Buisness Cycle Flashcards
At what point do firm hire workers
MPN = w.
In other Marginal Benefit of an extra worker = the cost of employing
Does consumption have leads or lags
There is no leads or lags with Real GDP and consumption but consumption moves by less than GDP, consumers donβt like fluctuations on the spending of goods.
Is investment procyclical/ have leads or lags
Investment is procyclical, with no obvious leads or lags however investment is more volatile than GDP
What do firms consider when investing ? (3)
- Addition of capital stock in the future
- Marginal product of capital
-Maintenance cost of capital (depreciation), and cost of financing, e.g. interest rate π paid on borrowing, or if self-financed, the opportunity cost π of postponing distribution of dividends
What is the demand for interest rate
It is the Marginal product of capital with is r + depreciation rate
What is consumption influenced by ? (3)
- Current and expected future income:
- Households consume more if they are better off, either due to higher current income or expectations of higher future income.
- Wealth effect:
- If expected future growth increases, it can boost consumption today as households feel wealthier.
- Consumption smoothing:
- Temporary changes in income have a smaller impact on consumption, as households save or borrow to smooth out the effect on their consumption over time.
How does real interest rate r effect consumption ? (3)
- Substitution effect:
- When the interest rate rises, consumption declines as it becomes more attractive to save rather than consume.
- Income effect:
- When the interest rate rises, it redistributes income from borrowers (who are worse off) to savers (who are better off). This can have an ambiguous overall effect on consumption.
The key assumption is that the substitution effect dominates the income effect overall, meaning a higher interest rate leads to lower consumption.
What is savings
Income - consumption
When do savings increase ?
- The interest rate (r) rises, due to the substitution effect.
- There is a temporary rise in current income, as households save some of the extra income.
Why is consumption demand downward sloping
Because SE of interest rate π is dominant
What is wage equal to
The marginal rate of substitution between leisure and consumption is equal to βw,β it means that the extra income youβd require to give up an hour of leisure is exactly equal to your hourly wage.
Why is investment demand downward sloping
diminishing returns to capital
How is labor supply affected if households are worse off eg increased taxes
Raises Ns
What does fiscal policy involve
Involves government spending (πΊ) as a component of aggregate demand.
- The governmentβs budget constraint dictates that the present-discounted value of its expenditure must equal the present-discounted value of taxes.
What does the Ricardian equivalence say
According to Ricardian equivalence, the timing of taxes doesnβt affect aggregate demand because households adjust their savings based on future tax expectations.
Why do government use bonds
Sells bonds to fund during budget defecit
Why do firms use bonds
Sells to fund investment
Why do households use bonds
Buy bonds as a form of saving
What is the wealth effect
The consumption demand shifts outward if households become wealthier, a phenomenon known as the βwealth effect.β
What factors can shift the AD curve
Changes in wealth effects, fiscal policy (government expenditure), or other determinants of consumption and investment demand can shift this curve.
What is AD
consumption, investment, government expenditure
Why is labor demand downward sloping
The labor demand (Nd) is downward-sloping, based on the marginal product of labor.
Why is labor supply upward sloping
Depends on the interest rate r but also as w increases, opp cost is higher for leisure and consumption
What do effects of a negative shock in the RBC model include ? (6)
- The production function shifts down, moving ππ (output supply) to the left.
- The reduced marginal product of labor shifts ππ (output demand) to the left, further shifting ππ .
- Lower investment (πΌπ) due to the expected decline in future output.
- Decreased consumption (πΆπ) and increased labor supply (ππ ) from the negative wealth effect.
- Overall, both ππ and ππ shift leftward, resulting in a decrease in GDP π.
- The wealth effect is smaller than the direct impact of the shock on ππ , leading to consumption smoothing for non-permanent shocks.
what happens when wages increase
When wages increase, people tend to work more due to the substitution effect (SE). This means theyβre substituting leisure time for work because work becomes more valuable.
Why will workers work more to compensate if households are worse off than leisure
Leisure is considered a βnormalβ good, meaning people want more of it when theyβre better off financially.
Why is the labor supply curve upwards
Labor supply is upward-sloping if the substitution effect (SE) of the wage dominates. This means that people are willing to work more when wages increase. It shifts to the right when the real interest rate (π) increases, which also affects peopleβs incentive to save and, consequently, their willingness to supply labor.
Current government budget
present value of its spending equals the present value of its taxes.
The bond market for government, firm, household
In the bond market, the government sells bonds to cover budget deficits, while firms sell bonds to fund investments in new equipment, and households buy bonds as a form of saving.
Factors shifting the demand curve
It shifts due to changes in wealth effects, fiscal policy (πΊ), or other factors affecting consumption and investment demand.
RBC theory and public intervention
Real Business Cycle (RBC) theory argues that supply shocks in such a model can offer a consistent explanation of business cycles.
In RBC theory, business cycles are seen as the economyβs efficient response to changes in its ability to produce goods.
According to this view, policy intervention is either futile or counterproductive.
In a recession caused by lower z, should government intervene according to the RBC model
The model suggests that even if policy intervention succeeds in increasing GDP, it ultimately makes households worse off.
For example, increasing government expenditure πΊ might boost GDP, but itβs inefficient because it encourages people to work more when productivity is low.
In equilibrium, the marginal product of labor (πππ) equals the marginal value of time (ππ
π).
Does monetary policy have an impact on real GDP according to the RBC model
Monetary policy has no impact on real GDP in the RBC model because money, nominal prices, and interest rates are considered irrelevant.
Temporary reduction in total factor productivity π§. Assume the duration of the shock
is expected to be sufficiently short, so wealth effects are small.
Find the implications for employment, real wages, and the
real interest rate.
Lower total factor productivity π§ reduces MPN, causing the labour demand curve to shift to the left. The output supply curve ππ
shifts to the left because of the direct effect of lower productivity and the decreased employment implied by the leftward shift of labour demand. As the duration of the shock is expected to be short, households aim to smooth consumption over
time, reducing πΆπ by less than the direct impact of the shock on income. Another way to cope with the shock and mitigate the effect on consumption is to increase labour supply ππ
, which offsets some of the leftward shift of ππ . However, these wealth effects are relatively small. The short duration of the shock also means any negative effect on investment demand πΌπ
is small because productivity is expected to recover by the time the current investment raises future capital stock.With both ππ and ππ
shifting to the left, real GDP π must decline. As explained above, the shifts of the output demand curve are small relative to the effects of the shock on the supply curve, so the real interest rate π rises to clear the goods market.
In the labour market, while ππ shifts left, the labour supply curve shifts to the right because households are worse off and supply more labour to compensate, and
second from as the rise of the real interest rate increases the incentive to build up
savings, which can be done by working more. As ππ shifts to the left but ππ shifts to the right, the real wage π€ necessarily declines, but the overall impact on employment π is ambiguous.
effect on ππ is dominant and employment falls.
Show that the fiscal policy response raises GDP according to the model. What happens to consumption πΆ and employment π? If the model is correct, are households better off because of the fiscal stimulus?
Higher public expenditure πΊ shifts the output demand
curve to the right. The increase in the tax burden causes a reduction in consumption demand because of a negative wealth effect, but this is smaller in magnitude than the change in πΊ because
the increase in public expenditure is only temporary. So overall, the output demand curve shifts to the right. The increase in the tax burden also increases labour supply, shifting the output supply
curve to the right. Together with the rightward shift of ππ
, real GDP π must therefore increase.
The effect on ππ smaller than the shift of ππ because the extra labour is only supplied to cope with the higher tax burden. This means that the real interest rate π rises. Higher π reduces consumption demand, so along with the negative wealth effect already considered, consumption must fall.
In the labour market, the labour supply curve shifts to the right because of the wealth effect discussed earlier and the greater incentive to save provided by the higher real interest rate. There is
no shift of the labour demand curve from higher πΊ itself (public expenditure does not change the production function here). Hence, employment π rises. While the fiscal stimulus raises real GDP, households end up having lower consumption because of the higher tax burden and higher real interest rate, and supplying more labour, which reduces leisure. If households value consumption and leisure, they are actually worse off as a result of the fiscal stimulus. Of course, households should directly benefit from the higher public expenditure πΊ but if it is optimal to sacrifice private consumption πΆ for higher public spending, the government
could already have chosen to do that prior to the supply shock. In this analysis, it does not make sense for the government to choose higher πΊ because of the shock that caused the recession.
Holding fiscal policy constant, explain why the effects of a permanently lower π§
(relative to a trend) are not the same as those of the temporarily lower π§ found in
part (a). Do the predictions of the model for employment and real wages fit the
empirical evidence on business-cycle fluctuations better for temporary or
permanent supply shocks?
Larger effects on consumption and investment than because it lasts long enough to have a significant effect on firmsβ investment plans, and because households cannot sustainably smooth consumption when future income also declines. The shifts of the output demand curve ππ are therefore larger, and it is possible that the real interest rate π declines. Since the shock is permanent, the adjustment of labour supply to cushion the blow to consumption
is larger than in part (a). However, the shift of the labour demand curve is the same because this
depends only on the current level of productivity π§. The larger wealth effect on labour supply thus makes it more likely that employment rises overall rather than declines, and increases the size of the
fall in the real wage. If such permanent productivity shocks were driving business cycles in the RBC model, employment would be less procyclical or even countercyclical, and real wages would be
more procyclical. Since the empirical evidence on business-cycle fluctuations shows that employment is strongly procyclical while real wages are only weakly procyclical, the RBC model fits the empirical evidence best for temporary supply shocks such as shocks to energy costs.