Topic 5- Business Cycles and Macroeconomic Policy Flashcards
What are the 2 main intellectual traditions?
Classical and Keynesian approaches
What point did Burns & Mitchell (1946) make about Business cycles and comovement?
That business cycles do not occur in just a few sectors or variables, they instead move together in a predictable way over the business cycle which is called comovement
What point did Burns & Mitchell (1946) make about Business cycles and aggregate economic activity?
Real GDP measures most closely aggregate economic activity however, it’s important to look at other indicators of activity such as employment and financial market variables
What point did Burns & Mitchell (1946) make about Business cycles and expansions & contractions?
Aggregate economic activity declines in a contraction until it reaches a trough and then increases in an expansion until it reaches a peak
What is a procyclical variable?
An economic variable that moves in the same direction as aggregate economic activity
What is a countercyclical variable?
A variable that moves in the opposite direction to aggregate economic activity
What is an acyclical variable?
A variable that does not display a clear pattern over the business cycle
What is a leading economic variable?
A variable that tends to move in advance of aggregate economic activity
What is a coincident economic variable?
A variable that tends to move at the same time with aggregate economic activity
What is a lagging variable?
A variable that tends to move after economic activity
What is the cyclical behaviour of production?
Coincident and procyclical
What is the cyclical behaviour of expenditure?
Coincident and procyclical
What is the cyclical behaviour of employment?
Coincident and procyclical
What is the cyclical behaviour of unemployment?
Strongly countercyclical
What is the cyclical behaviour of Average labour productivity?
Leading and procyclical
What is the cyclical behaviour of real wages?
Mildly procyclical
What is the cyclical behaviour of nominal money growth?
Leading and procyclical
What is the cyclical behaviour of Inflation?
Procyclical and lagging
What is the cyclical behaviour of Stock prices?
Procyclical and leading
What is the cyclical behaviour of nominal interest rates?
Procyclical and lagging
What are the 2 major components of business cycle theories?
- A description of the shocks
- A model of how the economy responds
What is the full employment output level (ȳ)?
The level of output when the labour market is in equilibrium
What is the full employment output level determined by?
The FE level of employment and the current levels of capital and productivity
Give 4 factors that shift the FE line right
- A beneficial supply shock
- An increase in labour demand
- An increase in labour supply
- An increase in the capital stock
What is the formula for aggregate demand (Y_ad)?
Y_ad = C^d + I^d + G
When is the goods market in equilibrium?
When aggregate demand is equal to aggregate supply
What is the aggregate equilibrium condition?
Y - C^d - G = S^d = I^d
How does the real interest rate affect real money demand?
Real money demand falls as the real interest rate rises
How does output affect real money demand?
Real money demand rises as the level of output rises
When is there equilibrium in the money market?
When the real money supply equal the real quantity of money demanded
Give 4 main factors that shift the LM curve
Changes in:
- Nominal money supply
- Price level
- Expected inflation
- Nominal interest rate
How does an increase in the nominal money supply (M) shift the LM curve?
Down and to the right because real money supply increases lowering the equilibrium interest rate
How does an increase in the Price level (P) shift the LM curve?
Up and to the left because real money supply falls raising the equilibrium interest rate
How does an increase in expected inflation (π^e) shift the LM curve?
Down and to the right because demand for money falls lowering the equilibrium interest rate
How does an increase in the nominal interest rate on money (i_m) shift the LM curve?
Up and to the left because demand for money increases raising the equilibrium interest rate
What does the IS curve show?
For any level of output (Y), the IS curve shows the real interest rate (r) for which the goods market is in equilibrium
Why does the saving curve slope upward?
Because a higher real interest rate increases saving
Why does the investment curve slope downward?
Because a higher real interest rate reduces the desired capital stock, thus reducing investment
How is the IS curve derived?
- Higher real interest rate causes people to increase saving thus reducing expenditure
- Quantity demanded and supplied of goods falls
- Consequently, output is reduced
What generally shifts the LM curve?
Any change that decreases real money supply relative to real money demand shifts the LM curve up
What generally shifts the IS curve?
Any change that reduces desired national saving relative to desired investment shifts the IS curve up and to the right
What are 6 main factors that shift the IS curve and why
Fall in saving: -Increase in expected future output -Increase in wealth -Temporary increase in government purchases -Decrease in taxes Rise in investment: -Increase in expected future MPK -Decrease in the effective tax rate on capital
What does the LM curve show?
At a given level of output (Y), the LM curve shows the real interest rate for which the money market is in equilibrium
How is the LM curve derived?
Real money demand is plotted for different levels of output and the resulting equilibrium is observed
When is there a general equilibrium?
When all markets are simultaneously in equilibrium which occurs where the FE, IS and LM curves intersect
How does a temporary adverse supply shock affect general equilibrium?
- Inflation rate rises temporarily as the price level rises
- The equilibrium real wage and employment level decline
- Output declines, while real interest rate rises
- Since the real interest rate is higher and output is lower, expenditure must be lower at the new equilibrium
How does a monetary expansion affect general equilibrium?
- Suppose there’s an increase in the nominal money supply
- Assuming P is constant, real money supply increases
- This shifts the LM curve down and to the right
How do classical economists see the IS-LM model?
They see rapid adjustment of the price level so the economy returns quickly to full employment after a shock
How do Keynesian economists see the IS-LM model?
They see slow adjustment of the price level
When is money neutral?
If a change in the money supply changes the prices level proportionately but has no effect on real variables
What does the Aggregate demand curve show?
The relationship between the quantity of goods demanded and the price level when the goods market is in equilibrium
What factors generally shift the AD curve?
Any factor that causes the intersection of the IS-LM curves to shift to the right causes the AD curve to shift to the right; the same goes for the left
What does the aggregate supply curve show?
The relationship between the price level and the aggregate amount of output that firms supply
What is the shape of the SRAS curve and why
In the short run, prices remain fixed so firms supply whatever output is demanded thus, the short-run aggregate supply curve is horizontal
What is the shape of the LRAS curve and why
LRAS curve is vertical because full-employment output isn’t affected by the price level
What factors generally shift the SRAS curve?
Whenever firms change their prices in the short run so any factor that changes the cost of production
What factors generally shift the LRAS curve?
Anything that changes the full-employment output
