Question

Business Cycle

We have learned that a competitive market always experience business cycles in the short run. The output fluctuate around the upward trend, creating four period: recovery(from trough to trend), expansion(from trend to peak), contraction(from peak to trend) and recession(from trend to trough) .

The cycle is usually self enforcing, when we are in the expansion, asset price goes higher and higher, so as the value of the collateral, people become optimistic and inclined to engage in the more risky activity. The high leveraged speculation was fueled by the 'shadow banking system' which generally refers to those unregulated institution or entity conducting financial activity without oversight. The shadow banks usually could attract swarm of investors since they provide higher return than traditional banking system. As a famous saying goes 'When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance.'

The MBS(mortgaged backed security) is considered as shadow banks before the 2008's financial crises. Banks could accelerate their debt-loan cycle by securitize their mortgage and sell to investors. In the process banks transfer their liability to the investor, this create the moral hazard since bank takes no risk to provide MBS. At the beginning the extra liquidity it provides benefit both creditor and debtor. Credible borrowers get loans from MBS investors otherwise bank may lack the liquidity to provide. Things go wrong when banks securitizing the loans from those borrowers who is likely to default, the so called sub mortgage.

In order to sell them off, they bundled the low profile submortgage together with high profile mortgage, create the so called CMO(Collateralized Mortgage Obligations) to get a good score from the rating agency like S&P and Moody's. On the one hand, rising housing prices made mortgages look like fail-proof investments, enticing investors to buy CMOs.

On the other, insurance companies like AIG selling CDS(credit default swaps) to investors, which act like insurance contracts on on those CMOs and MBSs. Investors thus could hedge the default risk of CMOs and MBSs by buying CDS.

The business cycle reach the tipping point as the collapse of the shadow bank system, liquidity shrink, more and more sub-mortgage default leading to the collapse of AIG. The defaulted CMOs and MBSs holding by the investment banks can not compensated by the CDS anymore. Leading to the collapse of Merrill Lynch and Lehman Brothers and the subsequent Financial Crises.

(a) Draw a graph of output to indicate the business cyclical behavior.
(b) Draw the trend along with the output
(c) Label the four period on your graph.
(d) What factors other than credit boom could cause the business cycle?

Answer 1

Business cycle is created due to shifts in Aggregate Demand (AD) and Aggregate Supply (AS) curves.

1. Say AD goes up (due to some reason)

2. This will create Peak

3. Now, inflation will be high, so upward wage pressure will be there

4. Due to upward wage pressure, cost of production goes up

5. This moves AS towards left (AS reduces)

6. Economy comes back to potential

These are six steps of the upward movement and back to potential

Let's talk about the other way

1. Say AD goes down (due to some reason)

2. This will create Trough

3. Now, recession will be there, so downward wage pressure will be there

4. Cheap labor will be available, reducing the cost of production

5. This moves AS up (AS increases)

6. Economy comes back to potential

Different school of thoughts talk about business cycle

Adam smith says that there is an invisible hand will take care of the market and business cycle, so, no need of monetary policy and fiscal policy. Other school of thoughts include keynesian, monetarist, austrian, new classical.

(a), (b) and (c)

(d)

As discussed above, business cycle is created because of shifts in AD and AS curves.

AD can shift right because of following reasons

1. increase in C (Consumption)

2. increase in I (Investment)

3. increase in G (Government)

4. increase in X (Exports)

5. decrease in M (Imports)

AS can shift right because of following reasons

1. Increase in labor

2. Increase in capital

3. Increase in human capital

4. Increase in technology

5. Increase in natural resources

6. Decrease in cost of production