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INTEREST RATES & THE BUSINESS CYCLE.   Term Paper ID:28823 Click to get this paper

Essay Subject: Defines business cycle & theories & empirical relationships between interest rates & the cycle. 6 Diagrams.... More...

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Paper Abstract: Defines business cycle & theories & empirical relationships between interest rates & the cycle. 6 Diagrams. Paper Introduction: Interest Rates and the Business Cycle Introduction What economists term the business cycle has been the subject of much study since its emergence during the industrial revolution. The roller coaster behavior of growth in the economy has eluded full explanation and led to the development of a variety of schools of thought on the issue. While traditional economists focussed on money as the key cause of cyclical activity, more recent analysis has turned to technological shocks as the driving force behind the business cycle (Christiano and Fitzgerald, 1998). Despite the tendency of these most recent studies (referred to as real business cycle theory) to discount the causal relationship between interest rates and the Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. The Region. Large scale changes inproduction technology, then, lead to above average growth. Labor is laid off and demand falls further. This correlation is quite strong as to short term interest rates.(Sill, 1996). Thenature of this relationship is difficult to determine. Interest Rates and the Business CycleIntroduction What economists term the business cycle has been the subject of muchstudy since its emergence during the industrial revolution. vol. vol.4. Interest rates, or the price of money, will therefore fall as well. For now, it issufficient to point out that those theories tending to see money as thecentral cause of economic fluctuations explain the decline in volatility interms of the success of counter cyclical measures taken by the centralbanking system, while those theories based on technological changes inmodes of production argue that the continued existence of the businesscycle despite monetary policies aimed at eliminating it is evidence thatchanges in the money supply are not the cause of cyclical movement in theeconomy. In the long run it is known that movement through the business cyclehas little correlation to movements in interest rates. This is the peak of the traditionalnotion of the business cycle. In other words, as output falls so do short term interestrates. This drop in price would subsequently lead to anincrease in demand, pushing production even higher. Real Business Cycles: ALegacy of Countercyclical Policies. One problem with these early models may be that they treated financialmovements as largely irrelevant, holding that it takes a technologicalshock to the economy to start the upswing of the cycle (Chatterjee, March1999). Before leaving the issue of definitions for a discussion of therelationship of interest rates to the business cycle, it is prudent topoint out that modern business cycle theory is mainly based on theempirical evidence occurring in the post war era. Thus, in the traditional view of business cycles, it is changes inthe supply of money, and subsequent rise or fall of interest rates, thatdrives the cycle. Fortunately,the need for a standard definition in order to give common ground to thetheoretical debate concerning business cycle models has led to the generalacceptance of the National Bureau of Economic Research's definition ofminor cycles as "recurrent fluctuations in the economy lasting from two tofour years" and "major cycles as recurrent fluctuations lasting about eightyears" (Sill 1996). This is in great partdue to the fact that fluctuations in the economy have been far less severeduring this time than in the pre war period. Rather, as Lucas has cometo believe, business cycles are an aggregate phenomena and therefore mustbe explained in terms of aggregate shocks. [Online]. Long term interest rates, on the other hand, show very littlecorrelation to changes in output. Federal ReserveBank of Minneapolis. In the alternative, if expectations are for continued growth, individualswill expect incomes and production levels to continue to rise. This growth inturn pushes firm to take advantage of the opportunity to increaseinvestment in capital and hire more workers. Quarterly Review. Quarterly Review. The economy is now in a period of contraction, the downside of the business cycle. Monetary Theories of the Cycle. These lower interest rates cause businesses to borrowmore, increasing capital expenditures. . In other words, a minor cycle is said to have occurredwhen the economy goes from a two to four year period of growth to a two tofour year period of contraction. Thus, in the long run expectations are unclear andtherefore cannot clearly determine interest rate movements.Conclusion Interest rates then are directly related to the business cycle. As aggregate demand catches up to the new technology, growth begins toslow. As Christiano and Fitzgerald (1998) point out, expansion andcontraction across all or most sectors of the economy are inherent in thedefinition of business cycle. Consumers have more money tospend, and producers are creating more output. This up and downcharacteristic of the economy is a fairly simple concept when thought of inthe abstract. If consumers expect the economy tocontinue to move in a cyclical fashion, then aggregate expectations arelikely to be ambiguous as to where production levels will be in the longrun. (Sill, 1996). Business Review. Manuelli, Roldofo E.(1986). (Fall, 1994), A Progress Report on Business CycleModels. A closer examination of business cycle theory will help toclarify this point. The correlationbetween interest rates and output then is the relationship between interestrates and the business cycle. Eventually, the increased borrowing associated with lowerinterest rates will dig deep enough into the reserves of banks that theywill begin to cut back on lending. For example,when can the determination be made that the economy is in a period ofcontraction? Proponents this idea argued that despite the generally successfulcounter cyclical policies the Federal Reserve has followed in the post warera, business cycles still exist. For example, and increase in the efficiency of aproduction technology leading to lower requirements of a particular inputwould effect not only the demand for that input, but the cost ofproduction, and thereforeprice, of the output. (March 1999). The economy is in an upswing. This lack ofcorrelation may actually be caused by the existence of the business cycleand its effect on long run expectations. New technology increases productivity/shifts supply curve; outputincreases; prices fall/real wages increase Price S S1 P P1 Demand q q1 outputDemand increases; output expands to capacity(*); prices rise Prices S* P1 p D1 D q q* outputDemand falls; output falls Prices S* P1 D q q* output Empirically, these models have led to results that closely matchfluctuations in the post war economy. Explanation for theflattening of the business cycle is the subject of much of the theoreticaldebate in this area, and will be discussed below. More recent real business cycle models have been less dismissive ofthe financial sector playing some role in the cause of cyclical movementsin the economy. In the short run,it is known that interest rates rise during the upswing of cycles and fallon the downswing of the cycle. Specifically, early real business cycle models underestimatedthe variability of consumption, hours worked and productivity andoverestimated the correlation between productivity and hours worked(McGrattan, 1994). Available:http://www.cepa.newschool.edu/the/essays/cycle/moneycycle.htm Christiano, Lawrence J. Expectations at this pointwill be that the economy is going to begin its downswing. This does not mean however, that some conclusions about thecorrelation between interest rates and the business cycle cannot be drawn.The definition of a business cycle is the alternate growth and contractionof the economy over a period of time. 4. The BusinessCycle: It's Still a Puzzle. Economic Perspectives. Producers will cut back on production, labor demand will drop, andincomes will fall. This is due in great part to the effect of consumer expectations.Interest rates are determined in part by expected income growth andexpected inflation.(Sill, 1996). The economy is in a periodof growth. The Cyclical Volatility of InterestRates. (Jan. Thus, this paper will attempt to firstdefine the business cycle and then to discuss the theorized and empiricalrelationships between interest rates and the cycle.The Business Cycle Defined Generally, the business cycle is the defined in terms of expansionand contraction of the economy. Federal Reserve Bank ofMinneapolis. Thus a variety of definitions have been putforth, each skewed slightly toward the model based upon it. . Lucas, a strong proponent of traditionalbusiness cycle theory counters that real business cycle theory is not analternative explanation of business cycles to financial movements, but thatit merely results in a close approximation of the empirical evidence whenmonetary policy has been conducted well (Chatterjee, January 1999). Because it is generally accepted that business cycles can lastanywhere from two to eight years, it is difficult for consumers to formdefinite expectations of where in a cycle the economy will be over the longrun. The use of this definition becomes important whencomparing business cycle theories because traditional theories tend to basetheir models on a one sector economy while the more recent real businesscycle theory has begun to attempt to create a multi-sector model (Manueli1986). Upswings,or periods of growth will be shorter because the risk of being caughtfinancially exposed in the downswing (expected to be severe) will leadconsumers to pay off loans and save well before the expected peak in thecycle. The economy is in adownswing. Modern Business Cycles Analysis: A Guideto the Prescott-Summers Debate. 4 Federal Reserve Bank ofMinneapolis. As economic growth is in partdetermined by an increase in output and a contraction with a fall in thelevel of output, it can be said that by definition the business cycle isdirectly correlated to the level of output in an economy. (1998). Business Review. The demandfor money will remain high, and thus interest rates will rise as well. In fact,Hawtrey's original theory spoke of "pure money cycles." (CEPA, 2 )According to this view, increases in the money supply lead to lowerinterest rates. Unfortunately, without afull understanding of the business cycle and what causes it a precisedefinition is hard to come by. Thus, short term interest rates may not only explain (in part)business cycles, but actually be explained by the extent of movement inpast cycles. These models have added financial shocks such as tax rateand government expenditures to the model. Major cycles would see alternatingperiods of growth and contraction lasting four to eight years each. In terms of the business cycle, this meansthat when individuals suspect that the economy is in an upswing and aboutto peak, short term interest rates will fall. Federal Reserve Bank of Philadelphia. The rollercoaster behavior of growth in the economy has eluded full explanation andled to the development of a variety of schools of thought on the issue.While traditional economists focussed on money as the key cause of cyclicalactivity, more recent analysis has turned to technological shocks as thedriving force behind the business cycle (Christiano and Fitzgerald, 1998).Despite the tendency of these most recent studies (referred to as realbusiness cycle theory) to discount the causal relationship between interestrates and the cycle, empirical data suggests that some relationship doesexist between the two (Sill 1996). If an economy suffers from very volatile swings do to the businesscycle, consumer expectations will have a more pronounced effect. . Chatterjee, Satyajit. This may be due in part tothe existence of business cycles. Thus, productionlevels will fall, labor will be laid off, and incomes will fall.Individuals will thus be less willing to borrow, lowering the demand formoney. a persistent period of decline on totaloutput, income, employment and trade usually lasting from six months to ayear and marked by widespread contractions in many sectors of the economy." Traditional theories consider only movements in the financial sector ofthe economy as explanation for business cycles, extrapolating explanationfor movements in the rest of the economy from that base.Real Business Cycle Theory The restrictive analysis of traditional business cycle theory wasinsufficient because it unrealistically treated the economy as a one goodmarket. Annual Growth Rate of Real Output Percentage Rates of Change Actual Predicted 6 4 2 -2 -4 -6 1955 196 1965 197 1975 198 1985 (Source: Chatterjee, March 1999)However, they have failed to explain some aspects of the empiricalevidence. However, a more precise definition is required in order todevelop a model that will explain the phenomenon. Thestandard model of real business cycle analysis is that of Prescott andKydland as presented in 1982 (McGrattan, 1994). RealTraditional Theory While there are many specific theories on what causes the businesscycle, they can generally be broken down into two categories - traditionalbusiness cycle theory and real business cycle theory. [Online]. At this point, the demand for money willexceed what the banks are willing to supply and interest rates will againrise. Traditional businesscycle theory, as developed by Hawtrey (CEPA, 2 ) and more recentlyadvocated by Lucas, is based on the notion that changes in the supply ofmoney are the key causes of fluctuations in the economy. For this answer some look to the NBER's definition ofrecession, ". (January 1996). Thus, in the late 197 's and early 198 's a new schoolof thought began to emerge and real business cycle theories appeared. References Chatterjee, Satyajit. For example, a consumer will not know if ten years encompasses fivecycles or one. Business Cycle Theory - Traditional v. (2 ). As capital expenditure increases,so does production and eventually labor usage is increased as well. Available:http://www.minneapolisfed.org/pubs/region/99/ 3/cycles.html CEPA. McGrattan, Ellen R. (Christiano and Fitzgerald,1998). Federal ReserveBank of Chicago. . The result was an increase inthe models ability to predict economic movements in relation to theempirical evidence (McGratten, 1994).Interest rates in relation to the cycle While traditional models based solely on financial sector shocks toexplain the business cycle fell short of adequately explaining movements inthe real world multi-sector economy, early real business cycle modelspredicted results that were inconsistent with the empirical evidence.Thus, it would seem that interest rates cannot wholly explain businesscycles, nor can they be completely discounted. However, even with this generally accepted definition of businesscycle, there are those who base their analysis not on the definition ofbusiness cycle but on the NBER's related definitions as well. Vol.18, No. It is the tendency of the economy to movefrom recession to growth and back again over time. Their argument is based on the NBER'sdefinition of recession as ". 1999) Real Business Cycles: A Legacyof Countercyclical Policies? This model is based on the notion that technological changes drivethe business cycle. Thus,as producer output increases so too does consumer wealth through increasedwages caused by higher demand for labor. Production levels change in response to changes in theprice of money, the interest rate.Shock leads to increase in money supply, interest rate drops Interest rates(price of money) S S1 r r1 D Money supplyFirms borrow, increase production, prices fall/real wages increase; demandincreasesPrices S P S1 p1 D outputAs demand increases, firms increase output further; more borrowing leads tostrain on bank reserves/ higher interest ratesInterest rates S1 S r1 r D Money supply While this view was widely accepted, traditional theoretical models failedto adequately explain the inter-relationships between sectors of theeconomy. What is not as clear, is whether it is thecycle driving interest rate movements or interest rates driving the cycle. Sill, Keith. In order to evaluate the true cause of business cycle fluctuation,it was felt; a model more closely approximating the true nature of theeconomy was needed. and Fitzgerald, Terry J. a persistent period of decline on total output, income,employment and trade usually lasting from six months to a year and markedby widespread contractions in many sectors of the economy." (Christiano andFitzgerald, 1998). If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.