Business Cycles notes

8/11/2019 Business Cycles notes

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Questions to Lecture 6 Business cycles

1. Why Great Depression could not be explained by classical theory?During the Great Depression, the classical theory defned economic collapseas simply a lost incentive to produce, and the mass unemployment as a result

o high and rigid real wages. o !eynes, the determination o wages is morecomplicated. "irst, he argued that it is not real but nominal wages that are setin negotiations between employers and wor#ers, as opposed to a barterrelationship. $econd, nominal wage cuts would be di%cult to put into e&ectbecause o laws and wage contracts. "urther, i wages and prices were alling,people would start to expect them to all.

Main problem is that classical economy assumes market clearingthrough price adjustment i.e. if we observe high unemployment, itshould be followed by lowering of wages and consequent decrease inunemployment which didnt happen during Great epression

'. Defne a model business cycle. Why is the economy inherently unstable ( always)uctuating?he business cycle can be defned a short run )uctuations in output and

employment. When recessions happen there is a decline in real GD* or two ormore consecutive +uarter, accompanied with unemployment and when there isdepression any economic downturn where real GD* declines by more than 1-percent, longer and more severe than recession. During recessions not only aremore people unemployed but those who are employed have shorter wor#wee#s,as more wor#ers have to accept part time obs and ewer wor#ers haveopportunity to wor# overtime. he economy is unstable because in the short runthe prices are stic#y. /when prices increase unemployment decreases, and whenprices decrease unemployment increases.0

Depression any economic downturn where real GD* declines by more than1- percent, longer and more severe than recession

Model business cycle! peak recession trough recovery "andconnected changes in income and unemployment#

2. $tate 2 styli3ed acts about business cycles.

4ne is persistence. 5nother regularity is cyclical variability 6et another

regularity is the co7movement.

$o predictable "regular# pattern

i%erent components of output are a%ected unevenly

&symmetries between rises and falls in output

8. Derive the shape o aggregate demand curve rom the +uantity theory o money.


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9: money supply and ;: velocity o money9 and ; determine the nominal value o output *6. When *6 is fxed i * goes up

6 goes down. his is why the aggregate demand curve slopes downward. 5t thesame time supply and demand are another reason or the downward sloping,because the higher the output there is a need or higher real balances and thehigher the real balances the lower the price level is, and the other way around.

t really have in hand so thereore reduction o money tells us that

or any given price level the amount o output is lower and or any given

amount o output the price level is lower thereore this would have an e&ecton the aggregate demand curve by shiting it inward.

'f they pay by card () higher velocity of money "the same *crown+

can be used in more transactions# () at the same level of money

supply and prices we see increasing demand for output & curve

shifts right.

. @ow does the long run aggregate supply curve loo# li#e and what assumption itis based on?


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=t>s a vertical line and it is based on the assumption that the level o output isindependent o money supply, the natural level o output, unemployment is at

its natural rate. he aggregate demand a&ect prices on the vertical aggregatesupply curve but not output.

A. What is the impact o the money supply decrease on the 5$75Dramewor# in

the long run?= the money supply decreases the aggregate demand curve would shit tothe let /or downward0 which in the long run would lower the price level but itwould leave the same output.

B. @ow does the short run aggregate supply curve loo# li#e and what assumption is

it based on?

=t is a hori3ontal line and not vertical because o price stic#iness. =n this case allprices are fxed in the short run thereore i it was put together with the


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aggregate demand curve it would decrease or increase output at a fxed pricelevel.

C. ???AWhat is the impact o the money supply decrease on the 5$75Dramewor# in

the long run?=t is the same +uestion as number seven. ( my mistake, ' mean in theshort run. 'n the short run, decrease in money supply impliesdecrease in aggregate demand at given prices

1-.What do we understand under classical dichotomy? Does it hold in the short run?Does it hold in the long run?

he classical dichotomy helps us determine what will happen with the priceand output in the long run and in the short run without #nowing the level onominal money supply or rate o in)ation. =t would probably not hold in theshort run because prices are stic#y and changes in the aggregate demandcurve only a&ect the output where as in the long run it will hold because

changes in the aggregate demand curve a&ect the price.

11.What is in)ationary gap? What implications does it have on the evolution oprices E unemployment?

=t is the amount by which the real GD* exceeds potential GD*, it is whenthere is too much demand in the economy. his causes the prices to increasei the economy is at ull employment and i it is not than it increases inproduction.

1'.What is recessionary gap? What implications does it have on the evolution oprices E unemployment?

=t is when an economy is operating at below its ull employment e+uilibrium.

=t leads to decreasing the prices in the long run because the real GD* is

currently lower than it is at ull employment.

12.Fxplain the combined short and long run e&ects odecreasein money supply.=n the short run a decrease in money supply causes the aggregate demandcurve to shit downward causing a decrease in the level o output becausethe aggregate supply curve is hori3ontal. =n the long run it would lower theprice level leaving the same output. he long run e+uilibrium contains andintersection combined rom the long run aggregate supply curve and theaggregate demand curve urthermore prices adust in the long run so the

short run aggregate supply curve crosses the same point. o conclude adecrease in money supply shits downward the aggregate demand curvewhich causes a decrease in output in the short run but a&ects only the pricelevel in the long run.7 't would be good to provide a picture

18.Give an example o negativedemand shoc# and positivesupply shoc#.egative demand shoc# decreases demand. When demand decreases, its

price typically decreases because o a shit in the demand curve to the let. "or


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example, taxpayers owe the government less money ater a tax cut, therebyreeing up more money available or personal spending ( H5D example ( actuallytax cut is a positive demand shoc#

5 positive supply shoc# could be technology advancement ma#ing betterproduction causing to increase output. 7 4!

1s a policy that maximi3es national income in order to help reduce

)uctuations in unemployment and in)ation by expanding demand when there

is high unemployment and to cut demand when in)ation raises.

1.What is laisse3 aire policy?=t is that economy will sel adust to optimal position. onintererence in thea&airs o others.=n other words, it means allowing industry to be ree o state intervention,especially restrictions in the orm o tari&s and government monopolies.

1A.What are the tools o fscal policy? @ow do they a&ect aggregate demand?"iscal *olicy reers to the methods employed by the government to

in)uence and monitor the economy by adusting taxes andEor public

spending. =n doing so, the government aims to fnd a balance between

lowering unemployment and reducing the in)ation rate. he main tools o

"iscal *olicy are changes in the composition o taxation and government

spending. he two main instruments o fscal policy are government

expenditure and taxation. Ihanges in the level and composition o taxation

and government spending can impact on the ollowing variables in the

economy aggregate demand and the level o economic activity Governments

use fscal policy to in)uence the level o aggregate demand in the economy,in an e&ort to achieve economic obectives o price stability, ull employment,

and economic growth.

1B.What are the tools o monetary policy? @ow do they a&ect aggregate demand?he monetary policy tools available to achieve these ends increasing interest

rates by fat reducing the monetary base and increasing reserve re+uirements.Wages and prices will begin to rise at aster rates i monetary policy stimulatesaggregate demand enough to push labor and capital mar#ets beyond their long7run capacities. =n act, a monetary policy that persistently attempts to #eepshort7term real rates low will lead eventually to higher in)ation and higher

nominal interest rates, with no permanent increases in the growth o output ordecreases in unemployment. *olicy also a&ects in)ation directly throughpeopleJs expectations about uture in)ation

open market operations.

1C.Which part o the economy is a&ected by supply side policy. What changes to5D75$ ramewor# does it imply.


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ypical policy recommendations o supply7side economics are lower marginaltax rates and less regulation. 9aximum benefts rom taxation policy areachieved by optimi3ing the marginal tax rates to spur growth, although it is acommon misunderstanding that supply side economics is concerned only withtaxation policy when it is about removing barriers to production moregenerally. $upply7side economists have less to say on the e&ects o defcits,

and sometimes cite Kobert Harro>s wor# that states that rational economicactors will buy bonds in su%cient +uantities to reduce long term interestrates. Iritics argue that standard exchange rate theory would predict,instead, a devaluation o the currency o the nation running the high budgetdefcit, and eventual Lcrowding outL o private investment..

'-.@ow does the trade policy a&ect the aggregate demand?

rade policy a&ects both 5ggregate Demand and 5ggregate $upply, and ita&ects other countries. "or example, tari&s will increase domestic 5ggregateDemand /diverting purchases away rom imports0 and decrease domestic5ggregate $upply /due to the higher cost o imported resources0 in theeconomy imposing the tari&s. ari&s have the opposite e&ect in the country

against which the tari&s are levied.

'1.=n case o positive demand shoc#, describe the optimal government response/thin# about monetary policy0.

5 positive demand shoc# increases demandhe case or monetary policy does not rely on it being ast to react relativeprices, rational expectations imply that anticipated Government policy canhelp clear current mar#ets. While rationality o expectations strengthens thecase or monetary policy it may wea#en the argument or increased price)exibility as a method o dealing with shoc#s,Muic# monetary policy aimed at ull employment is shown a slow response.Hoth give ull employment but a slow response re+uires the imposition o a

higher in)ation tax. While +uic# monetary policy is better than a slowresponse there is a case against instantaneous response to shoc#s. = ullemployment is guaranteed costless by government the wage and the pricelevel become indeterminate. Guaranteeing ull employment by means o anin)ation tax gives an incentive or wage and price setters to minimi3e theneed or government intervention.

-o sum up in case of positive & shock, economy is producing morethan natural level of output and prices are going up. &ppropriateresponse is therefore decrease in money supply, which should shifteconomy back to natural rate of output.

''.Why we cannot ully evaluate the fnal e&ect o governmental policies?@ow doyou understand the NmultiplicatorO e&ect?

=n economics, the multiplier e&ect or spending multiplier is the idea that aninitial amount o spending /usually by the government0 leads to increasedconsumption spending and so results in an increase in national income greaterthan the initial amount o spending. =n other words, an initial change in


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aggregate demand causes a change in aggregate output or the economy that isa multiple o the initial change.he multiplier may vary across countries, and will also vary depending on whatmeasures o money are considered. "or example, consider 9' as a measure othe P.$. money supply, and 9- as a measure o the P.$. monetary base. = a Q1increase in 9- by the "ederal Keserve causes 9' to increase by Q1-, then the

money multiplier is 1-.

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