Macro - Lecture 1

Macroeconomics and Economic Business Cycles
Introduction
Ester Faia
Goethe University Frankfurt
Fundamentals of Macro, WS 2021/22
Ester Faia (Goethe University Frankfurt) Macroeconomics and Economic Business Cycles
Fundamentals of Macro, WS 2021/22 1/
Over-view of the Course
Modern as well as more traditional macro theories

Real business cycle:
1 Definition of business cycle.
2 Measurement of business cycle in the data.
3 Real business cycle model: dynamic, optimizing agents, stochastic.
Traditional macro theories:
1 IS-LM closed and open economy (assumption of non-neutral policy).
2 Role of monetary and fiscal policy
Over-view of the Course: Part II
Theories of labour market frictions

1 Search and matching.
2 Efficiency wages.
3 Unions.
Theories of product market frictions: monopoly power and sticky
prices
Optimal monetary policy
References
Main book: Romer, Advanced Macroeconomics (any most recent

edition)
Refreshing macro concepts with simple treatment: Sørensen and
Whitta-Jacobsen, Introducing Advanced Macroeconomics
Advanced readings: specific articles given on lecture by lecture basis
Lecture ”slides” available on internet
Problem sets available on TA web-page one week before the
Mentorium, solved during the Mentorium
Importance of business cycle
Long run growth theory (Solow, Ramsey) assess the determinants of

long run growth (the trend)
Short run fluctuations (quarterly or yearly basis): business cycle
Important for forecasting
Important for policy analysis (monetary decisions taken every month,
fiscal decisions taken on a yearly basis)
Assess determinants of things like unemployment, inflation, financial
markets (or other high frequency macro variables)
Definition
”Cycle” in the scientific sense: ”recurrence of different phases of plus

and minus departures, which are often susceptible of exact
measurement”
Business Cycles in Macroeconomics: recurrence of different phases of
positive and negative deviations about trend in gross national product
Why not only the trend (growth theory), but also the deviations from
the trend are interesting?
1 Primarily since short run policy are based on business cycle.
2 Also forecasting: business and financial markets need professional
forecaster
In U.S. the National Bureau of Economic Research (NBER) is final
arbiter of the dates of the peaks and troughs of the business cycle
Expansion: period from a trough to a peak. Consumption and
investment spending raises, unemployment drops
Peak: Economy is close to full-capacity (except for frictions)
Recession: period from a peak to a trough. Spending falls,
unemployment raises, pessimism increases
Through: factories operate below capacity, it is difficult to find jobs
NBER identifies a recession as “a significant decline in economic
activity spread across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment, industrial
production.”
Common definition of recession: two consecutive quarters of GDP
decline in real GDP
If after recession the economy does not expand there is depression
Historical business cycle theories
Business cycle studies until 1950: attempt to define/measure

deterministic business cycles.
Example: Mitchell (1913) four phases. A business cycle is a sequence
of four phases: ’prosperity, crisis, depression and revival’.
These phases are linked by a causal relation: ”prosperity produces
conditions which lead to crises, crises run into depressions and
depressions after a time produce conditions which lead to new revival.
Problem: economies with empirically reasonable preferences and
technologies do not generate deterministic business cycles
Conclusion: random shocks necessary to generate cyclical economic
fluctuations
In reality business cycles are quantitatively important, but they do not
exhibit any simple regular or cyclical pattern. They vary considerably
in size and spacing
Business cycle theories
Slutzky’s (1937) random shock: cycles resembling business

cycle fluctuations can be generated by a sum of random shocks.
Example:
yt = 0.95yt −1 + et

0.5 with 50% probability
et = ∀t
−0.5 with 50% probability
If you plot yt you realize that it has a cyclical pattern, even though:
E (et ) = 0 and E (yt +1 ) = 0.95yt
We will see later how a persistent technological shock is an important
ingredient of modern real business cycle theory
In general, the effort of economists is now concentrated in the nature
of such shocks and the propagation mechanisms
Modern business cycle theories
Lucas’ (1977) deviations: Lucas defines business cycle as the

movements about trend in gross national product.
What is of primary interest is not that cycles are deterministic, nor
that they are characterized by certain phases that generate each other
But rather that we observe business cycle regularities in the
co-movements of the deviations from trend in different aggregate
time series (employment, investment, consumption)
Examples: consumption is less volatile than investment or durables,
wages tend to be pro-cyclical
Fundamentals of Macro, WS 2021/22 10
Modern business cycle theories
Real business cycles theories aim at explaining these co-movements:

Models derived by the standard Solow growth model
Optimizing representative agent
Markets perfectly competitive and complete
Productivity shocks as fundamental driving force of business cycle
fluctuations
Keynesian influence: focus on preference and government spending
shocks
How to measure business cycles
Define the trend

Take percentage (log) deviations from the trend
Generate time series of percentage deviations
Do the same in the data and the model and compare dynamic of
times series
Assess similarities: if discrepancies arise change model
How do we define the trend?
This is a key question. The business cycle we observe depends on how
we define the trend
Most commonly used nonlinear trend is the Hodrick-Prescott filter:
A time series xt with t = 1, 2, ...T , is decomposed in a trend x̄t and a
deviation from trend x̃t :
xt − x̄t = x̃t
x̄t with t = 1, 2, ...T minimizes the following formula:

T T −1
min
x̄1 ,...,x̄T
∑ (xt − x̄t )2 + λ ∑ [(x̄t +1 − x̄t ) − (x̄t − x̄t −1 )]2
t =1 t =2
If λ = 0 then xt = x̄t . The trend is so non-linear that is identical to the

series. The deviation x̃t = 0
As λ increases, changes in the trend are more ”costly”. The trend
becomes a smooth line
If λ = ∞, the trend is a straight line
Some business cycle regularities?
We already saw two regularities:

Employment is highly procyclical
Inventory investment is very volatile (and procyclical)
Both private consumption and private fixed investment are procyclical
Durable goods are more volatile than nondurable and services.
Business cycles: a summary
Business cycle: movements about trend in gross national product

Random shocks are essential
We aim at explaining the business cycle regularities in the
co-movements of the deviations from trend in the aggregate time
series:
1. Real Facts (concerning production and consumption)
Employment and hours worked are very procyclical
Consumption of non-durables and services are procyclical and not
very volatile
Consumption of durables and fixed investment are procyclical and
very volatile
Productivity is slightly procyclical but not very volatile
Wages are procyclical but even less volatile than productivity
Business cycles: a summary
2. Nominal Facts (concerning monetary aggregates)

Monetary aggregates are procyclical, but with a phase shift: some
evidence that in the ‘80 M2 leads the cycle
Note (causality):
If corr (xt , yt ) > 0, where y is the business cycle, then x is procyclical
If corr (xt , yt ) > 0, but corr (xt −1 , yt ) > corr (xt , yt ), then x leads the
cycle
If corr (xt , yt ) > 0, but corr (xt +1 , yt ) > corr (xt , yt ), then x lags the
cycle
Positive correlation between output and inflation, but with a
pronounced phase shift: inflation lags the cycle
Positive correlation between output and interest rate
Regarding these nominal fact the leads/lags are very important to
understand the causal linkages between nominal shocks and real
economic activity.

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Macroeconomics and Economic Business Cycles

Goethe University Frankfurt

Fundamentals of Macro, WS 2021/22

Modern as well as more traditional macro theories

Theories of labour market frictions

Main book: Romer, Advanced Macroeconomics (any most recent

Long run growth theory (Solow, Ramsey) assess the determinants of

”Cycle” in the scientific sense: ”recurrence of different phases of plus

Business cycle studies until 1950: attempt to define/measure

Slutzky’s (1937) random shock: cycles resembling business

Lucas’ (1977) deviations: Lucas defines business cycle as the

Real business cycles theories aim at explaining these co-movements:

Define the trend

x̄t with t = 1, 2, ...T minimizes the following formula:

If λ = 0 then xt = x̄t . The trend is so non-linear that is identical to the

We already saw two regularities:

Business cycle: movements about trend in gross national product

2. Nominal Facts (concerning monetary aggregates)

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