09 Business Cycles

Lecture from: 11.11.2025 | Video: Video ETHZ

Open-Economy Macroeconomics (Conclusion)

Before beginning the new topic, the open-economy macroeconomic analysis is concluded. The core concepts of Net Exports (NX), Net Capital Outflow (NCO), and the identity $NX=NCO$ have been established. The focus now turns to the prices governing these international flows.

Real Exchange Rates

• Nominal Exchange Rate ($e$): Rate at which currency is traded.
• Real Exchange Rate ($ϵ$): Rate at which goods and services are traded. A true measure of competitiveness.

$$\text{Real exchange rate}(ϵ)=\frac{\text{Nominal exchange rate}(e)\times \text{Domestic price}(P)}{\text{Foreign price}(P^{\ast })}$$

• Depreciation ($ϵ\downarrow$): Domestic goods become cheaper relative to foreign goods. Exports rise, Imports fall $\to$ Net Exports Rise.
• Appreciation ($ϵ\uparrow$): Domestic goods become relatively expensive. Net Exports Fall.

The Big Mac Index

The Economist’s index offers a standardized measure of PPP.

• US Price: $6.01
• Swiss Price: CHF 7.20
• Exchange Rate: 1.25 $/CHF
• Real Rate: 1.5

Interpretation: A Swiss Big Mac costs 50% more than a US one. The Swiss Franc is “overvalued” by 50%.

A Macroeconomic Theory of the Open Economy

The forces in an open economy are understood by simultaneously analyzing two key markets.

1. The Market for Loanable Funds

Coordinates saving, investment, and NCO. Identity: $S=I+NCO$.

• Supply ($S$): Upward sloping (higher $r$ incentivizes saving).
• Demand ($I+NCO$): Downward sloping (higher $r$ discourages borrowing and foreign asset purchase).

2. The Market for Foreign-Currency Exchange

Coordinates currency exchange. Identity: $NCO=NX$.

• Supply ($NCO$): Vertical. (Determined by real interest rate from the Loanable Funds market).
• Demand ($NX$): Downward sloping (higher exchange rate reduces demand for exports).

Simultaneous Equilibrium: The Real Interest Rate ($r$) connects the two. It is determined in the Loanable Funds market, which then determines NCO. NCO acts as the supply of domestic currency in the FX market, which determines the Real Exchange Rate ($E$).

Policy Effects

Government Budget Deficit ($G\uparrow$ or $T\downarrow$)

1. Loanable Funds: Supply shifts left ($S\downarrow$). Interest rate rises.
2. Crowding Out: Higher rate reduces Investment ($I$) and NCO falls.
3. FX Market: Supply of domestic currency falls. Exchange rate appreciates.
4. Trade: Appreciation kills exports. Trade Deficit worsens.

Trade Policy (Import Quota)

1. Direct Effect: Restricts imports, increasing NX demand at any exchange rate. Demand curve shifts right.
2. FX Market: Exchange rate appreciates.
3. Loanable Funds: Unaffected! Saving and Investment don’t change, so NCO doesn’t change.
4. Result: Currency appreciation offsets the initial protection. Exports fall to match the fall in imports. Net Exports remain unchanged.
   • Lesson: Trade policies affect the volume of trade, not the balance.

Capital Flight

(Sudden loss of confidence in a country)

1. Loanable Funds: People try to move money out ($NCO\uparrow$). Demand shifts right. Interest rate rises.
2. FX Market: Massive selling of domestic currency ($NCO$ supply shifts right). Exchange rate depreciates.
3. Result: The economy suffers from both high interest rates (crushing investment) and a crashing currency.

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Business Cycles

Attention now pivots from the long run (growth, steady states) to the short run. Business cycle analysis seeks to explain year-to-year economic fluctuations.

Three Key Facts

1. Irregular and Unpredictable: “Cycles” do not follow a fixed schedule.
2. Comovement: Most macroeconomic variables fluctuate together (GDP, income, sales, profits).
3. Output vs. Unemployment: Inverse relationship. When GDP falls, unemployment rises.

Okun’s Law

The empirical relationship between GDP growth and unemployment changes.

Okun’s Law (Swiss Context): To keep the unemployment rate steady, real GDP needs to grow at roughly 1.9%.

• Growth < 1.9% $\to$ Unemployment rises.
• Growth > 1.9% $\to$ Unemployment falls.

Unemployment is a Lagging Indicator

Labor markets react with a delay. Firms cut hours before firing people; they ask for overtime before hiring. Thus, unemployment peaks after the recession has officially ended.

Defining the Cycle

1. Classical Cycle: Fluctuations in the level of GDP. (Expansions vs. Contractions).
2. Growth Cycle: Deviations of GDP from its long-run trend (potential). (Boom > Potential; Bust < Potential).
3. Growth Rate Cycle: Accelerations vs. Decelerations in the growth rate.

Causes of Cycles

Fluctuations are driven by anything that shifts demand or supply:

• Household spending (confidence)
• Firm investment (“animal spirits”)
• External shocks (war, trade)
• Policy changes (Fiscal/Monetary)
• Self-fulfilling expectations

Models: A First Look

Model Type	Assumption	View on Fluctuations
(New) Classical	Markets clear quickly. Prices/wages flexible.	Optimal responses to shocks (e.g., technology) or information failures.
(New) Keynesian	Markets do not clear quickly. Prices/wages sticky.	Inefficiencies driven by demand shocks. Active policy can help.

The Crucial Distinction

• If prices are flexible: The economy stays near potential.
• If prices are sticky: Demand shocks push output away from potential.

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Continue here: 10 Keynesian Economics and IS-LM Analysis