The Role of Policymakers in Business Cycle Fluctuations

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Consequently, the monetarist leaders explained that monetary authorities should prevent excessive expansion of the money supply to maintain price stability. The aim of this paper is to identify the Lebanese business cycle over the period — and to explore how aggregate activity in Lebanon fluctuates with recurrent shocks. In other terms, this paper investigates how the output fluctuates around the trend level that reflects the business cycles amplitude and duration. Moreover, this paper discusses whether the adopted monetary policy in Lebanon had succeeded to smooth the business cycles or not?

The assessment of the causality relation between the capacity utilization rate and inflation allows to answer whether monetary disturbances matter for business cycle. As in Cogley and Nason , this paper uses Hodrick Prescott filter to identify Lebanese business cycle.

However, Granger causality test is used to evaluate the relationship between the capacity utilization rate and the inflation in the short run, while OLS method is applied to assess this relation in the long run. This paper is organized as follows: Sect. All the tests are performed using EViews. An overview of the world history shows incessant series of recurrent cycles with either uniformities or variabilities. The history repeats itself, and it goes through cycles in almost everything: climate, economy, war, geopolitics, life and so on.

Thus, the academic world of the historiography describes a cyclical view of history analyzing the cycles of episodes since the nineteenth century. However, the originators of this analysis were the Genius Ibn Khaldun He explained that empires are like organisms and their life trajectories can be plotted like points in a bell curve from their beginnings to their deaths.

Mitchell presented a descriptive approach to cycle which encompasses the decomposition of a wide number of time series into sequences of cycles. Explaining the major fact about cycles is the recurrent nature of the events; he divided each cycle into four different stages, unavoidably progressing from one into another: expansion, peak, contraction and trough.

The duration of these fluctuations can last from a few quarters to several years. Investigating the sources of GDP fluctuations, economists are divided into two main groups supported by empirical works. Keynes as well as a group of economists attached to its school point to the monetary disturbances as source of business cycle. Consequently, using time series techniques, Christiano and Eichenbaum accumulate evidences which support the important role of monetary policy in determining aggregate output, employment and other macroeconomic factors.

Alternatively, a second group, related to classical school, advocates that business cycles are generated by that non-monetary factors. In this line of view, Baxter and King present an empirical work which decomposes the GDP time series into periodic components by regressing the time series in a set of sine and cosine waves to conclude that fiscal shocks count in expressing business cycles fluctuations.

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However, the rational expectation idea initiated by Muth inspired Robert Lucas to develop in the rational expectation theory which emphasizes the monetary policy ineffectiveness. Luca explained that that policymakers can guide the economy by systematically influencing the economic agents to make false expectations. Thus, in contrast with the Keynesian perspective, where policy offers relief from unemployment and market failures, Luca clarified that, in a world of rational expectations and market clearing, monetary policy is not the primary source of macroeconomic instability and that only unanticipated monetary shocks can have real effects on real variables.

Nevertheless, while accepting Keynesian economics, the monetarist theoreticians explained that excessive expansion of the money supply is fundamentally inflationary. Otherwise, in the line of Shumpeter who has developed a theory of business cycles which puts its emphasis on industrial innovation rather than monetary sector, classical economists have developed the real business cycle model RBC which advocates the role of technology shocks as a cause of economic fluctuations and limits the role of monetary factors in generating these economic fluctuations.

The RBC ties a theory of economic growth, behavioral model of economic agents based on the utility maximization and an explanation of the business cycle. In other terms, it integrates both the growth Solow Model and the business cycles theory to confirm that business cycle fluctuations are the optimal responses to unanticipated supply shocks defined by the total factor productivity. However, Kydland and Prescott proposed a theory of business cycle fluctuations far from the Keynesian tradition. Integrating growth and business cycle theory, they characterized a general macroeconomic equilibrium model to predict the consequence of a policy rule upon the operating characteristics of the economy.

This simple model, based on microeconomic foundations and where there is no role for monetary factors, generates quantitatively significant business cycles. They argued that periods of temporarily low output growth are not the results of market failure to clear, but could simply be a supply shock where slow improvements in production technologies appear. Furthermore, Cooley and Hansen proved, in a cash-in-advance real business cycle model, that adding monetary factors made little difference to the results, which assumes a minimal role for monetary aggregates.

King et al. Nelson and Plosser argued that the long-run path of macroeconomy is permanently affected by contemporary events; their empirical work demonstrates that the hypothesis that GDP growth follows a random walk cannot be rejected. In other terms, that most of the changes in GDP were permanent, and that output growth would not revert to an underlying trend following a shock. Thus, changes in aggregate demand—the heart of Keynesian macroeconomics—must be of relatively little importance. Nevertheless, the conflict between normative implications and policy practice on one hand and between theoretical predictions and evidence on other hand is considered as an indication that some fundamentals that are essential in actual economies may be missing in classical monetary models.

To overcome these deficiencies, a group of economists, while maintaining the RBC as an underlying structure, introduces Keynesian assumptions to produce economic models. Consequently, the progress in economic research combined classical and Keynesian principles to develop the New Keynesian view. Thus, Keynesian elements as imperfect competition and nominal rigidities were incorporated into a dynamic model to analyze the connection between inflation, money and the business cycle. From that point of view, the new generation of Keynesian models has much stronger theoretical foundations than traditional ones.

However, the stressing on the nominal rigidities as being a source of monetary non-neutralities provides an important differentiation between classical monetary model frameworks and new Keynesian models.

The Role of Policymakers in Business Cycle Fluctuations : Jim Granato :

The emphasizing on the nominal rigidities as being a source of non-neutralities affords an important differentiation between classical monetary frameworks and new Keynesian models. Despite their different theoretical basics, there are important connections between the RBC models and the new Keynesian monetary model.

The Business Cycle

These similarities are reflected in the assumption of an infinitely lived representative household, who seeks to maximize the utility from consumption and leisure, subject to an intertemporal budget constraint and large number of firms with access to an identical technology, subject to exogenous random shifts. Nevertheless, some key elements of RBC theory are missing in the canonical version of new Keynesian model, like the endogenous capital accumulation. He considered that money has a primary role to explain the fluctuations of business cycles.

Furthermore, he assumed that economic recessions are not caused by technological shocks, since economic agents are rational and response to any technological downturn causing a recession. Their findings proved that imperfect competition affects the way in which the economy responds to several shocks which may occur. Merging Keynesian and classical elements, they produced the systematic application of intertemporal optimization and rational expectations as stressed by Robert Lucas proving that the evolution of inflation in the NNS models depends on current and expected future markups.

Moreover, their findings specify that considering an NNS model, the near-zero inflation rate targeting is possible. Nonetheless, a group of economists characterized business cycles by a dynamic stochastic general equilibrium DSGE models. These models are based on microeconomic foundations which emphasize that all agents are rational and make decisions based on intertemporal optimization under uncertainty.

Thus, Smets and Wouters developed a dynamic stochastic general equilibrium DSGE model with sticky wages and prices for the eurozone using Bayesian estimation techniques. Their model incorporates a variable capital utilization rate, while findings prove a considerable degree of price stickiness in the eurozone. However, Christiano et al. After policy shock, the model generates persistent response in output and inertial response in inflation.

Furthermore, findings prove that after the hit of a monetary policy shock, the money growth rate and the interest rate move persistently in reverse directions. This paper applies Hodrick Prescott HP filter to derive the output trend and the output gap. However, a positive gap is related to the nonuse of capacity utilization, while a negative gap is related to the total use of capacity utilization implying an increase in demand and in inflation as results. This paper analyzes therefore the relation between capacity utilization rate and inflation in the short and long run to conclude empirically on the relation between Lebanese monetary policy and business cycle.

As a result, the regular holding of elections will produce cyclical fluctuation of economic activity because of recurring patterns of government stimulus and restraint in order to induce an artificial boom in the election time. Politicians will try to drive up the natural or equilibrium rate of employment. Thus, the rate of inflation and interest rates will be higher than they need to be. Likewise, there is a political cycle found in welfare regimes. Accordingly, the state officials will tend to make the welfare system more generous in the preelection period and to restore restraint and incentives to work afterward.

3. Monetary policy - the example of the ECB

Nondemocratic leaders also have incentives to allocate budgets and credits to their strategic partners, but, without regular elections, they will have few reasons to engage in opportunistic manipulations of fiscal or monetary policies. However, their time horizons may be shortened by immediate threats to survival, such as war. In general, theorists of the political business cycle believe that democratic politicians will manage monetary and fiscal policy less responsibly than the nondemocratic leaders or politicians in the regimes with less political competition.

The theories of political business cycle are based on several assumptions. First, it is generally agreed by economists that there is a short-term trade-off between the level of utilization and employment in the economy and the rate of inflation. Second, it is assumed that politicians are rational actors, prioritizing their short-term political objectives.

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  • In the run-up to elections, they will trade inflation for lower levels of unemployment. Third, those who study the political business cycle often think that there is a single best policy solution in a given situation that is in the general interest. That solution leads to a natural equilibrium between inflation and unemployment.

    Very often, the understanding of such equilibrium is counterinflational. There are two streams of theories in the literature on the political business cycle.

    Depoliticizing monetary policy

    First, partisan theories stress the difference of fiscal and monetary preferences between parties. Whereas leftist parties are expected to boost real economic activity employment , rightist parties are thought to focus on fighting inflation. A second set of models concentrate on the manipulation of policy instruments by politicians who seek to get reelected. This induces a tendency for continuous increases in public debt and the tax burden. Second, many of the desirable features of automatic stabilisers are almost impossible to replicate by discretionary reactions of policy makers.

    For instance, tax changes must usually be adopted by Parliament and their implementation typically follows the timing of budget-setting processes with a lag. Not surprisingly, therefore, discretionary fiscal policies aiming at aggregate demand management have tended to be pro-cyclical in the past, often becoming effective after cyclical conditions have already reversed, thereby exacerbating macroeconomic fluctuations. Clearly, the short-term stabilising function of fiscal policy can become especially important for countries that are part of a monetary union, as nominal interest rates and exchange rates do not adapt to the situation of an individual country but rather to that of the union as a whole.

    Fiscal policy can then become a crucial instrument for stabilising domestic demand and output, which remains in the domain of individual governments. At the same time, however, the limitations of active fiscal policy may be greater when there is increased uncertainty about future income developments.

    This is the case today in many European countries where there is a growing concern about the difficulties faced by public pension and health care systems in view of demographic trends. Under such circumstances, cyclically-oriented tax cuts and expenditure increases today may simply translate into higher taxes or lower expenditure tomorrow. Aware of this, the public may increasingly react to fiscal expansions by raising precautionary savings rather than consumption.

    In the light of the previous discussion, what is the scope for discretionary fiscal policies? Discretionary policies are needed to implement long-term structural changes in public finances and to deal with exceptional situations, particularly when the economy experiences extraordinary shocks.

    The Role of Policymakers in Business Cycle Fluctuations

    Discretionary policies in fact reflect the changing tastes about the desirable size of the public sector, about the priorities of public spending, and about the level and characteristics of taxation. These policies determine the structure of public finances and substantially affect the functioning of the economy but also the features of a country's automatic stabilisers. Discretionary fiscal policy decisions are also needed to preserve the sustainability of public finances in the medium-term. This is the precondition for automatic stabilisers to operate freely, as fiscal policy can only act as an effective stabilising tool when there is the necessary room for manoeuvre.

    The experience of the industrialised countries in recent decades clearly shows that persistent fiscal imbalances limit the room for fiscal policy to stabilise the economy. Imbalances often necessitate tight fiscal policies during downturns to prevent unsustainable deficits and debt developments. Hence, when sustainability is in doubt, expansionary measures and even automatic stabilisers may not have the desirable effect on output as people adjust their behaviour. Consolidation measures may then re-establish confidence and improve expectations about the long-term outlook of public finances.

    Active fiscal consolidation with discretionary policies is therefore appropriate when budgetary positions are perceived as not being safe or when there are risks to fiscal sustainability due to high debt and future fiscal obligations. Finally, although automatic fiscal stabilisers are effective in dampening normal cyclical fluctuations, there may be situations where active policy decisions might be needed.

    For example, automatic stabilisers alone may not be sufficient to stabilise the economy when economic imbalances do not stem from normal cyclical conditions or are considered as irreversible. However, the benefits from expansionary policies in a recession must still be assessed against the risks to long-term sustainability or the persistent adverse effects on the structure of public finances, such as a permanently higher tax level, as well as the economic costs of an eventual policy reversal.

    What does history tell us? A number of studies have confirmed that public finance measures, implemented in European countries from the mids to mids, have performed poorly in stabilising their economies. Often, fiscal contractions took place in periods of low growth, whereas fiscal expansions occurred during economic booms. Thus, discretionary fiscal policies have frequently been pro-cyclical, overriding automatic stabilisers and possibly contributing to economic instability. In addition to this lack of timeliness, discretionary fiscal policy adjustments have shown two types of asymmetries that have undermined the sustainability of public finances.

    First, fiscal policies behaved asymmetrically with expenditure increases in downturns not being followed by expenditure cuts but rather by tax increases during expansions. This resulted in strong increases in the tax burden and the share of government in GDP. Second, in some Member States budget balances have improved less during upswings than they have deteriorated during downturns, pointing to asymmetric reactions of fiscal policy to economic fluctuations.

    A significant deficit bias emerged in the early s with chronic deficits peaking above 5 percent of GDP for the average of the countries that joined the euro area later on. The chronic high deficits together with the negative effects of a rising tax burden on investment and growth produced a very rapid and continuous build-up of public debt ratios until Only thereafter — during the convergence to Economic and Monetary Union — did deficits decrease and public debt ratios decline.

    How should fiscal and monetary authorities co-ordinate their policies to stabilise the economy? To avoid being vague and too general, let me take again the case of EMU as an example. With an independent central bank and its stability-oriented strategy, the euro area has a highly predictable monetary policy. There is no ambiguity as to how monetary policy will respond to economic, including fiscal developments: it will respond to the extent that they pose risks to price stability. The principle of central bank independence and the overriding focus of the single monetary policy on the objective of price stability are two cornerstones of the economic policy constitution enshrined in the Maastricht Treaty.

    They reflect the underlying economic logic that a clear division of responsibilities between the ECB and other economic policy actors is the institutional arrangement most conducive to the attainment of the wider objectives of the European Union. Naturally, fiscal policies and structural reforms have monetary policy implications if such reforms affect price developments.