Topic 3: Business Cycle Theory Flashcards
Classical Macro Assumptions
- All markets perfectly competitive. 2. all prices and wages flexible. 3. all resources are used to full potential (i.e. no involuntary unemployment, all physical capacity is utilized) 4. all economic actors have full info and behave rationally. 5. perfect financial markets (i.e. no info problems, people and firms can borrow at same rate, no frictions such as credit constraints)
Classical Macro Implications
- Business cycles are caused by rational responses of economic actors to shocks that impact economy. 2. There is no role for demand management policy (fiscal or monetary pol)
Monetarism
- believe in primacy of money influencing macro econ. 2. in early stages, believe monetary policy more effective than fiscal pol, though milton friedman concerned about uncertain effects of monetary pol as well as long lags and advocated constant money growth rule
The Quantity Equation
MV=PY; m=money supply, v=velocity of money, PY =nominal GDP
Quantity Theory of Money
constant velocity and real GDP at natural rate, ΔM/M = ΔP/P —– ΔM/M = ╥
velocity
measures how much money turns over each period, v=nominal GDP/nominal money stock = PY/M
aggregate demand curve
negative slope: consumption (wealth effect), investment (interest rate effect), net exports (exchange rate effect)
consumption (wealth effect) in classical model
when price level goes up, real value of wealth goes down, consumption falls
investment (interest rate effect) in classical model
price level rises - same amount of goods and services more expensive, people need more money to buy, consumption smoothers, borrow to buy things, competition for loans rises, price of loans rises, higher IR lead to less investment
net exports (exchange rate effect)
prices rises - IR rises relative to IR in other countries, funds flow into US to capture higher IR, increase in demand for $, demand rises, price of exchange rate rises, $ appreciates, imports cheaper, exports more expensive, NX falls
shifts in aggregate demand
increases in C, I, G or NX shift AD right; decreases in C, I, G or NX shift AD left (except increases and decreases in price level)
classical aggregate supply
vertical at natural rate of output
natural rate of output…
determined by amount and quality of factors of production
natural rate of unemployment
level that corresponds to natural rate of output
frictional unemployment
matching process takes time
structural unemployment
chronically unemployed due to lack of skills, reallocation of worker out of shrinking industry, etc.
real business cycle model
shock in econ driven by supply, resources more intensively employed when returns to doing so are high, people work more when return to work high and visa versa, no other imperfection, no role for fiscal or monetary policy, only major shocks on record are oil price shocks in 73, 79 and 90
productivity shocks (examples)
development of new products or production techniques, intro of new management techniques, changes in quality of capital or labor, changes in availability of raw materials or energy, unusual good or bad weather, change in gov’t regulation affecting production
new classical aka rational expectations
same as classical but modeled expectations and relied on shocks to AD, assume agents use rational expectations, no role for policy
keynesian business cycle assumptions
- markets and competition imperfect. 2. wages and prices sticky. 3. economy can get stuck in equilibria where resources not fully utilized. 4. economic actors don’t have full info 5. consumers and managers can suffer from money illusion 6. shocks driven by demand (autonomous or policy)
wage rigidity
explains unemployment, unemployment due to mismatch between workers and firms, real wage slow to adjust to equilibriate labor market
sources of wage rigidity
minimum wage and unions, turnover costs, efficiency wages – wages above market clearing level
keynesian macro implications
business cycle caused by demand shocks (shocks to spending), role for demand management, believe there was a self correcting mechanism but takes a long time, believed in using fiscal policy due to direct effects on spending
why didn’t classical model fit the Great Depression?
no supply shock and there wasn’t inflation, but deflation
reasons for holding prices/wages rigid
coordination failure (with competitors) cost based pricing with lags assume demand falls for other reasons implicit or nominal contracts menu costs (changing prices costly)
