If you imagine that the business cycle, or periods of economic growth, followed by economic contraction, could be modeled by the motion of a rocking horse1, the motion needs to start somehow. Say, a child is hitting it with a stick. Then if the child only hits once the rocking horse will move back and forth and then eventually stop. If the child hits the horse multiple times it will continue to rock back and forth, maybe sometimes with larger, sometimes smaller, swings to and fro like we observe in the business cycle.
You can measure the position of the tip of the tail, which over the course of the rocking might vary more than the base of the tail, or you can measure the position of the top of the head, which moves in the opposite direction of the tail. These variables could be analogous to something like consumption and investment, which increase during periods of expansion, and investment is more volatile than consumption. Or it could be something like unemployment, which is countercyclical and increases during periods of recession.
If the economy and business cycle is modeled by the horse rocking, then what is the child hitting the horse? Economists call these “shocks” to the economy. Where for some reason something happened to set in motion the economic expansion and contraction that follows. The shocks could in principle be to anything (like government spending, consumption, labor supply, etc.) but a large amount of literature is dedicated one type of shock called “total factor productivity.”
This productivity term typically includes advancements in technology, as a new technology typically leads to you becoming more productive.
For example when the wheel was invented it made it a lot easier to transport materials, or when the internet was invented it became a lot easier to communicate and transport information.
These productivity shocks are treated as exogenous to the model of the rocking horse, that is, they are given from an outside source (the child hitting with a stick) rather than from something internal such as the horse starting up on its own.
This model makes sense, a shock comes along (say computers and the internet), and all of a sudden firms are able to make more output. A higher capacity for output translates to a higher marginal product of capital, which means that the quantity of labor demanded is higher. More labor demanded means that there are higher wages and higher incomes for people, which in turn causes them to either spend less time working or spend more on consuming goods, which fits into the higher output of goods supplied. All is good.
But say some of these things operate on a lag, and firms hire too many workers, aren’t able to cover their expenses, and have to start laying off workers, producing less, and wages fall and the economy enters a recession. The rocking horse swings back the other way until eventually it loses its momentum, air resistance takes over and eventually the horse stops.
The impact of the shock here on consumption, investment, and output can be modeled using actual data via something called a VAR model2, and graphed using an impulse response function.
You can see that on the top left, center middle, and bottom right graphs there is a shock at time period 0, and the rest of the variables are moving in response to this shock throughout time. Towards the end of the time period however each variable returns back to its original level (0), or, the graph is not pictured long enough for the level to return to 0.
I like this analogy, but what doesn’t make sense to me is that these productivity shocks are treated as exogenous. Why doesn’t the shock to technology depend on the current state of the economy? Maybe this worked during periods of low economic activity since it would be too small to make a difference, but at the economic state at the time of this writing it makes sense to me that technological progress depends on the economic outlook.
With an aggressive interest rate policy over the last 6 months and ensuing mass layoffs from many tech firms, (13% reduction at Meta, 3% at Amazon, as well as obviously Twitter but also recently Doordash and Kraken which is a crypto firm) it seems that the discounted cash flow calculations have caused tech companies to be simply valued less.
While these companies are struggling to cover their expenses (hence the layoffs) I would guess that the first thing they would do is stop long term investments in technology, and try to find ways to generate cash now. These long term projects are put on the shelf, and so the productivity shock of new technology waits until the company can recover from the period of rising interest rates.
This doesn’t sound very exogenous to me!
One way to fix it would be to restrict when a positive technology shock could occur, say, the child is standing far enough away that they can only hit when the horse swings back close to them.
Or instead, if the shocks weren’t generated exogenously but rather endogenously, say, if the rocker was powered by an electric motor that only created motion when the horse was exposed to sunlight when it was rocking forward- or something along these lines, it might be better to describe the business cycle. This doesn’t mean however that the child isn’t there to amplify shocks, there might still be shocks to other things like demand which caused a huge recession during the start of the pandemic.
One thing I’ve learned as an engineer is that if you want a new piece of analysis, a new invention, or a new product, you just have to spend time working on it. Now, the implementation of that product might be ahead of its time, but the more time you spend working the more likely you will get your engineered solution.
A good example of this is Operation Warp Speed for the Covid vaccine. This was a huge success and brought a viable vaccine to market in record time. I suspect the reason is because there was a lot of time and effort spent working on not only the vaccines themselves, but the process for development and testing. If engineers at these tech companies aren’t working on new and innovative ideas, it would be hard for me to expect a new technology to just appear exogenously.
Now, this doesn’t necessarily mean we should cut interest rates. Technology shocks aren’t the end all be all, and if inflation is too high then either supply needs to increase or demand decrease so that prices do not spiral out of control. In this case the central bank is trying to decrease demand, and swing the horse in the opposite direction, without giving it too much of a push to make it topple over on the other side.
The rocking horse analogy was developed by Ragnar Frisch in 1933 in a chapter titled “Propagation problems and impulse problems in dynamic economics”
I used a VAR in my master’s thesis regarding uncertainty and consumer confidence. Check it out here: https://frank-gentile.github.io/.github.io/Gentile_disseration.pdf