Economic Transactions Govern Business Cycles

Olkhov, Victor (2018): Economic Transactions Govern Business Cycles.

Abstract

This paper presents the business cycle model based on treatment of economic agents as simple units of macroeconomics. Agents (banks, corporations, households, etc.) have numerous economic and financial variables like Assets, Credits, Debts, Consumption, etc. Agents perform economic and financial transactions with other agents. All agents are at risk but not for all agents risk assessments are performed now. Let’s propose that risk assessment can be made for all agents and let’s use agents risk ratings x as their coordinates. Agents coordinates for n risks define n-dimensional economic space. Economic and financial transactions between agents describe evolution of their economic and financial variables. Aggregations of economic or financial variables of agents in a unit volume at point x determine macro variables as functions of x. Aggregations of transactions between agents in unit volumes at points x and y determine macro transactions as functions of x and y. Macro transactions describe rate of change of macro variables at points x and y. We derive economic equations that describe evolution of macro transactions. We show that business cycle fluctuations are consequence of these equations. We argue that business cycle fluctuations of particular macro variable can be treated as oscillations of “mean risk coordinates” of this economic variable. As example we study the business cycle determined by model interactions between transactions CL(t,x,y) that provide Loans from Creditors at point x to Borrowers at point y and transactions LR(t,x,y) that describe repayments from Borrowers at point y to Creditors at point x. Starting with economic equations we derive the system of ordinary differential equations that describe the business cycle fluctuations of macro Credits C(t) and macro Loan-Repayments LR(t) of the entire economics.

• Item Type: MPRA Paper
• Language: English
• Keywords: Business cycle; Economic Transactions; Risk Assessment; Economic Space
• Subjects: C - Mathematical and Quantitative Methods > C0 - General > C02 - Mathematical Methods; E - Macroeconomics and Monetary Economics > E0 - General > E00 - General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F44 - International Business Cycles; G - Financial Economics > G0 - General > G00 - General

References

Alvarez. F. Jermann, U.J., 1999. Efficiency, Equilibrium, and Asset Pricing with Risk of Default. Econometrica, 68:775–797. doi:10.1111/1468-0262.00137

Arrow, K.J. and Debreu, G., 1954. Existence of an Equilibrium for a Competitive Economy. Econometrica, 22: 265-290.

Arrow, K.J., 1974. General Economic Equilibrium: Purpose, Analytic Techniques, Collective Choice. Am. Economic Rev., 64, (3): 253-27.

Baker, A., 2007. Occam’s Razor in science: a case study from biogeography. Biology and Philosophy, 22: 193–215.

Bilbiie, F.O., Ghironi, F., and Melitz, M.J., 2012. Endogenous Entry, Product Variety, and Business Cycles. Journal of Political Economy, 120, (2): 304-345

BIS, 2014. Foundations of the standardised approach for measuring counterparty credit risk exposures. Bank for International Settlements, WP 26

Bollerslev, T. and Zhang B.Y.B., 2003. Measuring and modeling systematic risk in factor pricing models using high-frequency data. Journal of Empirical Finance 10: 533– 558

Bordalo, P., Gennaioli, N., Shleifer, A., 2017. Diagnostic Expectations and Credit Cycles. Journal of Finance, Forthcoming

Brunnermeier, M.K., Parker, J.A., 2005. Optimal Expectations. American Economic Review, 95 (4), 1092-1118

Campbell, J.Y., 2016. Restoring Rational Choice: The Challenge of Consumer Financial Regulation, American Economic Review, 106 (5): 1–30

Cardenete, M.A., Guerra, A.I., Sancho, F., 2012. Applied General Equilibrium. An Introduction. Springer-Verlag Berlin

Chane-Kon, L., Neugebauer, M., Pak, A., Trebach, K., Tsang, E., 2010. Structured Finance. Global Rating Criteria for Structured Finance CDOs, Fitch Ratings, 1-27

Christiano, L., Motto, R., Rostagno, M., 2013. Risk Shocks. NBER WP18682. Cambridge, MA. http://www.nber.org/papers/w18682

Del Negro, M. et.al., 2013. The FRB NY DSGE Model. FRB of New York, Staff Rep. 647

Diebold, F.X. and Rudebusch, G.D. (1999) Business Cycles Durations, Dynamics, and Forecasting. Princeton Univ.Press.

Diebold, F.X. (Ed), 2012. Financial Risk Measurement and Management. International Library of Critical Writings in Economics. Edward Elgar Publishing Ltd.

Diebold, F.X. and Yilmaz, K., 2013. Measuring the Dynamics of Global Business Cycle Connectedness, PIER WP 13-070, Penn Inst. for Economic Research, Univ. Pennsylvania.

Dotsey, M. and King, R.G., 1988. Rational Expectations Business Cycle Models: A Survey. FRB Richmond, March/April, 3-15

Engle, R., 2017. Systemic Risk With Endogenous Cycles. Conf. “Banks, Systemic Risk, Measurement and Mitigation”, Sapienza Univ., Rome.

Farmer, R.E.A., Woodford, M., 1997. Self-Fulfilling Prophecies And The Business Cycle Macroeconomic Dynamics, 1, 740–769.

Fox, D.R., et.al, 2014. Concepts and Methods of the U.S. National Income and Product Accounts. BEA US DoC, 1-373.

Gintis, H., 2007. The Dynamics Of General Equilibrium. The Economic Journal, 117, 1280–1309.

Grandmont, J.M., 1985. On Endogenous Competitive Business Cycles. Econometrica, 53 (5) 995-1045

Greenwood, R., Shleifer, A., 2014. Expectations of Returns and Expected Returns. The Review of Financial Studies, 27 (3), 714–746

Grossman, H.I., 1980. Rational Expectations, Business Cycles, and Government Behavior. in “Rational Expectations and Economic Policy” Ed. Fischer, S. NBER, Chicago. http://www.nber.org/books/fisc80-1

Growiec, J., McAdam, P., Mućk, J., 2015. Endogenous labor share cycles: theory and evidence. European Central Bank, WP 1765.

Gupton, G.M., Finger, C.C., Bhatia, M., 1997. CreditMetrics™– Technical Document. J.P. Morgan & Co. Incorporated. NY.

Hayek, F.A. von., 1933. Monetary Theory and the Trade Cycle. London, Jonathan Cape.

Huang, X., Zhou, H., 2009. A Framework for Assessing the Systemic Risk of Major Financial Institutions, Finance&Economics Discussion Series, FRB, Washington, D.C.

Huggett, M., 2017. Business Cycles: Facts and Theory. Lecture 8. Economics Department, Georgetown University, Washington DC., 2017, http://faculty.georgetown.edu/mh5/class/econ102/

Jaimovich, N., Rebelo, S., 2007. Behavioral Theories Of The Business Cycle. Journal of the European Economic Association, 5(2–3), 361–368

Jorda, O., Schularick, M., Taylor, A.M., 2016. Macrofinancial History and the New Business Cycle Facts. FRB San Francisco, WP 2016-23

Kiyotaki, N., 2011. A Perspective on Modern Business Cycle Theory. Economic Quarterly, 97, (3), 195–208

Kraemer, N., Vazza, D., 2012. 2011 Annual U.S. Corporate Default Study And Rating Transitions, S&P: 1-96

Kydland, F., Prescott, E.C., 1980. A Competitive Theory of Fluctuations and the Feasibility and Desirability of Stabilization Policy, 169 – 198 in Ed. Fisher, S., Rational Expectations and Economic Policy, NBER, Univ. Chicago Press

Kydland, F.E. and Prescott, E.C., 1982. Time to Build and Aggregate Fluctuations. Econometrica, 50, (6): 1345-1370

Kydland, F.E. and Prescott, E.C., 1991. The Econometrics of the General Equilibrium Approach to Business Cycles. Scand. J. of Economics 93(2): 161-178,

Landau, L.D. and Lifshitz, E.M., 1981. Physical kinetics. NY: Pergamon Press Ltd

Landau, L.D. and Lifshitz, E.M., 1987. Fluid Mechanics, NY: Pergamon Press Ltd

Leontief, W., 1973. Structure Of The World Economy. Outline of a Simple Input-Output Formulation, Nobel Memorial Lecture, Harvard University, Massachusetts, USA

Lucas, R.E., 1972. Expectations and the Neutrality of Money. Jour. of Economic Theory 4, 103-124

Lucas, R.E., 1975. An Equilibrium Model of Business Cycle. Jour. Political Economy, 83: 1113-1144.

Lucas, R.E., 1980. Methods and Problems in Business Cycle Theory, Jour.of Money, Credit and Banking, 12, (4) Part 2: Rational Expectations, 696-715

Lucas, R.E., 1995. Understanding Business Cycles, in Estrin, S and A. Marin (ed.), Essential Readings in Economics, pp. 306-327. Macmillan

Manski, C.F., 2017. Survey Measurement Of Probabilistic Macroeconomic Expectations: Progress and Promise. NBER Macro Annual Conference, 1-76

Mendoza, E.G. and Yue, V.Z., 2012. A General Equilibrium model Of Sovereign Default And Business Cycles. Quart. Jour. Economics, 127, 889–946. https://doi.org/10.1093/qje/qjs009

Metz, A. and Cantor, R., 2007. Introducing Moody's Credit Transition Model, Moody’s Investor Service, 1-26

Mitchell, W.C., 1927. Business Cycles: The Problem and Its Setting. NBER, pp. 519 Morgenstern, O., 1959. International Financial Transactions and Business Cycles, NBER, Princeton University Press, pp. 591

Mullineux, A.D. and Dickinson, D.G., 1992. Equilibrium Business Cycles: Theory and Evidence. Journal of Economic Surveys, 6(4): 321-58

Muth, J.F., 1961. Rational Expectations and the Theory of Price Movements. Econometrica, 29 (3), 315-335

Nicolò, G.D. and Lucchetta, M., 2011. Systemic Risks And The Macroeconomy, WP 16998, NBER, Cambridge, MA http://www.nber.org/papers/w16998

Ohanian, L.E., Prescott, E.C., Stokey, N.L., 2009. Introduction to dynamic general equilibrium. Journal of Economic Theory, 144, 2235–2246

Olkhov, V., 2016a. On Economic space Notion, International Review of Financial Analysis, 47, 372-381

Olkhov, V., 2016b. Finance, Risk and Economic space, ACRN Oxford J. of Finance and Risk Perspectives, Special Issue of Finance Risk and Accounting Perspectives, 5: 209-221

Olkhov, V., 2017a. Quantitative Wave Model of Macro-Finance. International Review of Financial Analysis, 50, 143-150

Olkhov, V., 2017b. Quantitative Description of Financial Transactions and Risks” ACRN Oxford Journal of Finance and Risk Perspectives 6 (2): 41-54

Olkhov, V., 2017c. Credit-Loans Non-Local Transactions and Surface-Like Waves. https://ssrn.com/abstract=2971417

Olkhov, V., 2017d. Business Cycles: Derivation of Equations for Aggregate Fluctuations, Mean Risks and Mean Square Risks. https://ssrn.com/abstract=3030074

Olkhov, V., 2017e. Business Cycle Equations. https://ssrn.com/abstract=3034935

Pesaran, M.H., Schuermann, T., Treutler, B.J., 2007. Global Business Cycles and Credit Risk. in The Risks of Financial Institutions (Ed) Carey, M. and Stulz, R.M. NBER, Chicago.

Plosser, C.I., 1989. Understanding Real Business Cycles, J. Economic Perspectives, 3 (3), 51–77

Rebelo, S., 2005. Real Business Cycle Models: Past, Present, And Future, NBER, WP 11401, Cambridge, MA

Resibois, P., De Leener, M., 1977. Classical Kinetic Theory of Fluids. John Wiley, NY

Richter, M., Rubinstein, A., 2015. Back to Fundamentals: Equilibrium in Abstract Economies, American Economic Review, 105 (8), 2570–2594

Schmitt-Grohé, S. and Uribe, M., 2012. What’s News In Business Cycles, Econometrica, 80, (6), 2733–2764

Schumpeter, J.A., 1939. Business Cycles. A Theoretical, Historical and Statistical Analysis of the Capitalist Process. NY McGraw-Hill Book Company

Simon, H. A., 1959. Theories of decision-making and behavioral science. The American Economic Review, 49, 253–283

Skoglund, J., Chen, W., 2015. Financial Risk Management: Applications in Market, Credit, Asset and Liability Management, and Firmwide Risk, J.Wiley Sons Inc., US

Smithies, A., 1957. Economic Fluctuations and Growth, Econometrica, 25, (1), 1-52 Starr, R.M., 2011. General Equilibrium Theory, An Introduction, Cam. Univ. NY

Strauss, W.A., 2008. Partial Differential Equations. An Introduction. John Wiley&Sons, Inc., NJ, US. p.179

Tallarini, T.D., 2000. Risk-sensitive real business cycles. J. Monetary Economics 45, 507-532

Taylor, J.B., 1984. Rational Expectations and the Business Cycle. Annual Meeting, National Association of Business Economists, Atlanta

Tesfatsion, L. and Judd, K., 2005. (Eds.). Handbook of computational economics. Agent-Based Computational Economics, Vol. 2. North-Holland: Elsevier

Thaler, R.H., 2016. Behavioral Economics: Past, Present, and Future. American Economic Review, 106 (7), 1577–1600

Tinbergen, J., 1935. Annual Survey: Suggestions on Quantitative Business Cycle Theory, Econometrica, 3 (3), 241-308

Zarnowitz, V., 1992. Business Cycles: Theory, History, Indicators, and Forecasting. NBER.