Topic 3: Business Cycle Theory

Question 1

Classical Macro Assumptions

Answer 1

1. 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)

Question 2

Classical Macro Implications

Answer 2

1. 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)

Question 3

Monetarism

Answer 3

1. 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

Question 4

The Quantity Equation

Answer 4

MV=PY; m=money supply, v=velocity of money, PY =nominal GDP

Question 5

Quantity Theory of Money

Answer 5

constant velocity and real GDP at natural rate, ΔM/M = ΔP/P —– ΔM/M = ╥

Question 6

velocity

Answer 6

measures how much money turns over each period, v=nominal GDP/nominal money stock = PY/M

Question 7

aggregate demand curve

Answer 7

negative slope: consumption (wealth effect), investment (interest rate effect), net exports (exchange rate effect)

Question 8

consumption (wealth effect) in classical model

Answer 8

when price level goes up, real value of wealth goes down, consumption falls

Question 9

investment (interest rate effect) in classical model

Answer 9

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

Question 10

net exports (exchange rate effect)

Answer 10

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

Question 11

shifts in aggregate demand

Answer 11

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)

Question 12

classical aggregate supply

Answer 12

vertical at natural rate of output

Question 13

natural rate of output…

Answer 13

determined by amount and quality of factors of production

Question 14

natural rate of unemployment

Answer 14

level that corresponds to natural rate of output

Question 15

frictional unemployment

Answer 15

matching process takes time

Question 16

structural unemployment

Answer 16

chronically unemployed due to lack of skills, reallocation of worker out of shrinking industry, etc.

Question 17

real business cycle model

Answer 17

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

Question 18

productivity shocks (examples)

Answer 18

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

Question 19

new classical aka rational expectations

Answer 19

same as classical but modeled expectations and relied on shocks to AD, assume agents use rational expectations, no role for policy

Question 20

keynesian business cycle assumptions

Answer 20

1. 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)

Question 21

wage rigidity

Answer 21

explains unemployment, unemployment due to mismatch between workers and firms, real wage slow to adjust to equilibriate labor market

Question 22

sources of wage rigidity

Answer 22

minimum wage and unions, turnover costs, efficiency wages – wages above market clearing level

Question 23

keynesian macro implications

Answer 23

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

Question 24

why didn’t classical model fit the Great Depression?

Answer 24

no supply shock and there wasn’t inflation, but deflation

Question 25

reasons for holding prices/wages rigid

Answer 25

coordination failure (with competitors)
cost based pricing with lags
assume demand falls for other reasons
implicit or nominal contracts
menu costs (changing prices costly)