Chapter 11 > Business Cycles Flashcards
What are business cycles?
A cycle or series which consist on expansions (GDP increases) and recessions (GDP contracts). It’s the fluctuations of output above and below the trend level.
What is the trend level output?
Production function tells us that, for a given level of capital, labour, technology, a certain amount of output can be produced. We consider the economy of a country to have an optimal (Potential/Natural) level of activity that tends to increase over time (trend).
Does output always equal its trend value?
No. At any point in time, the economy can be producing:
- More than its Natural level,
- Less than it’s Natural (e.g. firms may produce less output if they work at less capacity); or
- At the Natural level of output.
How do we find the position of the economy in the cycle?
The difference (positive or negative) between actual and potential level of activity.
How do we observe the business cycle?
We do not actually observe the business cycle—we only observe GDP. To measure the business cycle, we have to take assumption about trend output.
What are the phases in the business cycle?
Depression
Recovery
Boom
Recession
What is the equation of the output gap?
Output Gap = (Actual GDP - Potential GDP) / Potential GDP (%)
Potential GDP is hard to pinpoint.
How do we estimate the output gap?
Three main approaches are used to estimate the output gap:
- Estimating trend over time (fitting a linear or non-linear regression line).
- Building and estimating a structural model (econometrics).
- Looking at inflation and unemployment rates:
- Raising inflation and unemployment unnaturally low imply a positive gap.
- Falling inflation/deflation and unemployment unnaturally high imply a negative gap.
What is an expansion in the business cycle?
The economy is moving out of recession. Money is cheap to borrow, businesses build up inventories again and consumers start spending. GDP rises, per capita income grows, unemployment declines, and equity markets generally perform well. This phase tends to last longer than recessions (around 3 years on average).
What is a contraction in the business cycle?
Economic growth begins to weaken. Companies stop hiring as demand tapers off and then begin laying off staff to reduce expenses. This phase tends to last just over a year.
What is a macroeconomic phenomenon?
An event that has an impact on the majority of people.
E.g. Business cycle > therefore, most rectors (e.g. government, manufacturing, services, construction, etc…) will be affected.
What is the relationship between GDP and unemployment?
When GDP growth is strong, unemployment falls.
When the economy moves into a recession, unemployment starts to rise (and employment falls).
What is Okun’s law?
The stability of the relationship between GDP and unemployment leads to a simple rule of thumb, now called Okun’s Law, which states that for every 2% output falls below trend, the unemployment rises by 1%.
Are business cycles good or bad?
Good or bad? → Answer is controversial.
Some economists think that recessions are useful to improve the efficiency of the economy and
boost long-run growth.
But short-run effect of recessions on welfare of households is significant (and unequally distributed).
More an academic question than a practical real world one.
All governments try to smooth recessions with expansionary policies.
What are the two views on business cycles?
Two views:
- Real business cycle theory → Says that business cycles are the efficient response of markets to shocks that have affected the economy; in other words, business cycles are a sign that the market is working correctly.
- Keynesian → Says that business cycles are a sign that the market is failing.
