4 Fluctuations & Stimulus

Question 1

Productivity

Answer 1

A measure of how efficiently inputs like labor and capital are used to produce outputs, often calculated as output per worker or per hour worked. Productivity grows through investments in technology, education, and infrastructure, but can decline due to ageing populations, underinvestment, or economic disruptions

Question 2

Recession

Answer 2

A significant decline in economic activity, often defined as two consecutive quarters of negative GDP growth.

Characterized by falling GDP, rising unemployment, and reduced investment. Recessions occur when aggregate demand (AD) falls below aggregate supply (AS), leading to unused resources and idle labour

Question 3

Inflation

Answer 3

persistent increase in the general price level, reducing purchasing power and potentially destabilizing economic growth

Question 4

Stagflation

Answer 4

Economy experiences stagnant growth, high unemployment, and high inflation simultaneously. Stagation is particularly challenging for policymakers because traditional measures to reduce inflation (e.g., raising interest rates) can exacerbate unemployment and slow growth further. Big example: Argentina.

Question 5

Fiscal policy

Answer 5

Uses tax incentives (supply-side) and government spending (demand-side) to stimulate the economy by facilitating investment

Expansionary: Increases spending or reduces taxes to stimulate demand during recessions.
Contractionary (Austerity): reduce spending/raise taxes to control inflation

Question 6

Monetary policy

Answer 6

Central bank actions to manage money supply and interest rates to achieve macroeconomic stability (expansionary vs contractionary)

Uses the relationship between interest rate, investment and output for economic recovery

Question 7

Policy rate

Answer 7

interest rate set by the central bank to influence the economy. For example, the Federal Reserve’s federal funds rate or the European Central Bank’s refinancing rate determines borrowing costs for commercial banks and indirectly impacts overall economic activity

Question 8

Marginal Propensity to Consume (MPC)

Answer 8

The fraction of additional income that households spend on consumption rather than saving. For example, if MPC is 0.8, households spend 80 cents of every additional dollar earned

Question 9

Multiplier effect

Answer 9

Amplified change in GDP resulting from initial change in spending or taxation.

Multiplier = 1 / (1-MPC)

Multiplier process: mechanism through which the changes in spending affect aggregate output

Question 10

Zero lower bound

Answer 10

where nominal interest rates are at or near zero, limiting the central bank’s ability to stimulate the economy using traditional rate cuts

Question 11

Quantitative easing (QE)

Answer 11

unconventional monetary policy where the central bank purchases financial assets (usually government bonds) to inject liquidity into the economy.

Question 12

Aggregate demand/supply

Answer 12

Total demand/ supply for goods and services in an economy at a given price level

Demand: signals an overall appetite for spending (Y = C + I + G + X − M)

Question 13

Automatic stabilizers

Answer 13

Economic policies or programmes that counteract fluctuations in the economy without additional government intervention.

Eg. unemployment benefits (which increase during downturns) and progressive taxation (which collects more revenue during booms)

Question 14

Consumption smoothing

Answer 14

Households usually maintain stable consumption levels over time even when income fluctuates eg. saving during high-income period and spend during low-income to stabilise consumption

Question 15

Supply vs demand-side crises

Answer 15

A supply-side crisis occurs when production capacity is reduced due to factors like supply chain disruptions or increased input costs (e.g., oil shocks). A demand-side crisis results from a decrease in aggregate demand, such as reduced consumer spending or investment during a recession

Question 16

Inflationary boom

Answer 16

Rising prices, eroding purchasing power, and overheating the economy.
Excessive AD relative to AS pushes prices upward and creates inflationary pressure.

Question 17

Monetary policy and transmission mechanism

Answer 17

transmission mechanism describes how changes in the policy rate affect borrowing, spending, and investment.

Eg. lowering interest rates reduces borrowing costs, encouraging businesses to invest and households to spend more, thereby boosting AD. BUT at the ZLB, the effectiveness of rate cuts diminishes, and central banks may resort to QE to ensure liquidity

Transmission mechanisms
1. Market interest rate
2. Asset prices
3. Expectations
4. Exchange rate

Question 18

Pareto efficiency

Answer 18

A state where no individual can be made better off without making someone else worse off

eg. in labour market, efficiency requires wages to reflect workers’ marginal productivity

Question 19

Effects of fiscal stimulus (AD-AS)

Answer 19

Expansionary fiscal policy shifts the AD curve rightward, increasing output (GDP) and price levels. This raises employment but may lead to inflationary pressures if the economy is near full capacity.

Question 20

Supply or demand shock

Answer 20

unanticipated shock to the demand/ supply side of the economy that affects production

Eg. energy prices, discovery of the internet, technological innovations to production processes
OR increase in online grocery shopping post-pandemic or war/pandemic which decreases AS

Question 21

How does the private sector stabilise/amplify shocks?

Answer 21

Stabilise: consumption smoothing
Amplify: credit constraints, rising value of collateral

Question 22

How does the government stabilise/amplify shocks?

Answer 22

Stablise: automatic stabilisers eg. taxes on corporate benefits during boom/ welfare benefits, also fiscal/monetary stimulus
Amplify: limit autonomatic stabilisers

Question 23

Consequences of high debt

Answer 23

1. rise in borrowing cost, decreased investment and decreased growth
2. inflationary pressure - inflation makes it easier for governments to service debt obligation (seigniorage)
3. decreased confidence in economy and ability of government to pay back debt
4. increased uncertainty in economy, perhaps hurting exchange rate and preventing the government from further borrowing

Question 24

Ricardian equivalence

Answer 24

Timing of tax cuts don’t matter, only the present discounted value does, because households will save during tax cuts to pay back for it in the future

Question 25

Examples of supply-side fiscal stimulus

Answer 25

1. Tax rate deductions
2. Depreciation of currency
3. Privatisation and deregulation
4. Flexible labour markets

Question 26

Does supply-side fiscal policy work?

Answer 26

Depends; the literature shows that temporary stimulus can work, but have limited effects in time of high uncertainty

Question 27

MPC

Answer 27

Change in consumption / change in income

Question 28

Negative fiscal multiplier

Answer 28

Happens more in LDCs, when gov spending
1. Crowds out private consumption
2. When debt levels are already very high (high debt countries have close to zero or even negative fiscal multipliers)
3. High degree of substitutability between private and public consumption

Question 29

Why does government stimulate private investment?

Answer 29

Long run - technological growth and innovation create growth. Short run - created by expansion and job creation

Question 30

How to deal with political inflationary pressure?

Answer 30

1. Central bank independence, which historically lowered inflation in many countries
2. Inflation targeting - publicly announcing target inflation rate and “price stability” as goal

Question 31

Time consistency problem

Answer 31

Central bank can exploit expectations - an unexpected decrease in interest rate can stimulate spending and investment. But over time, this creates inflation expectations and overly high inflation without any benefit to output