of them. At the same time, they generally appreciated the seriousness of the problem of economic instability. The business cycles of their principal concern were major fluctuations measured in years of cumulative expansions and contractions. The recurrent phases of widespread unemployment and underutilization of productive capacities did (and still do) present a deep puzzle to the classical doctrine, according to which the economy is always in, or at least tending closely to, the general equilibrium. Thus, for a long time, business cycles were simply ignored by most economic theorists or, at best, were viewed as merely temporary "frictional" interference with, and departure from, equilibrium. But students of the subject, including those who were themselves committed to the equilibrium theory, have done much to counteract this evasive and untenable position. 7. Both quotations are from Haberler (1937) 1964, p. 10. This characterization is strongly confirmed by numerous passages in works by Robertson (1915, in particular pt. II, ch. 4); Mitchell (1927, esp. chs. I and 5), Hayek (1933, esp. ch. 4), and Pigoll (1927, chs. 6-8,21). For Schumpeter, the basic mechanism of credit-financed innovations is of much greater intrinsic interest than the multitude of diverse "external factors," no matter how important the latter may be on any particular occasion (1935-1939, vol. I, chs. 1-4). 33 Recent Work on Business Cycles in Historical Perspective Third, in the historical periods addressed by these studies the level of prices tended to move up during the general business expansions and down during contractions. The positive correlation between cyclical movements in broad price indexes and real activity measures implied that fluctuations in total nominal expenditures parallel the fluctuations in the aggregates of real income, employment, and output. This was generally accepted as a central characteristic of business cycles by the early theories, in which the fluctuations in aggregate money flows of income and spending play a large, proximately "causal" role. Of course, for these fluctuations to produce cyclical movements in real variables, it is necessary that wages and prices adjust with some sufficient lags rather than being highly flexible. Sometimes this condition was assumed explicitly but it was not much discussed and often only implied (Haberler [1937] 1964, pp. 459-61).8 2.3.2 Uncertain Expectations, Unstable Investment, and Long Depression Cycles Keynes (1936, ch. 22, esp. pp. 314-15) attributed to the trade cycle a sudden, sharp downturn, a protracted decline, and a gradual, sluggish upturn. These are all characteristics of the 1929 peaks and the depressions and recoveries of the 1930s in Great Britain and the United States; also, in part, of the British experience in the depressed early 1920s. They are not typical of most cycles in these countries and elsewhere. The sharp downturn, or "crisis," is explained mainly by "a sudden collapse in the marginal efficiency of capital." During a boom, the supply of new capital goods and the cost of their production and financing rise, with growing adverse effects on the current returns on investment. The inducement to invest is further weakened if the current costs come to be viewed as higher than the probable future costs. Optimism about the always uncertain future returns lingers for some time, but sooner or later doubts arise about the reliability of the hopeful expectations engendered by the boom. Investment expectations are highly volatile because even those forecasts of long-term profitability of specific business projects which are viewed as most probable inspire little confidence. Observable frequencies of past outcomes are not generally a source of predictive knowledge in these matters. Keynes's world is thus one of pervasive uncertainty which is sharply distinguished from calculable and insurable risk (as in Knight 1921). It is easier and more rewarding to predict the short-term movements in the stock market, which are strongly affected by "mass psychology," than to divine the long-term prospects for individual business concerns. The market reacts promptly to news of fluctuating business profits with revaluations which 8. In terms of the present-day conventional macroeconomic model, let us add, the positive correlation of fluctuations in prices and real variables would indicate that shifts in aggregate demand dominate the shifts in aggregate supply over the business cycle. If this sounds rather alien to the early theories, it is because the latter are typically more disaggregate. 34 Chapter Two inevitably exert a decisive influence on the rate of current investment. A new business will not attract investors if a similar existing one can be acquired on the exchange at lower costs (Keynes 1936, p. 151). This last insight gave rise to an influential theory of James Tobin (1969), which makes investment in new plant and equipment an increasing function of q, the ratio of the value placed by the security markets on the existing firm to the replacement cost of its capital. This approach has several advantages: it is relatively simple, uses observable variables, and provides an analytically attractive linkage between investment and the expectations of the financial asset markets. Implicitly, it also relates the expected profit rate to the required rate of return on capital in the stock market and, hence, to the interest rate. However, the hypothesis has not fared well in empirical tests (Von Furstenberg 1977; P. K. Clark 1979; Blanchard and Wyplosz 1981; Abel and Blanchard 1983; R. J. Gordon and Veitch 1984). This is perhaps partly because of the use of average q instead of the theoretically more appropriate marginal q9 but more likely because of various simplifying restrictions used in this work: homogeneous capital and perfect financial markets with no liquidity constraints on firms. These idealizations are poorly suited for an analysis of cyclical movements in investment and they certainly clash with the Keynesian views on the instability of financial markets (sect. 2.4.6).10 Once aroused, the doubts about profitability of planned and current investment projects spread rapidly, bringing down in "disillusion" the stock market, which is revealed to have been overoptimistic and overbought. As the pendulum swings to overpessimism, the demand for broadly defined money will increase, raising the rate of interest and hence seriously aggravating the crisis. The revival of investment will require a "return of confidence . . . an aspect of the slump which bankers and businessmen have been right in emphasizing" (Keynes 1936, p. 317). But confidence, once severely shaken, takes time to mend. Also, the propensity to consume is adversely affected by the fall in the value of equities. Only as the downswing develops will it bring the level of interest rates down. This decline will not be as prompt and large as would be necessary to counter the "collapse" of investment. The demand for money is interest elastic, highly so at low levels of the rates, because of bearish speculation in the face of basic uncertainty as to future changes in the rate of interest. The con9. This is the ratio of the increase in the value of the firm from acquiring an additional unit of capital to the marginal cost of that unit (which, in contrast to the measured average q, is an ex ante and not directly observable quantity). 10. The same observations apply a fortiori to the "neoclassical" investment theory dating from Jorgenson 1963, which concentrates on the average long-term behavior as determined by the requirement that the expected returns over the life of a project exceed its costs. The short-run deterrent effect on investment of the rising flow supply price of capital goods (stressed in Keynes 1936, ch. 11) is not well captured in this approach, and the expectationallags are not distinguishable from the gestation periods or delivery lags (Abel 1980). For recent tests of this and other investment theories, see also Bischoff 1971; and Kopcke 1977. 35 Recent Work on Business Cycles in Historical Perspective clusion here is that a recovery from a severe slump is possible only after the capital stock of business has been reduced sufficiently to restore its profitability. This may take several years, through use, wear and tear, or obsolescence (Keynes 1936, p. 151). It might appear that overbuilding is the cause of the downturn and long slump but Keynes insists that it is not. Rather, the effective private demand fails to sustain full employment because investment is too unstable and the propensity to consume is stable but too low. It is only relative to the deficient demand that "overinvestment" can occur; there is no saturation of profitable investment opportunities at full employment. Keynes's concern was with long and severe depressions characterized by very large declines to low levels of both real investment and stock market values. Such major depressions have occurred at intervals of a few decades through the 1930s but most business contractions were much milder and shorter. Even in long contractions the stock of capital usually continues to increase, although at much reduced rates; also, an abrupt collapse of investment is rare. 1 1 Consumer spending is much less stable in the short run than Keynes assumed (but also much more stable and supportive of growth in the long run). As for the demand for money, there is a mass of evidence that its interest-elasticity tends to be relatively low (Laidler 1969). These observations raise serious questions about some elements of Keynes's theory. 2.3.3 Wage and Price Dynamics in Business Cycles Despite the great rise and persistence of unemployment, real wages increased throughout the 1930s, thereby failing to provide one classical cure for the apparent disequilibrium in the labor market. 12 Keynes (1936, chs. 19 and 21) did not argue that money wages are entirely rigid downward but rather that they adjust but sluggishly to excess supplies of labor. Such slow wage declines are apt to reduce incomes, consumption, and prices before they begin to improve profitability and stimulate investment. When the resulting gradual deflation becomes widely anticipated, people repeatedly postpone purchases, mainly of durable goods, while waiting for prices to fall further. The demand for money increases at the exp~nse of the demand for goods and equities. Moreover, unexpected deflation increases the burden of accu~ulated debt, which falls most heavily on businesses and individuals with high propensities to borrow, invest, and spend. The activities of these units are severely curtailed as their bank credit lines are cut. Business failures and personal bankruptcies rise in numbers and size. Irving Fisher (1932, 1933) ascribed the 11. These points were made early by Bums (in his collected essays, 1954, pp. 3-25, 207-35). On the dispersion of peaks in various categories of investment commitments and expenditures, see Zamowitz 1973, ch. 4. 12. In the United States, average hourly earnings in manufacturing divided either by the consumer price index or by the wholesale price index rose approximately 20% between 1929 and 1934, for example. Money wage rates declined less than prices. Hours of work fell along with the number of the employed workers (Temin 1976, pp. 138-41). 36 Chapter Two depth of the Depression to the confluence and mutual reinforcement of deflation and "overindebtedness" inherited from the boom. (This suggests overinvestment as the cause of the downturn.) His policy prescription was monetary reflation, a reversal of the price decline. A one-time large drop in the general wage level is a theoretical but hardly a practical alternative in a large decentralized economy with numerous, strongly differentiated labor markets and a complicated structure of relative wages. A spreading depression in an open system is more likely to result in competitive devaluations and various protectionist "beggar my neighbor" measures, with deeply damaging overall consequences. The actual and expected changes in the rates of change in wages and prices can certainly be of great importance in business cycle dynamics. The effects on aggregate demand of changes in the levels of wages and prices, on the other hand, are believed to have their main roles in comparative statics and the long run. 13 The static and dynamic elements were never clearly distinguished by Keynes and his immediate critics; the debate proceeded for a long time in the framework of comparative statics, which obscured the essentially dynamic disequilibrium nature of Keynes's theory (Leijonhufvud 1968). After World War II inflation became, for the first time, a chronic condition in peacetime, drawing attention away from the concurrent, relatively mild recessions and at the same time making their understanding apparently much more difficult. The old problem of depression-cum-deflation was replaced by the new problem of unemployment-cum-inflation. The famous Phillips curve emerged first as a nonlinear and inverse dependence of the rate of change in nominal wages (w) on the rate of unemployment (U) and was rationalized by relating U to the excess supply of labor (Phillips 1958; Lipsey 1960). Soon the rate of inflation (p) was similarly related to U, on the ground that p and w normally differ by a steady rate of growth in labor productivity (Samuelson and Solow 1960). 14 The classical view of an aggregated labor market posits the existence at any time of a unique equilibrium, or "natural," unemployment rate (UN) as a function of real wages (M. Friedman 1968). An inflation that has lasted for some significant time will be expected to persist at some positive average rate (pe). Changes in the price level that are generally and correctly anticipated are 13. The reference here is, first, to the "Keynes effect" (at lower prices, a given quantity of money represents a larger real quantity) and the "Pigou effect" (at lower prices, a given quantity of net nominal private wealth represents a larger real quantity). The former would raise investment through lower interest rates; the latter would raise consumption. To stimulate the economy in the short run both require downward flexibility of prices generally. The Keynes effect depends inversely on the interest-elasticity of the demand for money. The Pigou effect depends positively on the magnitude of net private wealth, which is probably small in relative terms. Deflationaryexpectations and distributional shifts may also greatly weaken this process (Pigou 1947; Patinkin 1948). 14. It should be noted that from the cyclical perspective it is far from innocuous to substitute price for wage inflation. As will be shown in section 2.3.6, labor productivity and the related price and cost variables undergo partly systematic changes over the cycle. 37 Recent Work on Business Cycles in Historical Perspective matched by wage changes and hence cannot cause deviations of U from UN. Only unanticipated inflation, that is, forecast errors (pe - p), can cause such deviations. Equilibrium requires that pe = p, hence a stable long-run tradeoff between p and U cannot exist (the natural-rate hypothesis-NRH: Friedman 1966, 1968; Phelps 1967). A short-run Phillips curve, associated with unanticipated or disequilibrium inflation, stays in place only as long as pe remains unchanged. 15 The initial reaction of most economists to the Friedman-Phelps critique was to embrace the NRH without questioning the existence of an inverse relationship between inflation and unemployment in the short run. This was because they assumed expectations to be "adaptive ," that is, backward looking and involving only partial and lagging corrections of past errors. 16 Indeed, it was frequently assumed that the errors of inflation forecasts are fully eliminated only on the average over the business cycle. On this permissive interpretation of a "long run," the NRH is entirely consistent with continuing parallel fluctuations in inflation and real economic activity around their (uncorrelated) long-trend movements. The expectations-augmented but only slowly shifting Phillips curve appears in Tobin's 1975 analysis of Keynesian models of cyclical contractions, with the qualification that this does not imply a full acceptance of the NRH. In this dynamic model, output (Q) moves in reaction to changes in aggregate real demand (E). In the short run the two variables can differ: say, E < Q when Q is rising because of lags in consumption and unintended inventory changes. E depends positively on Q and the expected price change pe and negatively on the price level P. Actual inflation p (= rate of change in P) adjusts to changes in pe and in Q relative to QN (the full-employment output). Finally pe reacts to the divergencies of p from pe. The equilibrium conditions are E = Q, Q = QN, and p = pe. The main inference from the model is that "a strong negative price-level effect on aggregate demand, a weak price-expectations effect, and a slow response of price expectations to experience are conducive to stability" (Tobin 1975, pp. 199-200). Large adverse shocks to E can push the economy into a depression, and market price adjustments will provide no reasonably prompt and effective remedy under conditions where the price-change effects on E are stronger than the price-level effects. 17 2.3.4 Disequilibrium Models with Capital Accumulation Keynes's analysis is only implicitly and partially dynamic. Since net investment varies, so does total capital, which influences output, investment, 15. The general form for the original equation is w, = I(U,); for the "expectations-augmented" equation satisfying the NRH it is w, = I(U,) + p~. 16. A simple model of this type if P~ - P~_I = k(p,_J - P~_I)' where O
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Table 2.1
Average Duration of Business Cycles in the United States, 1854-1982
Average Measures of Phase and Cycle Durations
Number of business cycles covered
(years, T to T)

1 Technical recession perio...

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