Economic fluctuations 2.0

Question 1

Remind me how the full intertemporal model looks like again?

Answer 1

Question 2

We are now going to talk about a temporary increase in governemnt spending, when doing this, what do we always have to talk about?

Answer 2

How it affects macroeconomic variables

Question 3

What is the fiscal multiplier again?

Answer 3

any change in any of the components of AD will lead to an even greater change in normal output e.g. how much does GDP increase by if i increase government spending.

Question 4

What are we going to assume about the Marginal propensity to consume?

Answer 4

MPC is constant ( so consumption is linear, no ricardian equivalence)

Question 5

What is the direct effect on the increase in government spending?

Answer 5

First of all an increase in goverment spending from g1 to g2, leads to output demand going up ( government want to buy more goods so output goes up)

Question 6

What are the 2 indirect effects on an increase in government spending?

Answer 6

1) increase in taxes ( now or in the future), which reduces consumption; decreasing lifetime wealth( current and future consumption fall) so you reduce consumption by MPC x change in lifetime wealth.
2) increase in income increases consumption in the economy, so if demand goes up by y2-y1, consumption goes up by MPC x Yd2 - Yd1)

Question 7

What is the equations to show an increase in government spending?

Answer 7

so you just collect like terms

dive both sides by (1-MPC) to get the final result.

Question 8

How can we use the output demand as a function of current income diagram to show an increase in government spending?

Answer 8

Question 9

Show an increase in government spending on the full intertemporal model, explain it and it this fiscal stimulus one on one?

Answer 9

1) first of all an increase in government spending, shifts output demand to the right, bt the exact amount in govt spending.
2) Sooner or later taxes will increase, this leads to an intertemporal subsitution effect of leisure, as future leisure is cheaper, so you want to work more today, as your lifetime wealth went down, so for the sam einterest rate the labour supply will shift to the right.
3) this means more employment in equibirum soo the output supply shifts to the right.
4) As you can see output demand is greater than supply( this is where the fiscal stimulus is (1:1), but actually the interest rate adjusts up untill OD = OS,
5) This increase in the interest rate will mean that, output supply will shift to the left, due to the intertemporal subsitution effect of leisure.
6) so we expect an equibirium in the labour market of an inccrease in employment and reduction in real wage, for the output market, we see an increase in real interest rate and a decrease in output

Fiscal stimulus is not one on one ( as there is an increase in real interest rate, meaning the increase from y1d to y2d is not one on one)

Question 10

Why is the fiscal stimulus not one on one?

Answer 10

This is because an increase in government spending means higher taxes, affecting labour supply and higher interest rate means investment and consumption get crowded out.

Question 11

How does an increase in current TFP affect the full intertemporal model?

Answer 11

1) The marginal product of labour will be higher for every worker i hire, as they will be more productive, meaning as a firm i want to higher more workers. so laabour demand will shift upwards
2) As there is an increase in employment and a higher wage this means output supply moves to the right (Y1s to Y2S), this leads to a lower interest rate and a higher output, this lower interest rate leads to the intertemporal subsitiution of lesiure. current lesiure is cheaper, so i want to work less, shown by the shift in output supply to the left.
3) for investment i have lower interest rates so i want to invest more, also consumption goes up tooo so these variables are procyclial with output.

Question 12

Lets say there is an increase in future tfp, first of all why may this be the case ?

Answer 12

Animal spritis

Expectations about the future.

Question 13

What is the effect of an increase in future TFP on the full intertemporal model what happenss to investment and consumption too?

Answer 13

1) This will mean that we can expect MPK to be higher in the future, so this means firms will invest more today in the current period, so the investment component of AD will be higher. So output demand shifts to the right, for the same level of the interest rate.
2) this leads to an increase in interest rate
3) the increase in interest rate leads to a intertemporal subsitution of lesiure, so this means you want to work more today, as future lesirue is cheaper. leading to a shift to the right of labour supply. Leading to a new equibrium of a lower wage and higher output.

We said investment will be higher overall, consumption is ambitigious because an increase in interest rate means a fall in consumption but on the other hand the increase in current income and expected price increase, will make consumption go up.

Question 14

A reduction in TFP or increase in TFP or increase in FUTURE TFP are all what?

Answer 14

Shocks in the economy.

Question 15

Why are fiscal mutpliers in general difficult to estimate using the empricial evidence?

Answer 15

there is a lag in fiscal implementation

other policy changes may happen at the same time ( monetary policy)

Question 16

Evidence on fiscal multipliers (Ramey, 2019 JEP) shows what?

Answer 16

Between 0.6 and 1

• Not strong evidence it is larger in deep recessions
• Some evidence for higher multipliers (1.5) with very low interest rates

Question 17

Additional Evidence on fiscal multipliers (Ilzetzki, Mendoza and Vegh 2013 JME) shows what?

Answer 17

Govt spending multiplier higher in developed countries

• Govt spending multipliers are much larger under fixed exchange rate regimes
• Much larger in closed economies.
• Govt spending multiplier smaller in highly indebted countries

Question 18

We have seen in our model, labour markets work perfectly, everything adjusts, and there is no unemployment, is this always the case?

Answer 18

No there are sectoral shocksthat change relative productivity or demand for different sectors ?

Question 19

Give an example of a recent shock affecting the transportation sector, how does this affect other industries which are growing and does this shock affect straight away?

Answer 19

COVID-19

one sector that was hit was the transportation sector, so demand for this went drastically down, same with retail.This leads to a reallocation of labour and capital from declining to growing sectors, however this can take time because of labour market mistach, skills mismatch etc.

Question 20

How can we link this sectoral shocks into our full intertemporal model?

Answer 20

we can think of this as additional costs on firms and workers trying to find jobs, affecting both labour supply and demand

Question 21

Show the effect of a sectorial shock on labour demand and supply for example covid 19 on our full intertemporal model?

Answer 21

1) If workers have additional costs for finding a job, this means for the same salary, they want to work less hours, as they have to pay additional costs to find a job, and for a firm for every worker, they hire, they will incur a cost so labour demand and supply shift to the left.
2) this leads to lower employment, so output supply shifts to the left, at r1, demand is larger than supply, so the interest rate will have to go up to bring the goodsd market back to equilibrium
3) this affects labour supply, which shifts to the right, for a higher level of interest rate, by not that much but a little ( as we are saying the effect of higher interest rate is not that big)
4) the new equibirum will have a lower GDP, meaning a higher interest rate, consumption and leisure both lower, employment will be lower wages may go up or down depending on the relative change of labour supply or demand but we say it goes up.

Question 22

What is an interesting by product of an a sectoral shock?

Answer 22

Average labour productivity With labour market mismatch, average labour productivity goes up!, by looking at the slopes off the blue and red line.

Question 23

Which of these shocks or policies will unequivocally increase current employment in equilibrium?

Select one or more:

a. Building a new space defense system to protect us from alien invasion
b. Consumers decide that after one year of sacrifices due to the pandemic, they want to consume more.
c. Firms are worried about the uncertain future and decide to reduce their investment until things cool down.
d. A new law mandates that firms need to pay for workers’ medical check-ups once per month.

Answer 23

a and b are correct

c is a shock on investment demand. We can think of this uncertainty as reducing the expected marginal product of capital in the future period. This will reduce current investment, and the current output demand will move to the left. Interest rate will then need to decrease, making the labour supply move to the left too. In equilibrium, employment decreases.

Question 24

Which of these shocks or policies will unequivocally increase investment in the new equilibrium?

Select one or more:

a. A new effective cure for COVID-19 is announced by scientists at the end of the first period, and it will become available in the second period.
b. Because of pollution, machines and equipment used in production tend to deteriorate much faster
c. An earthquake destroys a consistent number of existing plants.
d. Scientists announce that the weather next year is going to be particularly bad and cause several disaster-like meteorological phenomena
e. The government announce a plan to reduce the spending on hospitals now that the COVID-19 pandemic is almost over (crossing fingers here)

Answer 24

a c and e

Question 25

In December 1952, the Great Smog descended on London. This was a deep and heavy fog mostly caused by pollution, and it created chaos and several thousand deaths in around 4 days. After the fog disappeared, the prime minister, at the time, Winston Churchill decided to increase the spending on hospitals for respiratory diseases (as most deaths were caused by these types of health problems). At the same time, in a few months, the parliament discussed and passed the first legislation aimed at fighting pollution, imposing regulations and additional costs to companies. Can you predict what these two policy changes will imply in light of our full intertemporal model?

Select one or more:

a. Output goes up
b. Output goes down
c. Consumption increases
d. Consumption decreases
e. Interest rate increases

Answer 25