Business Cycles: Market Structure and Market Interaction

194 Pages·2000·5.575 MB·English

by  Priv.-Doz. Dr. Kirsten Ralf (auth.)

Business Cycles
Contributions to Economics
Christoph M. Schneider Ulrich Woitek
Research and Development Business Cycles
Management: 1997. ISBN 3-7908-0997-7
From the Soviet Union to Russia
1994. ISBN 3-7908-0757-5
Michael Carlberg
International Economic Growth
Lars 010f PerssonlUlf Wiberg 1997. ISBN 3-7908-0995-0
Microregional Fragmentation
1995. ISBN 3-7908-0855-5 Massimo Filippini
Elements of the Swiss Market for
Electricity
Ernesto FellilFurio C. Rosati!
Giovanni Tria (Eds.) 1997. ISBN 3-7908-0996-9
The Service Sector:
Productivity and Growth Frank HosterlHeinz Welsch!
1995. ISBN 3-7908-0875-X Christoph Bohringer
COl Abatement and Economic
Structural Change in the
Giovanni Galizzil
European Internal Market
Luciano Venturini (Eds.)
1997. ISBN 3-7908-1020-7
Economics of Innovation:
The Case of Food Industry
1996. ISBN 3-7908-0911-X Christian M. Hafner
Nonlinear Time Series Analysis
with Applications to Foreign
David T. Johnson Exchange Rate Volatility
Poverty, Inequality and Social
1997. ISBN 3-7908-1041-X
Welfare in Australia
1996. ISBN 3-7908-0942-X
Sardar M.N. Islam
Mathematical Economics of
Rongxing Guo Multi-Level Optimisation
Border-Regional Economics 1998. ISBN 3-7908-1050-9
1996. ISBN 3-7908-0943-8
Sven-Morten Mentzel
Oliver Fratzscher Real Exchange Rate Movements
The Political Economy of Trade 1998. ISBN 3-7908-1081-9
Integration
1996. ISBN 3-7908-0945-4
Lei DelsenlEelke de Jong (Eds.)
The German and Dutch
Ulrich Landwehr Economies
Industrial Mobility and Public 1998. ISBN 3-7908-1064-9
Policy
1996. ISBN 3-7908-0949-7 Mark Weder
Business Cycle Models
with Indeterminacy
Arnold PicotlEkkehard Schlicht
(Eds.) 1998. ISBN 3-7908-1078-9
Firms, Markets, and Contracts
1996. Corr. 2nd printing 1997 Tor R~dseth (Ed.)
ISBN 3-7908-0947-0 Models for Multispecies
Management
1998. ISBN 3-7908-1001-0
Thorsten Wichmann
Agricultural Technical Progress
and the Development of a Dual Michael Carlberg
Economy Intertemporal Macroeconomics
1997. ISBN 3-7908-0960-8 1998. ISBN 3-7908-1096-7
continued on page 192
Kirsten Ralf
Business Cycles
Market Structure and Market Interaction
With 25 Figures
and 1 Table
Physica-Verlag
A Springer-Verlag Company
Series Editors
Werner A. Muller
Marina Bihn
Author
Priv.-Doz. Dr. Kirsten Ralf
Department of Economics
University of Hamburg
Von-Melle-Park 5
20146 Hamburg
Gennany
Cataloging-in-Publication Data applied for
Die Deutsche Bibliothek - CIP-Einheitsaufnahme
Ralf, Kirsten: Business cycles: market structure and market interaction / Kirsten Ralf.
- Heidelberg; New York: Pbysica-Verl., 2000
(Contributions to economics)
ISBN 978-3-7908-1245-9 ISBN 978-3-642-51742-6 (eBook)
DOI 10.1007/978-3-642-51742-6
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Preface
When writing the preface the main work has been done. What remains is
thanking all those people who directly or indirectly contributed to the out
come. My thanks go to my family and friends for their encouragement towards
the completion of this book.
Among the academic profession, I would like to thank Prof. Dr. Dr. Harald
Scherf, my academic teacher, first. During the years at Hamburg University
I benefitted especially from his profound knowledge of Keynesian theory. His
way of examining an argument in an unbiased way helped me a lot to carry
out the reseach I wanted to do. His confidence enabled me to finish the work.
A part of the book was written while I was a visiting fellow at DELTA,
Paris, where I am particularly indebted to Roger Guesnerie. I have benefitted
from his encouragement, advice, and gentle criticism during discussions and
seminars, especially on the topic of the time structure of economic dynamics.
I would like to acknowledge the hospitality and stimulating atmosphere at
DELTA.
Different versions of the manuscript, or parts of it have been read by
Prof. Dr. Manfred Holler, Dr. Jorg Bibow and Dr. Gabriele Kasten. Their
comments and suggestions were quite helpul and are gratefully acknowledged.
Additionally, I have to thank Prof. Dr. M. Funke and Prof. Dr. V. Timmer
mann.
Last but not least, I wish to express my gratitude to Dr. Jochen Runde
who not has only been proofreading the whole manuscript in a admirable
way, but also made some very helpful comments on the text itself. This very
much improved the clarity of exposition.
Table of Contents
1. Introduction..... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. Basic questions, early theories and empircal evidence. . . . . 7
2.1 What is business cycle theory about? ..................... 7
2.2 A brief sketch of early theories. . . . . . . . . . . . . . . . . . . . . . . . . .. 11
2.3 Stylized facts .......................................... 16
3. Stability of the economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 23
3.1 Introduction........................................... 23
3.2 Stability of steady state equilibria . . . . . . . . . . . . . . . . . . . . . . .. 25
3.2.1 Backward oriented systems. . .. . . . . . . . . . . . . . . . . . . .. 25
3.2.2 One-step forward looking systems ................ " 29
3.2.3 Sunspots........................................ 33
3.3 Structural stability of a dynamical system . . . . . . . . . . . . . . . .. 37
4. Survey of modern business cycle theory .................. 41
4.1 Introduction........................................... 41
4.2 Business cycles in a stable economic system. . . . . . . . . . . . . . .. 43
4.2.1 Political business cycle models. . . . . . . . . . . . . . . . . . . .. 43
4.2.2 Monetarist business cycle models. . . . . . . . . . . . . . . . . .. 46
4.2.3 New-Classical business cycle models ................ 50
4.3 Business cycles in an unstable economic system ............ 56
4.3.1 Old-Keynesian models ............................ 56
4.3.2 New-Keynesian business cycle models. .. . . . . . . . . . . .. 63
4.3.3 Neo-Walrasian models. . . . . . .. . . . . . . . . . . . . . . .. . . .. 67
5. Market structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 73
5.1 Introduction........................................... 73
5.2 The static case. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 76
5.2.1 Monopoly....................................... 76
5.2.2 Oligopoly....................................... 82
5.2.3 Monopolistic competition. . . . . . . . . . . . . . . . . . . . . . . . .. 99
viii Table of Contents
5.3 The dynamic case ...................................... 104
5.3.1 State-contingent and time-contingent models ......... 104
5.3.2 A dynamic model of monopoly ..................... 105
5.3.3 Dynamic behaviour. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 108
5.3.4 Simulation results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 117
5.4 Relation to the literature ................................ 121
6. Market interaction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
6.1 Introduction ........................................... 123
6.2 General equilibrium. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 126
6.2.1 Overlapping generations models .................... 126
6.2.2 Optimal growth models ........................... 140
6.3 Partial equilibrium ..................................... 145
6.4 Relation to the literature ................................ 161
7. Conclusion ............................................... 163
A. Proofs of the theorems of section 5.2 ...................... 165
B. The existence of k-SSE ................................... 171
Bibliography. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 175
Index ......................................................... 185
1. Introduction
Business cycles are macroeconomic phenomena. They are defined as more or
less regular fluctuations in the aggregate economic activity of nations and re
flected in the serial correlations of key macroeconomic series, such as output,
consumption, investment, employment, and inflation. Business cycle theoriz
ing attempts to explain this cyclical behaviour of economic aggregates. Which
are the forces that induce the economy to fluctuate? Individual decisions of a
large number of economic agents on different markets lead neither to states
of stationary equilibrium nor to an entirely chaotic evolution of the economy,
but to a more or less regular sequence of booms and depressions.
Modern business cycle theory displays different approaches to questions
regarding economic stability, causes of fluctuations, and market clearing. An
economic system is said to be stable, if - without exogenous shocks to pref
erences or the technology, or government intervention - the economy will
eventually reach an equilibrium in which all markets clear and all agents are
able to carry out their optimal plans. Such a system is self-regulating in the
sense that exogenous shocks are fully absorbed. Otherwise, if there are states
of economic disequilibrium or endogenous fluctuations occur, the system is
called unstable. The central problem behind the question of economic stabil
ity is the question of economic policy: At which point of the business cycle
should the government intervene and what measures should be taken, if there
are any reasons for intervention at all? Exogenous shocks, monetary or real,
on the one hand, and endogenous forces from within the economic system,
on the other hand, are regarded as giving rise to economic fluctuations. Is it
possible to identify certain events as being the cause of the observed fluctua
tions or does the economy follow an endogenously determined business cycle?
With regard to the properties of the markets, models can be distinguished
according to the assumption of continuous market clearing and the interac
tions between different markets. Are economic agents able to carry out their
warranted actions or do they have to face restrictions on their optimal plans?
The present treatise "Business cycles: Market structure and Market In
teraction" aims at clarifying these issues. The purpose of my research is to
2 1. Introduction
provide a theoretical analysis of the interactions of markets and market struc
tures in their relevance for the business cycle. In this context, not only the dis
aggregation in different sectors, but also the market organization plays a vital
role. The analysis, therefore, proceeds in two directions. At first, the market
structure will be analysed. In particular, I shall examine the consequences
of different market structures, monopoly, oligopoly, or monopolistic competi
tion, in the presence of market imperfections. For the cases of monopoly and
monopolistic competition I shall draw on the existing literature, whereas for
the case of oligopoly a new approach will be presented. Additionally, I develop
a dynamic extension of the monopoly model with menu costs. Secondly, the
interaction of two sectors, the consumption goods sector and the investment
goods sector, becomes the central feature of the analysis. How these inter
actions and endogenous fluctuations are linked will be shown in a general
equilibrium context as well as in a partial equilibrium framework. Two sector
general equilibrium models are overlapping generations models and optimal
growth models. The partial equilibrium model I present is my own, which
emphasizes substitution between labour and capital. The inspection of the
literature leads to the result that the models have to be of nonlinear nature in
order to describe cyclical behaviour not entirely caused by exogenous shocks.
Nevertheless, exogenous shocks can have a great influence on the business
cycle; one may think here of the influence on the length of the cycle or its
amplitude.
The book is organized as follows: Chapter 2 is dedicated to the description
of the historical and empirical background of business cycles. It seeks to
answer the question what business cycle theory is about. A brief sketch of
early theories is given. Special attention is paid to the works of Haberler,
Schumpeter, or Keynes, since they all provide a strong influence on modern
theorizing. Furthermore, a list of stylized facts will be presented and discussed
in the light of recent empirical studies.
In chapter 3 mathematical methods for the analysis of dynamical systems
are described. Particular attention is paid to the different concepts of sta
bility, such as structural stability of a dynamical system and stability of an
isolated equilibrium. The fundamental controversy in modern business cycle
theory arises from the disagreement on economic stability. Do the state vari
ables of the economic system converge without exogenous shocks and gov
ernment intervention to a stationary state in which supply equals demand
on all markets? Or do market frictions, imperfect competition, or structural
instabilities lead to persistent unemployment and other states of disequilib
rium? The criterion of economic stability is seen to be fundamental because
of its consequences for economic policy. If the market mechanism leads to
1. Introduction 3
full employment, there is no need for stabilizing the economy. H, on the other
hand, no market mechanism exists, the government is responsible for choos
ing the correct policy for stabilizing the cycle. In order to apply the criterion
of economic stability in a formal way to business cycle models, in chapter 3
the mathematical concept of stability is defined. The mathematical tools for
the analysis of economic dynamics are discrete dynamical systems. In this
context, the methods of nonlinear modelling, bifurcation theory, and sunspot
equilibrium are applied. In a sunspot equilibrium, stochastic shocks which
do not influence the economic fundamentals lead to economic fluctuations
simply because the economic agents believe them to do so.
Chapter 4 provides a survey of the modern business cycle literature. The
property of economic stability is seen as the main distinguishing character
istic of this literature. Business cycle models that reveal confidence in the
stability of the economy can be divided into three groups: Political Business
cycle models, Monetarist business cycle models, and New-Classical business
cycle models. According to the theory of political business cycles , the be
haviour of the government is the very cause of business cycles. In opportunis
tic models the ruling party tries to manipulate the economy in order to be
reelected. The utility function of the individuals (the voters) depends on the
inflation rate and the rate of unemployment. The government is assumed to
be able to influence these two variables at least in the short run. In partisan
models every party represents a certain clientele and tries to act on behalf
of the people it represents. This is common knowledge in the economy. Cy
cles occur because there is the possibility of a change of government in a
democratic society. Monetarists regard monetary shocks as being responsible
for economic fluctuations. Economic disequilibria are possible in the short
run, whereas in the long run the economy has an inherent tendency to a
full employment equilibrium. Prices and wages react with a time-lag with re
spect to monetary shocks. During the transmission process trade takes place
at 'false' prices. New-Classical macroeconomists interpret economic fluctua
tions as the result of exogenous shocks. Individual agents act rationally at
any time. Early examples of this approach emphasize the significance of mon
etary shocks, whereas, later on, real shocks are regarded as more important.
A microeconomic foundation of the results is regarded as necessary, usually
implemented in the model by analysing the behaviour of a representative
household. Parameter calibrations and simulations of the models are used to
replicate the postulated variances and covariances of national time series.
Within business cycle models in an unstable economic setting it is pos
sible to distinguish between Old-Keynesian models, New-Keynesian models,
and Neo-Walrasian models. Old-Keynesian economists seek to analyse the