Chapter 10 - Introduction to macroeconomic fluctuations Flashcards
When is it a recession?
Old rule of thumb – a period of at least two consecutive quarters of declining GDP i.e. negative growth rate
What are the most volatile components of GDP?
Growth in consumption and investment decline when there is a recession. Investment is far more volatile than consumption over the business cycle
What is the average GDP growth?
3-3.5%
What are cyclical fluctuations?
When actual GDP differs from structural GDP
Structural GDP cannot be observed but can be estimated by use of an economic model: Y=F(K ̅,(EL) ̅)
Output gap=(GDP-Structural GDP)/(Structural GDP)
What is Okun’s law?
Short run: Negative relationship between unemployment and GDP – when real GDP declines, unemployment increases
In the long run: GDP determined by growth of technology and capital accumulation, Okun’s law does not apply
Short-run movements in GDP are highly correlated with the utilisation of the economy’s labour force
What is classical economic theory?
Chapters 3-9
Output is determined by supply side – supplies of capital, labour, technology
Changes in demand for goods and services (C;I;G) only affect prices, not quantities
Complete price flexibility is a crucial assumption
Classical theory applies in the long run
How does the short-run and the long-run differ?
Behaviour of prices, i.e. sticky in the short run and flexible in the long (respond to supply and demand)
Hence, output and employment also depend on demand for goods and services which is affected by fiscal policy (G and T), monetary policy (M), other factors like exogenous changes in C or I
Suppose CB reduces money supply, what happens in the short and long run respectively?
In the long run – money supply affects nominal variables but not real variables (remember classical dichotomy and monetary neutrality)
Thus, in the long run – 5% reduction in M lowers all prices by 5%, while output, employment and other real variables remain the same. Changes in M do not cause fluctuations in output and employment
In the short run – many prices do not respond to changes in monetary policy
The failure of prices to adjust quickly and completely means that, in the short run, real variables such as output and employment must do some of the adjusting instead – classical dichotomy no longer holds
How does the economy work differently when prices are sticky?
Output also depends on the economy’s demand for goods and services
As monetary and fiscal policy can influence demand, and demand can influence economy’s output, price stickiness provides a rationale for why these policies may be useful to stabilise economy in the short run
What is aggregate demand?
The relationship between the quantity of output demanded and the aggregate price level
The aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices
The aggregate demand curve is drawn for a fixed value of M, tells us the possible combinations of P and Y for a given value of M
Why does the aggregate demand curve slope downward?
M and V determine the nominal value of output PY
Once PY is fixed, if P goes up, Y must go down
If output is higher, people engage in more transactions and need higher real balances M/P
For a fixed M, higher M/P implies lower P
Another explanation – as we have assumed V is fixed, M determines the euro value of all transactions in the economy, if P rises, each transaction requires more euros i.e. the number of transactions and thus quantity of goods and services purchased must fall
What happens to the aggregate demand curve if the CB reduces money supply?
MV = PY, tells us that reduction in M leads to proportionate reduction in PY
i.e. for any given P, Y is lower and for any given Y, P is lower
opposite if CB increases M
What is aggregate supply?
The relationship between the quantity of goods and services supplied and the price level
Two different supply curves, depending on the time horizon – LRAS and SRAS
What is the aggregate supply curve in the long run? And what determines the price level?
Y=F(K ̅,L ̅ )=Y ̅
Output produced depends on the fixed amounts of capital and labour and on the available technology
What is the natural level of unemployment?
The average rate of unemployment around which the economy fluctuates (i.e., it applies to the long run). In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual unemployment rate falls below the natural rate. Depends on structural conditions such as unemployment benefits, regulations of hiring and firing, active labour market policies, skills in the population and population composition.
