Chapter 26

Question 1

economic fluctuations/ business cycles

Answer 1

short-run changes in the growth of GDP

Question 2

Can government policies avoid fluctuations?

Answer 2

No, government policies can only reduce the severity of fluctuations.

Question 3

What is a trend line?

Answer 3

A trend line is a line drawn over pivot highs or under pivot lows to show the prevailing direction of price. Trend lines are a visual representation of support and resistance in any time frame. They show direction and speed of price, and also describe patterns during periods of price contraction.

Question 4

How do we calculate the percentage deviation?

Answer 4

100 * (real GDP-Trend)/trend

Question 5

economic expansion (booms)

Answer 5

Periods between recessions. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession.

Question 6

What are recessions? (contractions, downturns)

Answer 6

Periods in which real GDP falls.

Question 7

peak point

Answer 7

high point of real GDP, before recession begins

Question 8

trough

Answer 8

low point of real GDP during the recession (corresponds to the end of recession)

Question 9

What are the 3 key properties of economic fluctuations?

Answer 9

1) co-movement of many aggregate macroeconomic variables
- many economic variables grow and contract together
- ex: consumption and investment co-move, employment and GDP co-move, unemployment moves negatively with GDP

2) Limited predictability of turning points
- recessions do not follow a repetitive, easily predictable cycle

3) Persistence in the rate of economic growth
- economic growth is not random
- recession this quarter, probably still recession the next quarter

Question 10

The great depression

Answer 10

Refers to the severe contraction that started in 1929, reaching a low point for real GDP in 1933. The period or below-trend real GDP did not end until the buildup to WW2 in the late 30’s.

• the crisis deepened as stock markets around the world continued to fall. At its bottom in 1933. stock market was about 80% below its peak 4 years earlier.
• millions of US farmers and homeowners went bankrupt.
• thousands of failing banks

Question 11

What is depression?

Answer 11

the term is typically used to describe a prolonged recession with an unemployment rate of 20% or more.

Question 12

labor market eqm

Answer 12

intersection of LS curve and LD curve

Question 13

downward wage rigidity

Answer 13

• with downward wage rigidity, firms are unable or unwilling to cut nominal wages because of contractual restrictions or because they are concerned that wage cuts would reduce worker morale and adversely affect productivity
• produce unemployment

Question 14

capacity utilisation

Answer 14

-rate of utilisation of physical K (recession+reduction of capital utilisation)

Question 15

What are the most important sources of recession?

Answer 15

-shift in the labour demand curve

Question 16

Sources of fluctuations

Answer 16

1) Real business cycle theory (emphasises changing productivity and technology)
2) Keynesian theory (emphasises changing expectations about the future)
3) Financial and monetary theories (emphasise change in prices and r)

Question 17

Real business cycle theory

Answer 17

-a school of thought that emphasises the role of changes in the technology in causing economic fluctuations

• technology differences across firms and workers in different countries help explain differences in cross-country income and growth
• research and development leads firms to invest more valuable products. This will increase the value of marginal product of labour => firms expand their operations => increase their labour demand
• firms are also likely to increase their productivity capacity, raising the level of investment in the economy => higher household income (employment increase, wages rise, rising corporate incomes) => households will raise their consumption

-emphasises the change in input prices: increase in price of oil, decrease in productivity of firms (shifts LD curve to the left)

Question 18

what is the key role of technological progress

Answer 18

• plays a key role in long-term variation in economic growth

- not the main force driving recessions

Question 19

Keynesian theory

Answer 19

• animal spirits
• a period of heightened optimism could give way to a period of deep pessimism
• sentiments (include changes in expectations about future economic activity, changes in uncertainty facing firms and households, and fluctuations in animal spirits. Changes in sentiments lead to changes in household consumption and firm investment. Sentiments can be powerful catalysts of economic change.
• pessimist firms cut back employment and investment => household are unlikely to increase their consumption (leftward shift in LD curve) => households cut consumption => further shifting LD curve to the left]
• multiplier effect
• pessimism leads to lower spending and causes recession

Question 20

animal spirits

Answer 20

-animal spirits are psychological factors that lead to changes in the mood of consumers or businesses, thereby affecting consumption, investment and GDP

Question 21

multipliers

Answer 21

economic mechanisms that amplify the initial impact of shock

Question 22

self-fulfilling prophecy

Answer 22

-situation in which the expectations of an event (such as a left shift in LD in the future) induce actions that lead to that event.

Question 23

aggregate demand

Answer 23

Is the economy’s overall demand for GS that firms produce. Aggregate demand drives the hiring decision of firms and consequently determines the labour demand curve.

• an economy might remain in a state of extended recession, or depression because of lack of aggregate demand.
• leftward shift in LD => multipliers and self-fulfilling prophecies => consumers might not spend, afraid of running out of savings => firms won’t hire, afraid of non-spending consumers=> these forces would reinforce one-another, leaving the economy permanently on its knees

Question 24

Monetary and financial factors

Answer 24

• contractionary monetary policy makes M2 fall sharply => price levels fall => reduces employment because of downward wage rigidity (LD to the left)
• contractionary monetary policy => real r rises => production more costly => hire less labour
• leftward shift in the supply of credit will shift firm’s LD curve to the left

Question 25

what are the 2 categories of recovery mechanisms

Answer 25

1) LD curve shifts back to the right due to market forces
- when excess inventory has been sold off, firms increase production
- when households become frustrated by the inconvenience of the delayed purchase and come back to the market
- P and H K shift from bankrupt firms to healthier firms
- when technological advances encourage firms to expand their activities
- as the banking system (and the financial intermediaries) recuperates and businesses are again able to use credit to finance their activities

2) LD curve shifts back to the right due to expansionary policies
- monetary policy used by the central bank (lowering r stimulates investment)
- overall inflation raises firm’s output prices => increase employment, more profitable production + LD curve to the right
- fiscal policy (government): increasing gov spending increase the demand for the products that firms produce, decreasing taxes = more after-tax income = increasing purchasing power

Question 26

Nominal wages vs real wages

Answer 26

N w: actual wages paid
R w: adjusted for inflation, in the presence of inflaion real wages can fall, even in nominal wages remain the same. Another explanation how modest inflation help the economy with downward rigid nominal wages recover from a recession

Rw: Nw/measure of overall price

Question 27

Phillips curve

Answer 27

• describes the empirical relationship between employment growth and inflation, showing that employment growth tends to produce more inflation, especially when the economy is near full employment
• LD shifts to the right (close to full employment) => relatively little room for the economy to grow => boom will generate inflation and very little employment and output growth

Question 28

What caused the recession of 2007-2009?

Answer 28

• chains of dominoes
• rapid rise of housing prices between 1990-2006 (bubble => prices did not reflect the true long-run value of the asset)
• bubble bursts => devastating effects on the home construction industry
• unemployment rose
• related industries also got hit, as real estate prices fell, including commercial real estate => large leftward shift in the LD curve => sharp drop in employment => multiplier effects deepening the fall in aggregate employment
• mortgages values not affected by the fall in the home value = house value less than debt value =by selling you won t receive enough money to repay the mortgage = this will lead to walk away = to default on their mortgages => foreclosures => banks suffered enormous losses on their portfolios of mortgages => ex: failure of Lehman Brothers = financial panic = bank failures => loans cut back => multiplier effects that reduced consumption and investment and shifted LD to the left

3 main factors:

1) fall in house pricing, which caused a collapse in construction of new homes
- already large inventory= new constructions unprofitable => labour demand curve to the left

2) sharp drop in household consumption, which caused a collapse in construction of new homes
- reduced the wealth of many consumers => substantial drop in demand => cut back production => labour demand curve shifts to the left

3) spiralling mortgage defaults that caused many bank failures, leading the entire financial system to freeze up
- The decline in housing values led to millions of mortgage defaults. These mortgages which were held on the balance sheets of many large banks, pushed those banks to the brink/ over the brink of solvency. As banks failed (or cut their lending activity to increase their reserves and strengthen their balance sheets), credit to the private sector fell, causing borrowing firms to cut their production. The decline in the credit to households reduced their consumption.

Question 29

What is a technology shock?

Answer 29

changes in firm’s productivity translate into shifts in the LD curve,causing fluctuations in employment and real GDP. When LD curve shifts to the left, employment and real GDP fall. When the LD shift to the right, employment and GDP rise.

Question 30

hat are the two key economic variables that justify calling this period the Great
Recession? Did what happened in this period satisfy the three properties of
economic fluctuations?

Answer 30

The big drop in GDP per capita and the big rise in unemployment.
This period satisfies the three properties:
(i) Comovement – consumption and investment are falling, both are pro‐cyclical
(ii) Persistent – the initial drop in GDP per capita happens around end of 2007, then it continued
into following months and lasted for many months
(iii) Limited predictability – in the middle of the recession, no one could predict when it was
going to end. It is hard to say when it would have ended without the countercyclical
monetary and fiscal policies that were implemented.

Question 31

There is still debate on what caused the Great Recession. Give three channels for
why the collapse in the housing market may have played an important role.

Answer 31

(i) Job loss and consumption demand – the collapse in house prices initially causes a big
reduction in the construction sector, thus many construction workers become unemployed.
This generates a demand fall in other jobs related to housing transaction such as real estate
sector. This channel causes a multiplier effect through the consumption demand of those
affected
(ii) Housing wealth and consumption demand – the fall in house prices reduces the collateral
value of homeowners’ home, thus reducing their wealth. This reduces their consumption
demand.
(iii) Mortgage default and bank failures – the fall in house prices together with rise in
unemployment implies that many homeowners went “under water”, i.e. the asset value of
the house was worth less than the mortgage value. Many of them default. This reduces the
asset value of banks that are holding mortgage as their long term assets. Failure of these
banks affects other banks in the financial system because of the interbank loans.

Question 32

The Bank of England responded by lowering the official Bank Rate. Explain why this
can help to bring the economy out of recession. What is the potential limitation of this
Policy?

Answer 32

By lowering the bank rate, it would lower the short term real interest rate in the economy (when there is some price rigidity in the economy). Lower short term real interest rate can help to encourage consumption thus contributing to stimulate GDP. By lowering short term rate, this can also lead to a lower long term interest rate because of arbitrage. Lowering long term interest rate encourages investment thus contributing to stimulating GDP. The potential limitation is that there is an effective lower bound which is what happened during great recession. When it happens, central bank can no longer use this monetary policy tool and they have to turn to other monetary tools.