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2. Business Cycle Theory

2.1. Introduction

It has frequently been observed that interest in business or trade cycle theory is itself cyclical (e.g. Zarnowitz 1985, p.524). In periods of sustained prosperity interest wanes, as it did in the 1960s and early 1970s when research into macroeconomic dynamics concentrated on growth theory. At the end of the 1960s the continued existence of business cycles was questioned (see section 1.5). The experiences of the 1970s and early 1980s, especially following the 1973 and 1979 oil price shocks, brought a resurgence of interest in business cycles. In this introductory section, the main themes in business cycle research in the 1980s will be reviewed. In section 2.2, the equilibrium approach to business cycle modelling, which has been dominant in the 1980s, will be discussed in more detail. In section 2.3, recent contributions by economists who do not accept that the business cycle can be adequately modelled using the linear Frisch-Slutsky approach, and that nonlinearities must be introduced, will be surveyed in order to update the survey of nonlinear business cycle models in Mullineux (1984, section 2.5). This chapter does not seek to provide a comprehensive survey of the vast literature on business cycles. Zarnowitz (1985) has recently made a Herculean attempt at this.

Mullineux (1984, Ch. 3) traces the renewed interest in business cycle theory to the contributions of Nordhaus and Lucas in the mid-1970s. Nordhaus (1975) revived interest in the idea of a political business cycle (PBC) and Lucas (1975) utilised rational expectations to revitalise interest in the equilibrium business cycle (EBC). Nordhaus's contribution differed from previous PBC literature1 in stressing the influence of the electoral period on the cycle in economic activity and drew on the ideas being developed by 'modern political economists' (e.g. Tullock 1976 and Frey 1978), who argue that governments manipulate the economy to maximise votes.2 Lucas viewed Hayek (1933) as an antecedent of his work. Lucas's EBC model marked a major change from the Keynesian approach to business cycle modelling, which regarded the cycle as an essentially disequilibrium phenomenon. 'Rigidities' or 'frictions' in the economy, such as sticky nominal wages and prices, were the proximate cause of disequilibrium.

Lucas, and other members of the 'New Classical School', aimed to derive the dynamic behaviour of the macroeconomy from the basic microeconomic principles of rational, maximising firms and individuals and in so doing made use of advances in microeconomic theory relating to intertemporal labour supply. In the latter connection, Lucas (1972) had developed the 'Lucas Supply Hypothesis' (LSH) which showed that, under rational expectations with restricted information, deriving from the 'islands market hypothesis' (Phelps 1972), a 'signal extraction problem' arises and labour and firms will tend to respond to a rise in price by increasing supply, even if they are uncertain if the price rise is a relative or an absolute one, in order not to miss out on profit maximising opportunities - see Lucas 1977 for an informal discussion. The LSH formed the basis of the Lucas (1975) EBC model.

One might have expected the 'New Classical School' to view the economy as essentially stable but to display erratic movements by virtue of being hit by a series of random shocks, as postulated by the Monte Carlo hypothesis (see section 1.2). Instead Lucas (1975) utilised a modified version of the acceleration principle, much favored in Keynesian cycle models, to explain the persistence of the effects of the shocks and the findings of the NBER - which he then distilled into a number of 'stylised facts' discussed in Lucas (1977).

(1975) model remained in the Frisch-Slutsky tradition that had dominated Keynesian econometric model building. The cycle was not endogenous. It was instead driven by external random shocks. In the Lucasian EBC and related models,4 these were a combination of real shocks, entering via random error terms, and nominal shocks, caused by unanticipated changes in the growth of money supply. (For further discussion, see Mullineux 1984, section 3.2.) These shocks were transformed or 'propagated' by the Lucasian EBC models to generate a cyclical output, the cycle being assumed to occur around a log linear trend. In the absence of the modified accelerator, the Lucas (1975) model would have generated a Monte Carlo cycle. Barro (1981, Ch. 2) considers alternative sources of the persistent effects of shocks which introduce the rigidity necessary to lock economic agents into incorrect decisions.

As a result of the major recession, or depression, experienced in many Western economies in the early 1980s, interest in business cycles was sustained and the EBC approach remained dominant. The practical applicability of the modern PBC and Lucasian EBC models was, however, increasingly questioned. Despite the fact that journalistic economic commentary continues to imply that government economic policy-making is heavily influenced by the stage of the electoral period, mainstream academic interest in the PBC has not been sustained in the 1980s. This is perhaps surprising in light of the widespread belief that the large US budget deficit was a major cause of the worldwide stock market crashes in October 1987 and that no significant action on the deficit was likely prior to the November 1988 US Presidential election. There were also suggestions that the US Federal Open Market Committee (FOMC) had been unwilling to raise interest rates in the run-up to the election, despite a buildup of inflationary pressures. In the United Kingdom, there has been widespread acknowledgement of the contribution of Chancellor Nigel Lawson's tax cutting budget to the 1987 Conservative Party election victory. Not only has the modern PBC approach been largely dismissed, but so too has the Lucasian EBC model. It received little attention at the NBER conference reported in Gordon (1986) and was rejected in Gordon's overview of the conference (Gordon (ed.) 1986, p.9).

Mullineux (1984, Ch. 5) concluded that, although apparently contradictory, the modern PBC and Lucasian EBC models could be usefully developed and merged using game theory. The major weakness of the PBC theory was the incredible naivety of the electorate, who were assumed to allow themselves to be repeatedly conned by the government in a way that seemed to be inconsistent with rationality. A weakness of the EBC was the assumption that the government was completely benign and would never be tempted to manipulate the economy in its own interests. Backus and Driffill (1985a, b) have shown that, under rational expectations, the PBC can indeed be rationalized using game theory. Building on the work of Barro and Gordon (1983a, b), they show that a government can exploit the time inconsistency identified by Kydland and Prescott (1977). By building up credibility for its anti-inflationary policies, or an anti-inflationary reputation, the government can create an opportunity to manipulate the economy to improve its chances of winning the next election. The electorate, which Backus and Driffill assume to be atomistic, has effectively only one strategic choice in this game. That is to form expectations of inflation on the basis of the rational expectations hypothesis (REH). It turns out that they can indeed be duped as long as the government's anti-inflationary reputation or credibility is not dissipated.

This point is apparently illustrated by recent UK experience. Prior to the 1983 election, UK Chancellor Geoffrey Howe can be regarded as being in the process of building an anti-inflationary reputation. He declined to engineer a pre-election boom in 1983, paving the way for the subsequent Chancellor, Nigel Lawson, to boost the economy by relaxing monetary policy and cutting taxes. This is widely acknowledged to have contributed to the electoral success of the Thatcher government in the summer of 1987. By the summer of 1988, however, it appeared that anti-inflationary credibility was evaporating rapidly. Broad money targets had been abandoned in the 1987 tax cutting budget and it appeared that a policy of shadowing the EMS had been adopted instead. Uncertainty over the status of the exchange rate policy was increased significantly by a public disagreement between the Chancellor and the Prime Minister prior to the 1988 tax cutting budget. As a result the Chancellor was forced to encourage a rise in bank base rates from 7 per cent in March to 12 per cent in August.

Further progress along the lines of Backus and Driffill could perhaps be made if the assumption of an atomistic electorate were to be dropped, the existence of trade unions recognised and wage demands regarded as a strategic variable. The economic game would then become richer and the two-player framework would need to be extended to allow for additional players.

In the 1980s there has been renewed interest in the analysis of economic decision-making under uncertainty, especially by 'New Keynesians'. Zarnowitz's survey article on business cycles (1985, section 5), draws attention to the fact that in models utilizing the REH, economic behaviour is guided by subjective probabilities which agree, on average, with the true frequencies of the events in question. The REH therefore deals with risk, rather than uncertainty, in the sense of Knight (1921) and Keynes (1936). In particular there is no uncertainty as to what the objective probabilities are. Lucas (1977, p. 15) goes so far as to argue that in cases of uncertainty, economic reasoning will be of no value. Shackle (1938) argued long ago that the view that we cannot theories rationally about conduct that is not completely rational has inhibited the development of economic thought and caused a preference for the Walrasian equilibrium framework. It may also have generated widespread acceptance of the REH but as a result of this renewed interest in the implications of uncertainty, the applicability of the REH is being increasingly questioned.

Meltzer (1982) distinguishes formally between uncertainty, which is associated with variations in nonstationary means resulting from permanent changes in economic variables, and risk, which is associated with transitory, random deviations from stable trends. He argues that uncertainty should form an essential part of an explanation of the persistence of business cycle contractions by allowing permanent changes to occur without being identified immediately. Stochastic shocks, he argues, have permanent and transitory components which cannot be reliably separated and new information cannot completely remove the confusion. The rational response to such shocks may well be adaptive, taking the form of gradual adjustments of prior beliefs about the permanent values of endogenous variables.

If uncertainty prevails, then economic agents cannot behave atomistically - as they are implicitly, in models employing the REH, and explicitly, by Backus and Driffill (1985a, b), assumed to do. Under uncertainty, instead of forming expectations independently, agents must take account of the weight of opinion guiding the activities of other agents in the manner of the Keynes (1936, p. 156) 'beauty contest' example. Such complications are ignored under the REH and by the New Classical models that employ it.

Gordon (ed.) (1986, p.9) identifies two further problems with the New Classical EBC models. The first is their inability to explain how an information barrier of a month or two could generate the output persistence observed in the typical four-year US business cycle and in the twelve-year Great Depression. This is perhaps a bit harsh considering that Lucas (1975) generated persistence using a modified accelerator and the information lag merely gave time for decisions about investment to be made based on misperceptions. Further, the incompleteness of information upon which the investment decisions are made can be alternatively rationalised as being the result of costs of processing information rather than a lag in its availability - a view that Lucas (1987) seems to hold. The second problem is the internal inconsistency of stale information itself. If it is solely responsible for the phenomenon of business cycles, Gordon argues, then one would have expected an 'information market' to develop to diffuse the 'signal extraction problem'. This would also go some way towards removing the alternative rationalisation of the information deficiency, based on the cost of processing information, if the market could provide processed information at a sufficiently low price. Lucas would presumably counter, in line with the arguments in Lucas (1987), that because of the excessive volume of information to be processed this would not be the case. Alternatively, it can be argued that the information market cannot provide full information if the world is one in which uncertainty plays an important role, but it can, and probably already does, provide a picture of how other agents view the economy.

As well as attempting to model economic decision-making under uncertainty, the New Keynesian School, rather than accept the New Classical approach of deriving macroeconomic theory from traditional microeconomic foundations, is attempting to derive rationalisations for the key Keynesian rigidities from alternative micro foundations. Greenwald and Stiglitz (1987) review some of the contributions to the

New Keynesian literature, such as efficiency wage models, which attempt to explain wage rigidities, and analyses of equity and credit rationing and the implications of the latter for the role of monetary policy. The analysis relies heavily on imperfect information and asymmetries of information and, as such, is related to the work of Lucas, referred to above, and Friedman (1968), who used information asymmetries between workers and firms to explain how a rise in the money supply could have real effects in the short term.

Greenwald and Stiglitz (1987) claim that New Keynesian economics provides a general theory of the economy, derived from microeconomic principles, that can explain the existence of an equilibrium level of unemployment, based on efficiency wage theories, and business cycles. The latter result from the effect of shocks on the stock of working capital held by firms. They note that even in the absence of credit rationing, firms' willingness to borrow would be limited by their willingness to bear risk. Given risk aversion, the fixed commitments associated with loan contracts implies that as the working capital which is available declines, the risk of bankruptcy probability, associated with borrowing, increases. Thus a reduction in working capital will lead to a reduction in firms' desired production levels and it takes time to restore working capital to normal levels. The effects of aggregate shocks will, therefore, persist. They also argue that sectoral shocks (e.g. oil price shocks) will have redistributional effects via their influences on the stocks of working capital of firms in various sectors and, because it takes time to restore working capital to desired levels, there will be aggregate effects.

It is clear that the New Keynesian school also tends to adopt the linear Frisch-Slutsky approach and there are certain similarities with Lucasian EBC models in that incomplete information is stressed and shocks have persistent effects because of their influence on capital investment decisions. The New Keynesians do, however, stress that markets are not perfect and that markets do not clear continuously, as assumed by New Classical economists. They accept that the decisions of economic agents are based on future expectations and influenced by past decisions but reject the view that individuals have perfect foresight or rational expectations concerning the future. Instead, they postulate that events which economic agents confront appear to be unique and that there is no way that they can form a statistical model predicting the probability distribution of outcomes, as assumed in Lucasian EBC models. Decisions are made under uncertainty rather than risk.

Despite these criticisms, the EBC approach itself has not been abandoned. In its place real EBC (RBC) models have proliferated. These usually retain the REH but reject the information deficiencies inherent in the Lucasian EBC models. The RBC models retain the Frisch-Slutsky approach but postulate that real, as opposed to unanticipated monetary, shocks are the major source of impulses. The contributions of Kydland and Prescott (1982) and Long and Plosser (1983) have proved very influential. Kydland and Prescott relied on 'time to build' to form the basis of a propagation model which converts technology shocks into a cyclical output. These models will be discussed further in section 2.2. The coexistence of Lucasian EBC and RBC models in the early 1980s revived an old debate about whether the cycle is primarily real or monetary in origin. At present the theoretical literature appears to be dominated by the view that it is real. Some of the empirical studies reported in Gordon (ed.) (1986) attempted to identify the major sources of shocks and more work clearly needs to be done in this area. The issue runs deeper, however, because it is also important to decide on the roles real and monetary factors play in the models that propagate these shocks. Acknowledgement of this is evident in the synthetic EBC models suggested by Lucas (1987) and Eichenbaum and Singleton (1986), who attempt to introduce money into RBC models; this issue will be discussed further in section 2.2.

While conforming to the linear Frisch-Slutsky modelling strategy, the RBC approach does attempt to integrate growth and cycle theory by analysing stochastic versions of the neoclassical growth model. It does not attempt to derive a truly endogenous theory of the cycle. The majority of RBC models stress technological shocks and are therefore related to the work of Schumpeter (1935, 1939), which is discussed in section 4.2 and Shackle (1938), which is discussed in section 4.4. Schumpeter and Shackle, however, argued that innovations occurred in 'swarms' when favourable economic conditions prevailed, rather than as a random series of exogenous shocks.

The role of innovations and their dissemination has not, however, been completely neglected in the cycle literature. The experiences of the 1970s and 1980s have stimulated a revival of interest in long cycles or waves,7 with the deceleration of growth following the 1950s and 1960s being interpreted as a downswing in the long wave (e.g. Mandel 1980). An alternative, and perhaps dominant, view is that the deceleration marked a response to major historical episodes in the form of oil price shocks.8 The long cycle literature includes contributions which emphasise the impact of major innovations and the dissemination of technological innovations (e.g. Metcalfe 1984). No attempt will be made to review the literature in this chapter, but if innovations contribute to the business cycle, as well as the long cycle, then it will be important to pay attention to their dissemination. To do this, sectoral models that allow for input-output interactions, such as those developed by Goodwin and Punzo (1987) (see section 4.5), will be required and the tendency towards reduced form vector autoregressive (VAR) modelling will have to be reversed in favour of a more structural approach.

The relative roles of induced and autonomous investment remain unresolved but explanation of the dynamic economic development process will require a judicious mix of these elements with various 'multipliers'. Hicks (1950) used a trend in autonomous investment to bring about a gradual rise in the floor, while Kaldor (1954) and Goodwin (1955) groped for a richer mix to explain both the business cycle and growth. The division between growth and cycle theory had followed the decision by Harrod (1936) to concentrate on growth, leaving the cycle to be explained by multiplier-accelerator interaction. Goodwin and Kaldor, however, felt that the role of innovations in stimulating cyclical growth, as stressed by Schumpeter, had been overlooked and that undue stress had been placed on induced investment via the acceleration process and autonomous investment - which was regarded as a separable trend resulting from replacement investment and a steady stream of innovations. In particular, the Schumpeterian bunching of innovations had been ignored. They expressed the view that an integrated theory of dynamic economic development was required. As a consequence, it is incorrect to decompose economic time series into a linear trend and business cycles components because they are part of the same process and the statistical trend has no economic meaning. Nevertheless, Goodwin (1955) combined a nonlinear accelerator with a trend in autonomous investment, while Hansen (1951) made autonomous investment depend on a steady stream of innovations. Attempts to develop a theory of dynamic economic development will be discussed further in Chapter 4. In the next section the equilibrium approach, which adopts the linear Frisch Slutsky approach and which was dominant in the 1980s, will be discussed and in the final section of this chapter recent developments in nonlinear business cycle modelling will be reviewed.

Before discussing the equilibrium theories of the business cycle, another influential contribution to the literature should be mentioned. Azariadis (1981) considers the possibility that, under uncertainty, business cycles are set in motion by factors, however subjective, that agents happen to believe to be relevant to economic activity. Such factors could include Keynes's "animal spirits', consumer sentiment, pronouncements of Wall Street gurus, the growth of certain monetary aggregates, or even sunspots if a sufficient number of people naively believe they influence economic activity, as Jevons (1884, Ch. 7) asserted they did. 'Sunspot theories' demonstrate that extraneous or extrinsic uncertainty is consistent and commonly associated with rational expectations equilibria in an aggregate overlapping generations model with no price rigidities and continuous market clearing. Azariadis finds that even well-behaved economies typically allow rational expectations equilibria in which expectations themselves spark cyclical fluctuations. This is because if individuals naively believe in indicators of future prices, such as sunspots or perhaps certain monetary aggregates, they take actions that tend to confirm their beliefs. These self-fulfilling prophecies are a source of indeterminacy which augment the multiplicity of equilibria that typically emerge in generalised monetary models with perfect foresight. A significant proportion of the equilibria may result from self-fulfilling prophecies and resemble perpetual cycles. It is also possible that equilibria resembling permanent 'recessions' or permanent 'booms' will result. Azariadis shows that such 'perpetual' and 'permanent' states may unravel if the uncertainty is reduced by introducing contracts, or as a result of the development of financial markets for claims contingent on predictions, which permit hedging.

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