Reading 15: Understanding Business Cycles Flashcards
Explain real business cycle (RBC) theory and identify criticisms.
Business cycles have real causes; no impact from monetary variables (such as inflation). Aggregate supply plays a prominent role in business cycles. Fiscal/monetary harmful.
Unemployed workers should adjust wage expectations or enjoy extra leisure/lower consumption.
Criticisms: During recessions, people are eagerly looking for jobs and unable to find employment despite reducing their wage demands.
List the three biases of using a fixed basket of goods and services to measure the cost of living.
- Substitution bias: Consumers to replace expensive goods with cheaper substitutes.
- Quality bias: Higher prices may reflect higher quality rather than inflationary increases.
- New product bias: Recently introduced products are excluded from a fixed basket.
Describe types of unemployment and compare the measures of unemployment.
Labor force – People over a certain age either legally working or seriously looking for work.
Unemployed – Those looking but unable to find work.
Underemployed – Employed in a job significantly below their qualifications (hidden employment).
Discouraged worker – No longer looking (hidden employment).
Measures:
Unemployment rate = Unemployed / Labor force
Labor force participation rate = Labor force / Working age population
Explain the defining assertions of the monetarist school of thought and identify criticisms.
Exogenous shocks/government actions cause cycles. Government should maintain a steady growth rate of money supply, even during recessions. Government’s fiscal actions may do more harm than good; government should play very limited role.
Criticisms: Anticipation of lower interest rates in a recession results in delayed investment until a recession. Low investment causes a recession during which they will easily be able to obtain cheap loans from the government.
When does cost-push and demand-pull inflation occur?
Cost-push inflation occurs when rising costs compel businesses to raise prices. Costs of production may rise because of an increase in money wage rates or an increase in the price of raw materials.
Demand-pull inflation occurs by increasing demand, which causes higher prices and eventually results in higher wages to compensate for the rise in cost of living.
Describe the following:
- Deflation
- Disinflation
- Hyperinflation
- Overheating
- Stagflation
Deflation: Persistent decrease in price level over time; the value of money rises
Disinflation: Inflation rate falls but remains positive unlike deflation, where the rate becomes negative
Hyperinflation: Inflation rate is extremely high; typically when government increases the money supply to fund spending rather than increasing taxes
Overheating: High inflation, high economic growth, and low unemployment; monetary authority may take steps to cool it down
Stagflation: High inflation, high unemployment, and slow economic growth
List how economists try to measure inflation expectations.
Expectations that participants will follow past trends.
Conducting surveys of inflation expectations. However, these are often biased.
Government bond yield spreads to TIPS, which adjust with inflation. However, several other market factors affect bond yields.
Explain the defining assertions of the neo-Keynesian theory.
Draws macroeconomic conclusions based on microeconomic (utility-maximizing) reasoning.
Disequilibrium adjusts slowly due to:
“Downward sticky” prices and wages.
Businesses resist cost of price changes.
Slow to adjust production to shocks.
Explain the monetarists’ view on inflation.
They explicitly place the blame for demand-pull inflation on excess money growth. Analysts track money supply growth rates relative to nominal GDP growth rates. Inflation occurs when money supply grows faster than GDP.
Describe consumer and producer price indices in the United States.
The CPI-U covers urban areas, which may not apply to the entire country. The Personal Consumption Expenditures (PCE) index uses seller surveys of selling price.
The Producer Price Index (PPI) tracks price changes experienced by domestic producers.
Headline inflation is based on an index that includes all goods and services in the economy.
Core inflation is based on an index that excludes food and energy prices from the basket.
List the three stages of the interaction of the inventory-sales ratio with the business cycle.
Stage 1: Involuntary build-up; sharp increase in the inventory-to-sales ratio.
Stage 2: Production cutbacks/ inventory liquidation; inventory-to-sales ratio returns to normal.
Stage 3: Sales rise, businesses struggle to keep production on pace with sales growth; declining inventory-to-sales ratio.
Explain the neoclassical school of thought and identify the criticism of this school of thought.
Invisible hand manages equilibrium, quickly adjusting to economic fluctuations. MC = MR, efficient resource allocation, full employment/capacity utilization.
Supply creates its own demand and production sells quickly.
Payments to factors of production create purchasing power and stimulates demand.
Criticisms:
Great Depression disproves theory; treats business cycles as short-term disequilibria that self-adjust
Offers no theory on business cycles, only Schumpeter’s creative destruction theory where technology advances cause cycles
Explain the defining assertions of the Keynesian school of thought and identify criticisms.
Price/wage reductions are hard to attain. Expectation of lower salaries results in further demand decline. Self-correction may work in the long run, but not in the short run.
Lower interest rates will not necessarily reignite growth due to weak business confidence.
Criticisms:
Fiscal deficits imply higher government debt, which must be serviced and repaid. No importance to money supply.
Intervention may cause overheating.
Recognition, policy, and implementation lags may miss trough and cause overheating.
Give an overview of business cycles and describe the phases in a business cycle.
Comprises a sequence of distinct phases
Recurrent, but not periodic
Typically last between 1 and 12 years
Most sectors of the economy undergo phases of the cycle at about the same time
Phases:
Trough: Lowest point of a business cycle as the economy moves from recession to expansion.
Expansion: After the trough, economic activity builds toward the peak.
Peak: Top of a business cycle; expansion slows toward a recession.
Contraction (or recession): Economic activity declines. A severe recession is a depression.
Identify the three stages in which changes in capital spending affect business cycles.
Stage 1 (slowdown): Spending on equipment falls abruptly.
Stage 2 (initial recovery): Orders pick up, but low capacity utilization dampens growth.
Stage 3 (late expansion): Businesses expand to meet consumer demand.
