Economic Fluctuations

Question 1

Economic Fluctuations

Answer 1

• Recessions happens quite frequently -> it is not a rare event, and each one has a different duration
• The aggregate economy relationship is not casual -> the causes and effects flow in circuit form. The decisions made by households and firm have a wider impact on the whole economy -> “My spending is your income, your spending is my income”

Question 2

Components of Aggregate Output and Aggregate Demand

Answer 2

GDP = C + I + G - NX = Y = C + I + G - NX

C = Goods and services bought by household = Household’s spending

I = Investment goods bought by firms = Firm’s spending

G = G&S bought by government = Gov’s spending

NX = G&S bought - sold abroad = Net external demand

Question 3

Multiplier Effect

Answer 3

M = 1 —> Total increase in GDP is equal to initial increase in spending

M > 1 or < 1 —> Total increase in GDP is greater (>1) or smaller (<1) to initial increase in spending

M = 0 —> no effect

M < 0 —> some spending has negative effects

Question 4

UK GDP annual growth rate vs UK unemployment rate

Answer 4

• Inverse relationship

- Government is looking to avoid both peaks and troughs

Question 5

Cons of unemployment

Answer 5

• Makes people unhappy on a major scale
• Crime rate increases
• Government finances and debt increases

Question 6

Shocks (triggers/shocks)

Answer 6

“Shocks are unexpected/random events that enter the system by changing the demand and/or supply for goods or services”

• Expansionary shocks —> substantial rise in economic activity
• Recessions shocks —> substantial declines in economic activity
• Fluctuations —> change of LR growth due to shocks

Triggers: Asset bubbles, oil-prices, interest rate hikes

Shocks: technological advancements, natural disaster, consumer preferences, government actions (e.g. tax, interest rates, fiscal policy)

Question 7

Aggregate Demand Shocks

Answer 7

Anything that causes:
- an increase in gov spending
- an increase in desired investment 
- an increase in desired consumption 
- an increase in net exports 
???????

Question 8

Examples of Demand Shocks

Answer 8

For G: wars, changes in political ideology, fiscal crises

For I and C: changes in taxes, wealth, psychological changes (animal spirits)

For NX: changes in exchange rates, foreign demand shocks (appreciation/depreciation)

Question 9

Demand Shocks under sticky prices

Answer 9

• small effects on prices, large effects on quantities
• supply is determined by demand
• so AD shocks cause fluctuations

Question 10

Explanations for Price Stickiness

Answer 10

• Menu costs -> cost of changing prices
• Information costs
• Consumer reaction -> risk of firms changing prices (GT)
• Wage rigidity -> what’s hardly change
• in LR = flexible price, in SR = sticky price

Question 11

Consequences of Price Adjustment

Answer 11

• In a boom/recession, the increase/decreases in prices gradually undoes the effect of the initial demand shock
• the economy gravitates back towards its natural or normal level of output
• Big boom = inflation, Recession = unemployment