Understanding why Recessions happen.

Question 1

What is a Recession?

Answer 1

Recessions are those periods of time during which the economy’s output of goods and services declines. When output falls, firms need fewer workers, and the typical result is massive layoffs, which cause significant increases in unemployment.

Question 2

How do Recessions begin?

Answer 2

Recessions begin with what economists like to call shocks - unexpected adverse events such as terrorist attacks, natural disasters, the introduction of bad government policies or sudden spikes in the cost of important natural resources like oil.

Question 3

What would happen if the prices of goods and services in the economy were free to adjust to changes in demand and supply caused by shocks?

Answer 3

If the prices of goods and services in the economy were free to adjust to changes in demand and supply caused by shocks, the economy would be able to recover quite swiftly. Unfortunately, however, not all real-world prices are totally free to adjust to shocks.

Question 4

What are STICKY prices?

Answer 4

Some very important prices are quite slow to adjust - they are, STICKY. As a result, recessions can linger and cause a lot of harm unless the gov intervenes to help the economy recover more quickly.

Question 5

What are positive shocks?

Answer 5

Factors which lead to a sudden growth in demand in the economy such as the discovery of a new resource or a sudden or substantial tax cut.

Question 6

Graphically, what does the business cycle look like?

Answer 6

Question 7

What is the difference between recessions and recovery periods?

Answer 7

Recessions, or contractions are periods of time during which Y falls - that is, after a peak and before the next trough.

Recoveries, or expansions, are the periods of time during which Y increases - that is, after a trough and before the next peak.

Question 8

With regards to the business cycle, what are the two natural goals of Macroeconomic policy?

Answer 8

1) Making the long-run average growth line as steep as possible: the steeper it is, the faster (on average) output and living standards rise.
2) Reducing the size of the business-cycle fluctuations around the long-run average growth line: smaller distances between peaks and troughs translate into fewer people suffering through bouts of unemployment when output falls.

Question 9

What do economists use the concept of full-employment output as?

Answer 9

Economists use the concept of full-employment output (Y^*) as their measure of how well an economy should be doing.

The idea of full-employment output revolves around the concept of full employment, by which economists mean a situation in which everyone who wants a full-time job can get one.

Full-employment output is how much output is produced in the economy when full employment exists in the labour market.

Question 10

Define, Maximum output.

Answer 10

Maximum output, is the larger amount of output that be produced if everyone were forced to work as much as humanly possible.

Question 11

What is Frictional Unemployment?

Answer 11

Even when everyone who wants a job can get one, some unemployment always exists as people voluntarily leave one job to search for a better one.

For the duration of their job search these people are counted as unemployed.

Similarily, although the economy may be growing, some firms may be laying off workers, and those workers may be out looking for jobs.

Economists call this situation, Frictional Unemployment as though the delay in finding a better job is due to some sort of friction slowing the process down.

Question 12

Why does the economy naturally want to adjust back to Y^* (full-employment output) anytime it deviates from Y^*?

Answer 12

Because, if that adjustment process was rapid enough, you wouldn’t ahve to worry about the business cycles, recessions and unemployment.

If the economy reverted back to Y^* fast enough, recessions would be too brief to cause any serious damage.

Unfortunately, the natural adjustment process can be very slow, and as a result, recessions can be quite lengthy.

Question 13

After an economic shock, how might an economy return to producing at Y^*?

Answer 13

After an economic shock, PRICE ADJUSTMENTS tend to return an economy to producing at full employment.

Question 14

What happens when aggregate (total) demand falls off due to an economic shock?

Answer 14

When aggregate (total) demand falls off due to an economic shock - i.e. individuals, firms and the gov demand and buy less output than the economy is producing - firms lower prices to make sure that they sell off their outputs.

Question 15

What happens when firms lower prices to ensure they sell of their output?

Answer 15

This process eventually leads to two outcomes:

1) prices all over the economy fall (more or less)
2) the economy again produces at full-employment output, Y^*.

If prices don’t adjust quickly, you can get a recession and until prices do adjust, the recession lingers.

Question 16

What is the difference between the short run and the long run ?

Answer 16

The short run refers to a period of time in which firms haven’t yet made price changes in response to an economic shock.

The long run refers to the period of time after which firms have made all necessary price changes in response to an economic shock.

Question 17

How do economists define P (price) ?

Answer 17

To understand the meaning of P, consider this: although each individual good and service has its own price, and some may be going up while others go down, an overall trend in prices exists for the economy as a whole. P is simply a measure of how prices of goods and services as a whole behave.

Question 18

What symbol is used to represent the equilibrium level of prices?

Answer 18

• P^* *
• P^* is the price level at which consumers want to buy exactly the amount of full-employment output (Y).</sup>

That price level is determined by the intersection of what’s called the long-rum aggregate supply curve (LRAS) with the aggregate demand curve (AD).

Question 19

What is the aggregate demand curve?

Answer 19

The aggregate demand curve represents the total amount of goods and services that people want to buy.

The AD curve slopes downward. That’s because an inverse relationship exists betweeen the price level and the amount of stuff people want to buy.

The downward slope of the AD curve captures the fact that at lower prices, people buy more.

Question 20

What is the long-run aggregate supply curve?

Answer 20

The long-run aggregate supply curve represents the amount of goods and services that an economy is going to produce when prices have adjusted after an economic shock.

The LRAS is a vertical line and is drawn above the point on the x-axis that represents the full-employment level, Y^*.

Why? because in the long run, changes in prices always return the economy to producing at Y^*.

Question 21

Graphically, what does the macroeconomy look like?

Answer 21

The horizontal axis measures the value of the output of goods and services sold in the economy (Y). This number is the same as a country’s gdp. The vertical axis measures the overall price level in the economy, P.

Question 22

What happens to a firm’s profits, when it cuts prices to increase sales?

Answer 22

Firms don’t necessarily lose profits in this situationbecause their costs are falling at the same time.

That’s because when the ecnomy is producing at less than Y^* , a lot of unemployed workers are available, as well as a lot of unused productive inputs such as iron and oil.

Unemployment puts downward pressure on wages, meaning, having lots of labour readily available means you can hire people at lower wages. An the more piles of unues productive inputs that exist, the more their prices fall.

Question 23

Why can’t prices remain below P^* for long?

Answer 23

Because at price level P^low, people want to buy Y^high worth of output. But that’s more than firms can produce at full employment.

The only way to produce that much output is if employees work longer than the standard working week. The only way to get them to do so is to pay them more, and the only way to give them higher wages is for firms to raise prices.

So with demand exceeding supply, prices are raised until they reach P^***, at which price level the quantity demanded by consumers is exactly equal to the full-employment output level, Y*.

Question 24

What causes prices to be too high or too low in the first place?

Answer 24

The usual cause is a shock to aggregate demand.

Here we see the aggregate demand curve shifting to the left from AD₀ to AD_1. A leftward shift of aggregate demand is called a neagative demand shock, and it may be cause, for ex. by a decline in confidence in the conomy that amkes people want to save more and consume less.

Question 25

Why is the new price level P¹ less than the original price level P⁰ ?

Answer 25

Demand for goods and services decreases after the negative demand shock. The only way to entice consumers to again purchase at Y* levels is to lower the prices of buying that much output.

Question 26

What happens to prices in the short run?

Answer 26

Although, after an economic shock prices will eventually adjust to return the economy back to Y*, this process may take some time because in the short-run, prices are essentially fixed.

Even the managers of the most nimble firms need time to decide how much to cut prices. And some firms aren’t quite as nimble.

Question 27

Give an example of a firm dealing with fixed prices in the short-run.

Answer 27

Suppose a firm prints catalogues listing the prices of all the things it sells. The firm only distributes these catalogues once a year and so is commited to selling to customers at these prices until the next catalogue is sent out.

in such a situation, the firm adjusts its production to meet whatever amount of demand happens to come along these fixed prices.

If a lot of people show up to buy at these prices, the firm increases its production, typically by hiring more employees. If very few people show up to buy, the firm decreases its production by hiring less.

Question 28

Graphically depict a situation in which firms have committed to a fixed set of prices.

Answer 28

Here a firm has committed to a fixed set of prices and can respond to a chnage in demand only by adjusting its production levels.

This figure shows the short-run aggregate supply curve (SRAS), which is not a curve at all but a straight line.

This curve corresponds to price level P⁰ because the firms, in the short run, can’t adjust their prices.

Movements right and left along the SRAS curve capture the increases and decreases in output that firms have to make as demand for their products varies at the fixed price level.

Question 29

Why is the SRAS horizontal?

Answer 29

In the short run, it makes sense to think of the firm as having more control over its production levels than its prices, which leads to modelling the SRAS curve as horizontal.

Question 30

In the long run, how is potential output capped?

Answer 30

In the long run, potential output is capped at a level given by a number of underlying long-run factors.

Question 31

What happens between the short and long run?

Answer 31

In between, we have a number of models of various degrees of elaborateness explaining what happens.

Generally, at some point, these models all agree: the SRAS first becomes upward sloping (implying that prices and output rise together) and then vertical (LRAS).

Of course, in reality economies don’t just jump from a horizontal SRAS to a vertical LRAS, from growth to recession, or from one price level to another.

However, the model is simpler to understand if we pretend this is the case.

Question 32

Describe the differences a leftward shift in aggregate demand will have in the short vs the long run.

Answer 32

In the short-run when prices are fixed, output falls and unemployment rises - because lower output means that firms need fewer works you end up with a recession.

In the long-run, prices fall and output returns to the full-employment level.

Question 33

Why is there such a huge difference between the short and long run?

Answer 33

Because firms aren’t stuck with their original catalogue prices. Eventually they print new catalogues with lower prices. The lower prices entice customers to purchase more, and soon the economy can return to producing at the full-employment output level, Y*.

Question 34

Graphically represent the short-run and long-run responses to a negative demand shock.

Answer 34

Here we see how the economy adapts to a negative demand shock both in the long and short run.

The economy begins at Point A, where the orginal agreggate demand curve AD₀, interescts both the LRAS and the SRAS. At point A, the economy is in equilibrium because at price level P₀, the aggregate demand for output equals the full-employment level of output, Y*. Neither a surplus nor a shortage exists that may cause a change to price.

Question 35

What happens when the AD curve shifts to the left because of a negative demand shock?

Answer 35

Because prices are fixed in the short-run at P₀, the economy’s first response is to move from point A to B. In other words, because prices are fixed, production falls from Y* to Y^low, as firms respond to decreased demand by cutting production.

Question 36

What happens at point B?

Answer 36

At point B, the economy is operation below full employment, implying that there a re a lot of unemployed workers. This high level of unemployment causes wages to fall. As wages fall, firms’ costs also fall, allowing them to cut prices in order to attract more customers.

Question 37

How do we reach point C?

Answer 37

Falling prices cause increased AD for goods and services, which eventually moves the economy all the way from B to C. When the economy reaches C, it is once again at full employment, Y*.

Question 38

What determines the length and severity of any recession after a negative demand shock?

Answer 38

Price flexability (or lack of flexibility).

If prices are infinitely flexible - they can change within seconds or minutes after a shock - the economy moves from A to C.

But if prices are fixed for any period of time, the economy goes into a recession as it moves from A to B, before prices eventually fall and the economy returns to Y*.

Question 39

In the real world, what do economists call prices that are clow to change?

Answer 39

Sticky prices.

interestingly, they tend to be stickier when going downward than upward, meaning that prices appear to have a harder time falling than rising.

The major culprit seems to be one price: wages. Unlike any other prices in the economy, people are particularly emotionally attached to wages and how they change over time.

Question 40

Eventually, why do all firms end up cutting wages?

Answer 40

Labour costs are very slow to fall because managers don’t want to risk alientating workers by cutting their wages. But because there are so many unemployed workers when the economy is at point B, wages eventually decline.

Some firms hire unemployed workers at lower wages, which reduces their costs, meaning that they can undersell firms that keep their wages high.

Eventually, such competitive pressures mean that all firms end up ctting their wages.

Question 41

During a recession, why might other costs decline?

Answer 41

Because, during a recession, with output so much diminished, a significant portion of the economy’s productive capacity is unused i.e. unused factories, trucks, ships etc, as well as large amounts of unused productive inputs i.e. iron and oil.

Question 42

What do the owners of these unused inputs do to try and sell them?

Answer 42

They lower their prices.

As their prices fall, firms costs also fall, allowing firms to reduce the selling price of their output.

And as these selling prices fall the ecnomy moves from point B to Crestoring the economy to producing at the full-employment level Y*.

Question 43

Why was John Maynard Keynes the most influential economist of the 20th century?

Answer 43

He was the first economist to realise that sticky prices (caused by wages) are the culprit behind recessions.

He was led to the idea by the horrible state the economy reached during the Great Depression of the 30’s.

Question 44

What makes a recession a recession?

Answer 44

There are multiple definitions.

i.e. you may read in a newspaper that an economy is in a recession if real GDP falls for two consecutive quarters - but sometimes (i.e. US April 1960) real output may go up, yet the economy is labelled ‘in a recession’.

the best internationally accepted definition comes from the National Bureau of Economic Research (NBER) which is accpeted and used by other bodies, including the Organisation for Economic Co-operation and Development (OECD), although for some obscure reason, governements tend to like to use their own definitions.

NBER has a long set of criteria that begins with output faling and unemployment rising and includes lots of other things, such as how fast factories receive new orders. Somethimes these other factors casue the NBER to feel that economy had passed a peak and has entered a recession even if output isn’t falling.

Question 45

Explain the Keynesianism model.

Answer 45

not only did Keynes figure out that sticky prices cause recessions, he also developed a his own hugely influential model - Keynesianism which is a small part of a larger approach to managing the macroeconomy.

The approach favoured large gov interventions into the economy rather then the sort of laissez-faire policies of non-intervention preferred by others.

Question 46

Explain the non-controversial aspect of Keynesianism.

Answer 46

Keynesianism has attracted a lot of critics and is not the be all end all of economics.]The non-controversial aspect of Keynesianism explains how an ecconomy adjusts to equilibrium - a place where aggregate supply matches aggregate demand - in the extreme short run after an economic shock when prices can’t change at all.

Question 47

With regards to the SRAS, what does the Keynesian model elaborate on?

Question 48

What does Keynes’s model focus on?

Answer 48

Keynes’s model focuses our attention on firms’ inventories of goods that have been made but not sold yet. According to Keynes, changes in inventories guide firms to increase or decrease output during situations in which prices are sticky and can’t serve as signals of what to do.

Question 49

How might one see the novelty of Keynes’s inventory idea?

Answer 49

To see the novelty of Keynes’s idea, understand that if prices were able to change, prices (not inventories) would guide firm decsions about how much to produce:

• if prices are rising, a firm knows that its product is popular and that it should increase output.
• if prices are falling, the firm knows that the product isn’t doing well and that it should probably cut output (and maybe get into another line of business)

In an economy with fixed prices however, firms need some other way of deciding whether to increase or decrease production. Keynes realised that the guiding force would be changes in inventories.

Question 50

What are the costs and benefits that each firm weighs to come up with its target inventory level?

Answer 50

Having less inventory than the target inventory level is deangerous because the firm may not be able to keep up with sales spikes.

Having more inventory than the target inventory level is wasteful because there’s no point in having stuff sitting around unsold, year after year.

Target inventory levels may vary from year to year depending on whether the firms are expecting strong or weak sales.

Question 51

What did Keynes realise about aggregate demand shocks?

Answer 51

Keynes realised that aggregate demand shocks (which, by definition are, unexpected) would show up as unexpected changes in in firms inventories.

• Unexpectedly low aggregate demand means that sales slow so much that inventories increase and reach levels higher than firms had planned on.
• Unexpectedly high aggregate demand means that sales increase so much that inventories decrease and reach levels lower than firms had planned on.

Question 52

How do unexpectedly large changes in inventories cause firms to change their output?

Answer 52

If inventories rise above target levels, firms respond by cutting production. By reducing production rates to less than sales rates, inventories begin to fall down toward target levels.

If inventories fall below target levels, firms respond by raising production. By increasing production rates to more than sales rates, inventories begin to rise toward target levels.

Question 53

Why are changes in output levels caused by changes in inventories important?

Answer 53

The changes in output levels caused by changes in inventories are hugely important because they determine not only whether output (Y) is increasing or decreasing, but also whether unemployment is rising or falling.

i.e. if firms increase production because inventories have fallen below target levels, they need to hire more workers, and unemployment falls. If, on the other hand, firms decrease production because inventories rise above target levels, they need to lay off workers, and unemployment rises.

Question 54

What are planned expenditure?

Answer 54

Planned expenditures are the amount of money that households, firms, the gov and foreigners want to spend on domestically produced goods and services.

Question 55

What are Actual expenditures?

Answer 55

Actual expenditures are equal to tGDP; they are what households, businesses, the gov and foreigners actually end up spending on domestically produced goods and services.

Question 56

What happens when actual expenditures are different from planned expenditures?

Answer 56

Inventories automatically change.

Ex. if more money is spent on goods and services than was planned, people are buying up more output than is currently being produced.

This situation is possible because firms sells goods from their inventories that were produced in previous periods.

on the flip side, if people spend less money on goods and services than was planned, firms inventories rise because firms have to store up all the output that they can’t sell.

Question 57

How did Keynes algebraically represent planned expenditures?

Answer 57

• PE = C + I^P + g + NX*
• I^P* = the amount of output that firms plan to buy as investment goods i.e. factories, equipment as well as any inventory changes that firms plan to make.

Question 58

How did Keynes algabraically represent actual expenditures?

Answer 58

For actual expenditure, Y, Keynes used the same equation we use to calculate GDP.

Y = C + G + I + NX

Why? Because actual expenditure is equal to national income because every penny of expenditure made in the economy is income to somebody.

Also, actual expenditure is also equal to the pound value of all goods and services produced in the economy because every bit of output produced is sold to someone.

Question 59

What is meant by inventory investment?

Answer 59

Any output that a firm makes but can’t sell to customers is counted as being ‘sold’ by the firm to itself as that output is placed into inventory.

These inventory changes are known as inventory investment and are totalled up in GDP as part of the total investment, I.

Question 60

Withing the Keynesian model, what are the three ways of looking at Y?

Answer 60

• Y =* actual expenditures
• Y* = national income
• Y* = output

We switch between these three definitions were we see fit.

Question 61

How do planned expenditures differ from actual expenditures?

Answer 61

Y and PE differ only because of differences made in investments caused by inventories increasing or decreasing unexpectedly when sales are more or less than planned.

Question 62

Algabraically represent how higher income (Y) leads to higher consumption (C).

Answer 62

PE = C₀ + c(1 - t)Y + I^P + G + NX

This equation shows that the total planned expenditure on goods and services in the economy (PE) depends on the total income in the economy (Y).

The higher the total income, the more money people are going to plan to spend.

Question 63

What is a good way to simplify this equation?

Answer 63

By creating a variable called A and to define it as:

A = C₀ + I^P + G + NX

Now we can represent our original equation as:

PE = A = c(1 -t)Y

Question 64

What does variable A stand for?

Answer 64

Autonomous expenditures, by which economists mean the part of planned expenditures that doesn’t depend on income (Y).

The part of plnned expenditures that does depend on income, c(1 - t)Y, is known as induced expenditures.

Question 65

Graphically, what does the planned expenditure line look like?

Answer 65

Question 66

Why is any situation where PE = Y an equilibrium?

Answer 66

If planned expenditures = actual expenditures, you truly have ab equilibrium because everybody is getting what they want - consumers buying as much as they wanted to consume (C), gov’s buying as much output as they wanted (G), foreigners buying as much stuff from us they intended (NX) and firms are spending exactly as much on investment as planned (I) which implies that inventories aren’t changing unexpectedly - and nobody has any incentive to change behaviour.

Question 67

Algebraically express the Keynesian model’s uquilibrium value of output.

Answer 67

Y~ = A + c(1 - t)Y

This equilibrium is stable, meaning that if the economy starts out at any other income level other than Y~ , it soon moves back to Y~ . The thing that returns the economy to Y~ is inventory changes.

Question 68

Show the Keynesian model’s equilrium, grapgically.

Answer 68

The point where the actual expenditures line meets the planned expenditures line is the equilibrium. At that point planned expenditures exaclty equals actual expenditures in the economy.

Question 69

Using geometry, how does the PE = Y line show how the economy behaves when it’s not producing at the equilibrium output Y~?

Answer 69

The trick is that the PE = Y line shows up on a graph at a 45-degree angle, meaning it can be used to draw squares- shapes whose sides have the same length.

That means you can transpose any value of Y onto the vertical axis. To do so, take any value of Y, go straight up until you hit the 45-degree line, and then go straight sideways until you hit the vertical axis. The point you hit represents how many pounds vertically as Y represents horizontally.

Question 70

According to Keynes, what should gov’s do if inventory adjustments have carried the economy to equilibrium income, Y^~, but that Y^~ ​is less than the economy’s full employment output level Y^* ?

Answer 70

Gov’s can choose to do nothing. Eventually, because Y^~ < Y^*, prices will fall and the economy will return to full employment (as it does moving from point B to point C).

But Keynes argued that govs could be able to speed up the recovery by boosting planned expenditures.

Ex. suppose the gov increases G. If it does so, PE clearly increases. An increase in G means an increase in Autonomous expenditures (A). Graphically, a larger A means that the planned expenditure line shifts vertically from PE₁ to PE₂.

Question 71

Graphically, how does increasing gov expenditures increase equilibrium output from Y^~₁ to Y^~₂?

Answer 71

Given the fact that the actual expenditure line (PE = Y) doesn’t change, the vertical shift in the planned expenditure line causes equilbrium output to increase from Y~1 to Y~2.

Question 72

What did Keynes suggest using in order to increase planned expenditures?

Answer 72

Keynes suggested using government policy to increase planned expenditures by whatever amount was necessary to increase the economy’s short-run sticky-price equilibrium, Y~, all the way to full-employment output level, Y^*.

Famously, he extended this idea to paying some people to dig holes in the ground and others to fill them in again - in other words, any action is better than no action.