Business Cycles

We are now ready to take a look at what happens to the island during both permanent and temporary shifts in production (which is the GDP for the island) and look at the behavior of variables like investment, labor, consumption, and interest rates. We will be able to compare the prediction of the model with the data: more precisely, we will compare the cyclicality of various variables in the model to that in the data. (Cyclicality)

Let's first take a look at what happens when there is a temporary change in the production possibilities. Because the weather was nice (ie. new, lower branches grew for the oranges), it is a lot easier to initially produce goods, but marginal productivity of both labor and capital is unaffected. Hence there is no substitution effect. What happens? Because of increases in production, the quantity of goods sold increases and prices drop. The increased wealth in this economy incites people to consume more and work less, hence demand for goods increases and labor hours (supply) decreases. On the labor market, since there is no change in productivity, labor demand is unchanged, thus real wages will increase to reconcile demand and supply of labor.

On the goods market, since the change is temporary, the change in demand is relatively small compared to the change in supply. People want to save part of the wealth for future periods. Hence the interest rate decreases, thus increasing a bit the incentives to consume.

Let's assume the shock is now permanent: technology on the island has improved, and will stay at a higher level. There is both a change in levels of production and in the marginal productivity of labor. However (and unrealistically), let's keep the marginal productivity of capital constant for a while. Since the shock is permanent, there is no incentives to increase saving in this economy, so in this case the interest rate is going to remain the same. Output and consumption will increase by similar amounts. As in the temporary case, labor supply decreases but labor demand increases, increasing the real wage and increasing labor slightly.

By introducing a change in the marginal productivity of capital, which is more realistic, we can reintroduce an increase in investment. This of course increases demand on capital, increasing interest rates slightly (interest rates are slightly procyclical as well). Since machines are more productive, they yield higher returns, thus giving incentives to invest more. This, of course increases demand on capital, increasing interest rates slightly (interest rates are slightly procyclical as well). In the discussion about volatility, we saw that investment is a lot more volatile than consumption. Changes in output are absorbed by changes in capital investment, due to a mix of temporary and permanent shocks. Many the temporary shocks have some persistence: they affect not only the current period, but also future ones, although by a different magnitudes. These persistent shocks support the fact that changes in output are absorbed by capital investment changes.