Lecture 7: Business cycle

Question 1

Long-run economic evolution

Answer 1

• Changes in productivity
• Changes in physical capital
• Changes in human capital
• Changes in institutions

Question 2

Short-run economic evolution

Answer 2

• 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

Question 3

Recession

Answer 3

when output and employment fall

Question 4

Expansion:

Answer 4

economy is growing

Question 5

Business cycle:

Answer 5

alternating between recessions and expansions

Question 6

Marginal propensity to consume

Answer 6

• 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)

Question 7

MPC

Answer 7

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

Question 8

Multiplier pt. 2

Answer 8

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

Question 9

Aggregate demand curve

Answer 9

how much
demand there is for the aggregate product as a function of the aggregate
price level

Question 10

aggregate production function

Answer 10

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.

Question 11

Micro vs macro

Answer 11

• 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

Question 12

Wealth effect:

Answer 12

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

Question 13

Interest rate effect:

Answer 13

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)

Question 14

Shifts of aggregate demand curve

Answer 14

Can be due to
• changing expectations about future income
• Changes in wealth (for instance due to stock market changes)
• Government policy

Question 15

Fiscal policy:

Answer 15

Changes in tax rates or subsidies

Question 16

Monetary policy:

Answer 16

Changes to interest rates

Question 17

Aggregate supply curve (short-run)

Answer 17

Higher price leads to higher profits and therefore firms will produce
more (as long as they have sufficient capacity)

Question 18

Aggregate supply curve (long-run)

Answer 18

In long run supply curve is vertical

• Supply is equal to capacity which is a function of productivity and capital

Question 19

Bringing aggregate demand and aggregate supply together

Answer 19

There is an equilibrium at which supply and demand are equal to each other

Question 20

Stagflation:

Answer 20

When commodity prices increase prices increase (inflation) while output stagnates

Question 21

What about Covid?

Answer 21

• 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

Question 22

What type of policy to pursue after a negative demand

shock?

Answer 22

• 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)

Question 23

What type of policy to pursue after a negative supply shock?

Answer 23

• 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…

Question 24

Recessions and policy can have a large effect on prices

Answer 24

• If prices increase: inflation
• If prices decrease: deflation
• Economists are very worried about both inflation and deflation

Question 25

Inflation

Answer 25

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.

Question 26

Deflation

Answer 26

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

Question 27

Monetary policy done by central bank

Answer 27

• 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

Question 28

Inflation currently

Answer 28

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

Question 29

Fiscal policy and government debt

Answer 29

• 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

Question 30

Political debate

Answer 30

Every recession there is a debate on whether the government should
do more fiscal policy

Question 31

Right party arguments

Answer 31

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

Question 32

Left party arguments

Answer 32

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

Question 33

Spending

Answer 33

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

Question 34

Government deficit

Answer 34

A negative government budget

During a recession the budget deficit increases
• This is because tax revenue declines
• And spending on unemployment benefits increases

Question 35

Surplus

Answer 35

A positive government budget

Question 36

From deficit to debt

Answer 36

• 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
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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

Question 37

Debt

Answer 37

debt overtime can decrease without being paid

Question 38

What if the interest rate goes back to 5%?

Answer 38

It is risky to run a too large deficit for too long in case interest rates
start to increase

Question 39

Ageing

Answer 39

• 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