Lecture 7: Business cycle Flashcards
Long-run economic evolution
- Changes in productivity
- Changes in physical capital
- Changes in human capital
- Changes in institutions
Short-run economic evolution
• People stop consuming because - Are worried to get unemployed - Are worried for a virus • Bank doesn’t lend money to buy a house • Firms do not invest because • Don’t expect demand to be high in the near future • Bank doesn’t lend money
Recession
when output and employment fall
Expansion:
economy is growing
Business cycle:
alternating between recessions and expansions
Marginal propensity to consume
• Suppose I give you 1 additional euro
• How much of this extra euro are you going to save and how much to
consume?
• The fraction you will consume is called the Marginal Propensity to
Consume (MPC)
MPC
The MPC leads to a multiplicative effect on consumption
- Suppose the government increases its consumption by 100 euros (for instance, by spending more on education)
- This means someone else’s income increases by 100 euro (let’s say of teachers)
- This person in turn spends 60 euro on ice-cream and puts 40 euro in the bank
- Then the owner of the ice-cream store will spend 36 euro (0.6 x 60) on buying books
- The owner of the bookstore will spend 0.6 x 36 euros on …
- Total consumption (government + private) increases by 100 + 60 + 36 + … = 250 euros
This only works when there is sufficient capacity in the economy
• If not: firms will increase prices and nominal GDP will increase but real GDP stays constant
Multiplier pt. 2
If people lose their job they will consume less
• This leads to income loss of others who in turn will also consume less
• This can cause a recession
Aggregate demand curve
how much
demand there is for the aggregate product as a function of the aggregate
price level
aggregate production function
An aggregate production function relates the total output of an economy to the total amount of labor employed in the economy, all other determinants of production (that is, capital, natural resources, and technology) being unchanged.
Micro vs macro
• In micro the demand curve is downward sloping as this gives the effect of the price
changing on demand of that product while holding the price of other products constant
• For the aggregate demand curve we cannot use the same logic as all prices are
changing simultaneously
Wealth effect:
suppose you have 100 euros in your bank account and prices fall.
Then the real value of your bank account increases. Hence you become more
wealthy and can consume more
Interest rate effect:
that you can buy more with the money you have (after a decline in
prices) means that people need to borrow less. This lowers the interest rate and
makes it cheaper for firms to invest (which is part of aggregate demand)
Shifts of aggregate demand curve
Can be due to
• changing expectations about future income
• Changes in wealth (for instance due to stock market changes)
• Government policy
Fiscal policy:
Changes in tax rates or subsidies
Monetary policy:
Changes to interest rates
Aggregate supply curve (short-run)
Higher price leads to higher profits and therefore firms will produce
more (as long as they have sufficient capacity)
Aggregate supply curve (long-run)
In long run supply curve is vertical
• Supply is equal to capacity which is a function of productivity and capital
Bringing aggregate demand and aggregate supply together
There is an equilibrium at which supply and demand are equal to each other
Stagflation:
When commodity prices increase prices increase (inflation) while output stagnates
What about Covid?
• Demand shock as people stay home because scared for the virus
• Supply shock as firms run at limited capacity to be able to ensure social
distancing
- Output goes down
Effect on prices depends on
slopes and shifts of curves
What type of policy to pursue after a negative demand
shock?
• Loss in output leads to unemployment. Want to avoid that
Fiscal policy
• In response to negative demand shock government can try to shift demand curve back to AD1 • For instance by • investing in infrastructure • giving money directly to households and firms (as happened during Covid)
What type of policy to pursue after a negative supply shock?
• Policy that shifts aggregate demand leads to high prices
• Shifting supply using policy is more difficult than shifting demand. One way is
to lower wages. This makes it more profitable for firms to produce and they
will increase production at a given price. But decrease in wages will be bad for
demand…
Recessions and policy can have a large effect on prices
- If prices increase: inflation
- If prices decrease: deflation
- Economists are very worried about both inflation and deflation
Inflation
Too high inflation is bad
• As it leads to uncertainty -> what you earn today might not be worth much in the future
• People feel loss of purchasing power
Once inflation starts to increase might be hard to stop
• Some firms increase prices -> other firms respond with also increasing prices etc.
Deflation
Economists are worried about deflation as
well
• If you know that prices will be lower next month you might
wait with purchasing new products (cars, furniture etc.)
• Thus leads to a fall in consumption demand
• Falling prices also makes it less attractive for firms to
invest
Monetary policy done by central bank
- Goal is inflation rate close to 2%
- Better word is interest rate policy
- Central bank can change the interest rate
- Lower interest rate makes it cheaper to borrow
- Leads to more consumption and investment
- Increased demand leads in turn to inflation and higher output
Inflation currently
High inflation mainly (but not only) due to high energy prices (supply shock)
Increasing interest rates lowers demand and therefore lowers inflation, but might also cause a recession
Fiscal policy and government debt
• The government can increase its spending during a (demand-based)
recession to compensate for the drop in demand
• But this comes at a cost: the government has to borrow money
• One day the government has to repay this debt, meaning that the
government has to raise taxes or lower its spending
Political debate
Every recession there is a debate on whether the government should
do more fiscal policy
Right party arguments
The right argues that government spending crowds out private
spending
• Because households/firms know that taxes have to increase in the future to repay
government debt they are going to save more today and consume less
• -> Fiscal policy has no effect on aggregate demand
• This argument requires perfect foresight which is probably unreasonable
Left party arguments
The left argues there is a fiscal multiplier
• Increasing government spending by 100 euros increases consumption (and output) by
250 euros
• -> Fiscal policy has a large effect on aggregate demand
• This argument requires that there are no capacity constraints which might also be
unreasonable
Spending
Government consumption of goods and services:
- Payments of government employees
- Payments of school teachers, police etc
- Spending on infrastructure
Government transfers:
• Unemployment benefits
• Social welfare payments
Government deficit
A negative government budget
During a recession the budget deficit increases
• This is because tax revenue declines
• And spending on unemployment benefits increases
Surplus
A positive government budget
From deficit to debt
• If the government runs a deficit it has to borrow money
• This adds to its existing debt
We express the debt of a government as relative to GDP (DEbt / GDP)
• When the government runs a deficit during a recession it will increase its
debt to GDP ratio
𝐷𝑒𝑏𝑡
𝐺𝐷𝑃
• There are three ways in which the government can lower its debt to GDP
ratio after a recession
• Running a budget surplus: is difficult as that means increasing taxes or
cutting spending
• Increasing real GDP: is difficult as for rich countries it typically grows at
2% and cannot grow faster
• Increasing inflation: also undesirable as there are risks with having a
too high inflation. In general a high inflation rate is good for indebted
people/governments and bad for savers
Debt
debt overtime can decrease without being paid
What if the interest rate goes back to 5%?
It is risky to run a too large deficit for too long in case interest rates
start to increase
Ageing
• Is especially risky to have too large debt given ageing society • Relatively more people will be over 65 • Thus, government transfers (AOW) and health payments will increase • Number of workers (or tax payers) is declining • Will be very difficult to have a govern- ment surplus and repay debt
