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