Real business cycles and learning the value of major technological changes

The true value of any technological improvement is uncertain. Investors adopt a new technology after forecasting the likely productivity of the new technology. Investor learning in the face of imperfect information about the true value of major new technologies can also lead to business cycle fluctuations (Li 2007).

As a new technology slowly diffuses, entrepreneurs learn more about the true potential of the new technology and re-evaluate in hindsight whether they have invested beyond the optimal amount. If entrepreneurs have not over-invested, they revise their beliefs about the magnitude of the innovation and invest more.

Because the agents have to learn the magnitude of the technology shock, they are cautious in making investment decisions before they have learned much about the underlying technology. Consequently, GDP growth is gradual, which stretches out the length of booms.

When entrepreneurs later find that investment has over-shot the optimal amount, they reduce investment demand perhaps sharply and start a recession (Li 2007). This eventuality may seed a recession within many major technology advances such as the IT boom in the 1990s and the computer revolution in the 1970s.

The true value of the major technological improvement is  often discovered only after investment over-shoots the optimal level (Li 2007). A general technological innovation affecting many industries is required for the cluster of entrepreneurial errors about the true magnitude of the productivity increase to seed a recession (Li 2007).

The 2001 US recession followed a long boom involving major new information and communication technologies that raised the productivity of many existing technologies. The information, communications and software boom lasted over a decade in the US (Li 2007).

Entrepreneurs invested gradually in new information and communication capital to learn more about the underlying technologies that they embodied. These new information and communication technologies were productivity improvements of a major but uncertain scope (Li 2007).

The eventual productivity gains come from two complex sources – both from adopting the new technology itself and from its interface with existing capital and expertise. Because both productivity gains must be forecasted and because both are discovered only by experimentation and learning by doing, it is entirely possible that entrepreneurs can invest ahead of consumer demand.

This surplus capacity will emerge despite the best efforts of investors to mitigate this risk by staggering investments to learn more about the true value of the new technology. This investor caution and staggering to allow for more learning is an important factor that stretches out the length of investment booms in major new technologies (Li 2007).

There was a sharp decline in US investment in 2001, with large accumulations of unused capital in some sectors. For example, 90% of the optical fibre laid in the US in the 1990s was unused in the years that followed. Entrepreneurs discovered the optimum investment level in, for example, optical cable fibre by investing past it and revised plans for further investments in light of this over-shooting (Li 2007).

Real business cycles of a significant magnitude can emerge simply from technological learning.

Li (2007) argued that many investment booms start with the advent of a revolutionary technology and ended with overinvestment. For example, canal building boomed after the invention of the steamboat, and by the year 1860 more than 4,000 miles of canal had been completed. However, many of these canals did  not live up to the expectations of their promoters. Many of these projects eventually turned out to be financial failures.

Later in the same century, the railroad expansion shared a similar fate. Thousands of miles of railroad were built and left unused or under used, a phenomenon described by Schumpeter (1949) as construction “ahead of demand.”

That real business cycle theory required technological regress for there to be recessions is one of its oldest criticisms. That criticism that standard equilibrium business cycle models have difficulties in predicting the investment boom and overshooting grows weaker by the day.

Li presents a strong internal propagation mechanism with respect to technology shocks and endogenous recessions without invoking technological regress:

…firms invest in new capital to take advantage of the IT revolution, without knowing the limit to which this new technology can increase productivity.

The belief of this limit becomes increasingly optimistic over time as investors repeatedly realize that they have not invested enough to exhaust the potential of the new technology.  Such belief revisions lead to increasingly aggressive investment and a capital overhang, followed by a recession.

The shape of recoveries from recessions

Milton Friedman (1993) proposed a model of the depth of recessions and steepness of recoveries built on two empirical regularities:

  • output is on average below a ceiling defined by supply capacity and tends back to this ceiling; and
  • large contractions are followed by large expansions and mild contractions are followed by mild expansions.

The strength of a recovery should be positively correlated with depth of the recession but there should be no correlation between expansions and recessions (Friedman 1993; Alchian 1969).

The figure below illustrates Friedman’s model, which likens the time path of output to a string on the underside of an upward sloping board that is plucked downward at random intervals to various extents into busts that are followed by booms.

Source: Garrison (1996).

The upward sloping board plotted as a thick line in the figure represents a ceiling on feasible output and employment in a given year that is set by resource and technology availabilities. The upward slope of this board accounts for trend real GDP growth over time due to technological progress and other factors.

The business cycle starts with a bust caused by an adverse policy or other shock and is then followed by a boom as the market self-adjusts and the policy errors are reversed. Without the initial adverse policy or other shock, there would neither be a bust nor a boom.

The correlation between busts and booms arises from the monetary contraction that caused the bust eventually inducing an offsetting correction in monetary policy.

The monetary contraction that pushed or plucked output below the upward sloping ceiling is later followed by a monetary expansion that offset the earlier contraction. With the amplitude of monetary expansions correlated to offset the prior contractions, GDP growth will have similar plucks or falls and rebounds to the upward sloping output ceiling because of the link albeit with a lag between monetary growth and output fluctuations. The increases and decreases in monetary growth are independent policy choices with unique causes.

The associated upward and downward movements in GDP growth are not correlated with each other but should be correlated with the prior fluctuations in monetary growth. There would not be a bust and later boom if there is no monetary contraction to start the cycle. This is why Friedman (1993) proposed that the depths of busts are unrelated to the duration and strength of prior economic booms.

BooksIcon.com

Reading lists

Climate Audit

by Steve McIntyre

New Discourses

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Green Jihad

Your source that tells the truth about the environmentalist movement's holy war against mankind

New Historical Express

(Formerly Hatful of History)

Bowalley Road

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

History of Sorts

WORLD WAR 2,EIGHTIES,MUSIC,HISTORY,HOLOCAUST

Notes On Liberty

Spontaneous thoughts on a humble creed

Tudor Chronicles

News, reviews and talk all about the Tudors

The Logical Place

Tim Harding's writings on rationality, informal logic and skepticism

Karl du Fresne

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Great Books Guy

Reading The Classics

Velvet Glove, Iron Fist

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

@STILLTish. Gender Abolition

Examining Gender Identity ideology and its impact on Women's Sex based rights and Gay Rights. d protections. Exploring how this has taken such firm root in Western societies (Cognitive & Regulatory Capture).

200-Proof Liberals

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

What Paul Gregory is Writing About

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Kids Prefer Cheese

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Offsetting Behaviour

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

JONATHAN TURLEY

Res ipsa loquitur - The thing itself speaks

Adventures of a Tudor Nerd

Exploring the 16th Century and Beyond

Weapons and Warfare

History and Hardware of Warfare

Conversable Economist

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Barrie Saunders

Thoughts on public policy and the media

The Victorian Commons

Researching the House of Commons, 1832-1868

Coyote Blog

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

The History of Parliament

Blogging on parliament, politics and people, from the History of Parliament

Catallaxy Files

Australia's leading libertarian and centre-right blog

Books & Boots

reflections on books and art

Legal History Miscellany

Posts on the History of Law, Crime, and Justice

Sex, Drugs and Economics

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Vincent Geloso

Economics, History, Lots of Data and French Stuff

Climatism

Tracking Anthropogenic Climate Alarmism

Point of Order

Politics and the economy

FREEcology

Libertarian environmentalism

Doc's Books

A window into Doc Freiberger's library

Newmark's Door

Celebrating humanity's flourishing through the spread of capitalism and the rule of law

Media Myth Alert

Calling out media myths

Uneasy Money

Commentary on monetary policy in the spirit of R. G. Hawtrey

European Royal History

Exploring the History of European Royalty

Tallbloke's Talkshop

Cutting edge science you can dice with

Marginal REVOLUTION

Small Steps Toward A Much Better World

%d bloggers like this: