13-14

Question 1

business cycles def

Answer 1

the business cycle is the fluctuations of output around its trend

Question 2

product function is

Answer 2

a long-run model of output

Question 3

output above trend

Answer 3

boom phase of business cycle

Question 4

output significantly below trend

Answer 4

recession

Question 5

how is the business cycle measured?

Answer 5

only by observing the GDP not its long-run trend

Question 6

simple definition of recession of an economy

Answer 6

an economy is in recession if it experiences two consecutive quarters of negative growth

Question 7

growth recession

Answer 7

when the economy keeps growing, but growth is lower than the long-run trend

Question 8

depression

Answer 8

no precise definition, used to refer to a particularly bad and long-lasting recession

Question 9

how to measure the output gap

Answer 9

1. estimate trend (normal times)
   - business cycle = actual GDP - trend (absolute measure)
   - output gap = actual GDP / trend (% deviation)
2. estimate a production function
3. use business surveys on capacity utilization

Question 10

4 business cycles facts

Answer 10

1. employment, consumption and investment are procyclical variables (they rise when GDP rises and vice versa)
2. unemployment is countercyclical (it rises when GDP falls and vice versa)
3. Expansions are longer than recessions; recessions are sharper than expansions
4. cycles are correlated across sectors, regions and countries

Question 11

Okun’s Law

Answer 11

when output falls, unemployment rises (2% output fall below trend –> 1% increase in unemployment)

Question 12

Robert Lucas argument if business cycles are bad

Answer 12

• gains from increasing long-run growth are enormous
• gains from stabilizing business cycles are relatively small

motivation: aggregate consumption does not change much in recessions

but changes are very heterogeneous (across households and sectors)

=> the economy does not suffer much but somebody does

Question 13

who is most influenced by the business cycle during a recession?

Answer 13

under 20 and above 46

unskilled manual

Question 14

Distribution of impact of recession

Answer 14

• mostly fine for majority
• but sizable group of the population is badly hurt –> 1% of population suffers more than 10% consumption loss
• also, impact seems to be highest among the poorest

Question 15

potential good out of recessions

Answer 15

• in booms, firms do not want to reorganize or change productive processes - it is too costly not to produce
• recessions can act as a pit stop to increase efficiency

Question 16

Frisch-Slutsky Paradigm / Business cycle paradigm

Answer 16

idea: economy is subject to shocks = external impulses that affect the economy

• shocks create business cycles by affecting the economy through a propagation mechanism

Question 17

examples of shocks affecting economies

Answer 17

• productivity shocks
• shifts in preferences
• changes in policy
• terms of trade shocks

Question 18

how do shocks propagate?

Answer 18

1. real business cycle theory
   - business cycles are the efficient response of markets to the shocks that affected the economy
2. keynesian theory
   - markets malfunction and the government should intervene to stabilize economy

Question 19

real business cycle (RBC) theory

Answer 19

• business cycles are driven by changes in aggregate supply
• changes in TFP, changes in production costs
• idea: profit-maximizing decisions of firms and consumers respond to changes in TFP
• better TFP: firms want to hire more K and L, interest rates and wages rise, people consume more
• economy needs to be flexible: AS is verticl prices move fast; AD is downward slopping –> higher prices –> lower demand

thus, propagation mechanism is actually the efficient response of agents to mutated conditions in the market

Question 20

Keynesian Viewpoint

Answer 20

• business cycles are driven by changes in aggregate demand
• questions whether markets actually work well during recessions
• argued that prices might not be able to adjust that quickly –> tend not to adjust downwards
• when prices do not adjust –> quantities have to move more because the market does not adjust
• sharp recessions and a potential role for governments

Question 21

Keynesian viewpoint: market functions badly

Answer 21

• slow price adjustment
  -wage rigidities
• imperfect competition
• flaws in credit markets and banking sector

Question 22

keynesian view of aggregate supply

Answer 22

• less vertical in the short run (but still vertical in the log run)
• firms may find it optimal to raise their production with a rise in the sales price
• hence in the short un, the level of prices affects output

Question 23

In the short run…

Answer 23

demand determines output –> Keynesian model

Question 24

in the long run…

Answer 24

supply determines output –> RBC model

Question 25

from short run to long run

Answer 25

• as long as economy operates below capacity (recession) we can stimulate demand to raise output
• government: increase spending, lower taxes
  central bank: lower nominal interest rate

Question 26

combining short run and long run

Answer 26

• works at capacity, demand stimuli only raise prices
• we need to raise aggregate supply to raise output
  (technology, human capital, institutions)