Week 20 - Short-term fluctuations: Intro Flashcards
What are business cycles?
Business cycles refer to short-term fluctuations in GDP and other economic variables, which involve periods of expansion and recession.
What is a recession?
A recession is a period in which the economy is growing at a rate significantly below normal.
It can be defined as:
A period when real GDP falls for two or more consecutive quarters.
A period when real GDP growth is well below normal, even if not negative.
A variety of economic data are examined to assess recession.
What is the difference between a recession and a depression?
A depression is a particularly severe recession with prolonged economic downturns and deeper impacts on output and employment.
What is a peak in the business cycle?
A peak is the high point of the business cycle, marking the beginning of a recession. It represents the point where economic growth stops accelerating and begins to slow down.
What is a trough in the business cycle?
A trough is the low point of the business cycle, marking the end of a recession. It represents the point where the economy starts recovering and growth begins to pick up.
What is an expansion in the business cycle?
An expansion is a period in which the economy is growing at a rate significantly above normal, characterised by increasing production, employment, and consumer spending.
What is a boom in the business cycle?
A boom is a strong and long-lasting expansion where the economy experiences sustained high growth and economic activity over a prolonged period.
When did the National Bureau of Economic Research (NBER) declare the 2020 recession
The 2020 recession was declared in February 2020 by the NBER, marking the end of the previous recession that had ended in June 2009, after a 128-month expansion.
What are three important monthly indicators used to date recessions?
The three important monthly indicators used to date recessions are:
Real personal consumption expenditures
Non-farm employment
Real after-tax household income
What are coincident indicators?
Coincident indicators are economic indicators that move in tandem with the overall economy, helping to reflect the current state of economic activity.
How long have economists studied business cycles?
Economists have studied business cycles for at least a century, recognising the irregularity and unpredictability of recessions and expansions in terms of length and severity.
How do recessions and expansions affect the economy?
Recessions and expansions affect the entire economy and can have a global impact.
Can recessions affect global economies?
Yes, recessions can have a global impact. Some examples include:
The Great Depression of the 1930s
U.S. recessions in 1973 – 1975 and 1981 – 1982
The Great Recession in 2007 – 2009
The Covid-19 Crisis.
What happens to cyclical unemployment during recessions?
Cyclical unemployment rises sharply during recessions as demand for goods and services decreases, leading to job losses.
How does unemployment behave during an economic recovery?
Decreases in unemployment lag the recovery, meaning it takes time for the job market to improve even after the economy starts growing again.
How do real wages, promotions, and bonuses change during a recession?
Real wages grow more slowly for those employed.
Promotions and bonuses are often deferred or postponed.
New labor market entrants have difficulty finding work.
Which types of goods are more volatile during business cycles?
The production of durable goods (such as cars, houses, and capital equipment) is more volatile than services and non-durable goods (such as food and clothing).
What generally happens to inflation during the course of a business cycle?
Inflation generally decreases during a business cycle, especially during recessions when demand for goods and services falls.
Does inflation always decrease during recessions?
No, inflation can decrease at other times as well, even outside of a business cycle or recession, depending on various factors like policy changes or external economic conditions.
What is potential output (Y)**?
Potential output (Y) is the maximum sustainable amount of output that an economy can produce, also known as full-employment output. It’s the level of output achievable when all resources are fully utilised.
Does potential output grow over time?
Yes, potential output grows over time due to factors like capital accumulation, technological innovation, and improvements in labour productivity.
Does actual output always equal potential output?
No, actual output does not always equal potential output. Variations occur due to factors like economic fluctuations, technical innovations, and other conditions that affect actual economic performance.
What factors influence the growth of potential output?
The growth of potential output is influenced by capital formation, technical innovation, and factors like weather conditions and labor force changes.
What is the output gap?
The output gap is the difference between an economy’s actual output (Y) and its potential output (Y*), expressed relative to potential output, at a point in time. It is calculated as:
Output gap (%) = Y - Y/ Y x100
What is a recessionary gap?
A recessionary gap occurs when actual output (Y) is *less than potential output (Y)**, meaning the economy is underperforming. It is represented by a negative output gap:
Y*>Y
What is an expansionary gap?
An expansionary gap occurs when actual output (Y) exceeds *potential output (Y)**, leading to inflationary pressure. It is represented by a positive output gap:
Y*< Y
How do policymakers respond to output gaps?
Policymakers use stabilisation policies to address output gaps:
Recessionary gaps (negative) prompt policies to boost output and employment to their sustainable level.
Expansionary gaps (positive) lead to policies aimed at controlling inflation.
What occurs during a recessionary gap (Y* > Y)?
In a recessionary gap:
Capital and labour resources are underutilised.
Output and employment are below normal levels.
The economy is performing below its potential, leading to a need for policies that stimulate growth and employment.
What occurs during an expansionary gap (Y > Y*)?
In an expansionary gap:
Output and employment are higher than normal.
Demand for goods exceeds the economy’s capacity to produce them.
This creates inflationary pressure, driving prices up.
High inflation can reduce economic efficiency by distorting decision-making and redistributing wealth.
What is the relationship between recessionary gaps and unemployment?
During recessionary gaps, unemployment rates tend to be high because the economy is underperforming and resources, including labour, are not fully utilised.
What is frictional unemployment?
Frictional unemployment is short-term unemployment that occurs as workers are in the process of matching with suitable jobs. It typically involves workers voluntarily changing jobs or entering the workforce for the first time.
What is structural unemployment?
Structural unemployment is long-term chronic unemployment that arises from a mismatch between the skills of the workers and the demands of available jobs, often due to changes in the economy, such as technological advancements or shifts in industries.
What is the natural rate of unemployment (u*)?
The natural rate of unemployment is the sum of frictional and structural unemployment. It is the unemployment rate that occurs when there is no cyclical unemployment, typically when the economy is at potential output (Y*)
What is cyclical unemployment?
Cyclical unemployment is the difference between total unemployment (u) and the natural rate of unemployment (u*). It occurs due to the economic cycle — higher during recessions and lower during expansions.
How does cyclical unemployment relate to recessionary and expansionary gaps?
In a recessionary gap, cyclical unemployment is positive (u>u*) because the economy is underperforming.
In an expansionary gap, cyclical unemployment is negative (u< u*) because the economy is producing above potential output, leading to lower unemployment.
What does Okun’s Law describe?
Okun’s Law relates changes in cyclical unemployment to changes in the output gap. Specifically, for each 1 percentage point increase in cyclical unemployment, the negative output gap widens by 2% of potential GDP.
Given an example, how does cyclical unemployment relate to the output gap under Okun’s Law?
Suppose cyclical unemployment starts at 1% and the recessionary gap is -2% of potential GDP.
If cyclical unemployment increases to 2%, the recessionary gap increases to -4% of potential GDP. This illustrates a 2% widening in the gap for each percentage point increase in cyclical unemployment.
What causes output gaps in the short-run?
Output gaps arise due to changes in total spending at preset prices and wages, affecting the economy’s output levels. When spending is low, the output will fall below potential output.
How does low spending affect output in the short-run?
When total spending is low, the economy produces less than its potential output. This leads to a recessionary gap, where actual output is below the economy’s potential.
What are sticky wages and prices, and how do they affect the economy?
Sticky wages and prices are wages and prices that do not adjust quickly to changes in demand, causing slow adjustments in the economy. This happens due to:
Contracts (wages and prices set for a period)
Coordination argument (difficult to coordinate price changes among all firms)
Menu costs (costs of changing prices)
Wage cuts depress employee morale and productivity.
What is the primary cause of output gaps in the short-run?
The primary cause of output gaps in the short-run is changes in economy-wide spending, which directly affect aggregate demand. When demand shifts, the economy adjusts slowly due to sticky wages and prices.
How can policymakers address output gaps?
Policymakers can adjust government spending to close output gaps by influencing the demand side of the economy. For example, increasing government spending during a recessionary gap can boost demand and output.
What is the main reason output gaps arise?
Markets take time to reach equilibrium price and quantity because firms adjust prices and production gradually.
Why don’t firms change prices immediately when demand shifts?
Firms face menu costs, meaning:
Changing prices requires costly resources (analysing competitors, market demand).
Frequent price changes can be confusing to customers.
Firms often adjust production rather than prices in the short run.
How do firms adjust production before reaching equilibrium?
Firms produce to meet demand at current prices, leading to temporary output gaps until the market reaches equilibrium.
How does the economy self-correct in the long run?
Prices eventually adjust to eliminate output gaps, bringing production back to potential output levels.
In the long run, does spending affect output?
No. Spending influences only price levels and inflation, while output is determined by the economy’s productive capacity.
What was the primary economic problem during the Great Depression?
Available resources (factories, workers) were unemployed due to a collapse in spending rather than a lack of productive capacity.
What happened when public spending declined?
Lower production → Firms laid off workers.
Laid-off workers reduced their spending → Further drop in demand.
Insufficient spending to support normal economic activity.
Was the Great Depression caused by supply-side or demand-side shocks?
It was a demand-driven shock → A fall in spending rather than a reduction in productive capacity.
If the U.S. had the same factories, workers, and technology in 1933 as in 1929, why did the economy shrink?
The lack of demand and spending caused underutilisation of resources, leading to high unemployment and a massive drop in output.
How did John Maynard Keynes change economic policy?
He introduced the idea that government intervention (fiscal policy) was necessary to stimulate demand during economic downturns.
What did Keynes predict about the consequences of World War I peace terms?
He argued that harsh German war reparations would prevent economic recovery and likely lead to another war.
What is Keynes’s most well-known book, and when was it published?
The General Theory of Employment, Interest, and Money (1936).
What key economic problem did Keynes try to explain?
Why economies remained in recessionary gaps for long periods instead of naturally recovering.
Why did Keynes believe economies stayed in recession?
Aggregate spending was too low to sustain full employment, preventing recovery.
What did Keynes propose as a solution to low aggregate spending?
Government intervention through stabilisation policies, such as increasing government spending or cutting taxes to boost demand.
How do producers determine output levels in the short run?
Producers meet demand at existing prices, adjusting output based on total spending rather than changing prices.
What primarily drives output levels in the short run?
Total spending (aggregate demand).
What happens to prices and output in the long run?
Prices adjust to reach equilibrium, and output settles at its *potential level (Y)**.
How do firms decide on pricing and production in the short run?
Firms gather data and analyse business opportunities before making adjustments.
How does the economy self-correct output gaps?
Firms eventually adjust prices based on spending levels, leading to long-run equilibrium.
What do firms do if spending is less than potential output?
Firms will slow the increase of prices or reduce prices to stimulate demand.
What happens if spending exceeds potential output?
Firms will increase prices, creating inflationary pressures.
What happens to output gaps in the long run?
Prices adjust to equilibrium, eliminating output gaps, and *production returns to potential output (Y)**.
According to monetarists, how does spending influence the economy?
Spending affects only price levels and inflation, while output is determined by productive capacity (capital and labor).
What was the primary cause of the U.S. housing bubble before the 2007-2009 financial crisis?
An increase in demand for real estate, fueled by easy access to credit, low mortgage rates, and speculative investment, led to rapidly rising home prices.
How did the increase in home prices and weakened mortgage standards interact?
Rising home prices encouraged lenders to offer riskier loans, while easy lending fueled more demand, further driving up prices.
Why did many people rush to buy homes during the housing bubble?
They believed that real estate prices would continue to rise indefinitely, making homes a “safe” and profitable investment.
What factors contributed to the speculative flurry in the real estate market?
The aftermath of the dot-com bubble led investors to seek alternative assets.
Unprecedented access to credit allowed more people to qualify for mortgages.
Very low mortgage rates made borrowing cheap, increasing demand for housing.
What role did the dot-com bubble play in the housing market bubble?
After the dot-com crash of the early 2000s, investors sought new opportunities, and many turned to real estate as a “safer” alternative investment.
How did mortgage lending practices contribute to the financial crisis?
Lenders issued high-risk loans (subprime mortgages) to borrowers with low creditworthiness, assuming home prices would always rise.
Why were mortgage rates so low before the financial crisis?
The Federal Reserve kept interest rates low to stimulate economic growth after the dot-com bubble and 9/11, making borrowing more affordable.
How did mortgage lending standards change before the financial crisis?
Before the early 2000s, homebuyers typically made significant down payments and provided full financial documentation. However, as housing prices rose, lenders loosened these standards.
What were nonprime mortgages, and how did they differ from traditional mortgages?
Nonprime mortgages were loans given to borrowers with lower creditworthiness. They often required little or no down payment and minimal financial documentation, unlike traditional mortgages.
Why did lenders offer riskier mortgages to less-qualified borrowers?
Lenders assumed that rising home prices would protect them from defaults, as borrowers could refinance or sell their homes at a profit.
What were some characteristics of the risky mortgage products offered before the crisis?
Many mortgages had low initial interest rates (teaser rates), adjustable rates (ARMs), or interest-only payments, which made them affordable at first but risky in the long run.
How did rising house prices contribute to the housing crisis?
As home prices surged, housing became less affordable, making it harder for new buyers to enter the market.
What happened to mortgage payments as home prices increased?
Mortgage payments as a share of household income rose sharply, straining homeowners’ budgets.
How did rising costs of homeownership impact housing demand?
Higher costs discouraged new buyers, reducing demand for homes and ultimately leading to a slowdown in price growth.
What happened when demand for housing began to decline?
Home prices stopped rising and eventually began to fall, leaving many homeowners with properties worth less than their mortgage debt.
When did house prices begin to decline, marking the burst of the housing bubble?
House prices started to fall in early 2006 as demand for homes declined.
By how much did house prices drop between 2007 and 2010?
House prices fell by more than 30% during this period.
What does it mean for a homeowner to go “underwater” on a mortgage?
It means the homeowner owes more on their mortgage than their house is worth due to falling home prices.
Why were borrowers with little or no down payment particularly vulnerable when house prices fell?
Since they had little equity in their homes, they quickly went underwater when prices declined, making it difficult to sell or refinance.
What happened as more homeowners went underwater?
Mortgage delinquencies and foreclosures surged as borrowers struggled to make payments or walked away from their loans.
What is a credit default swap (CDS)?
A CDS is a financial security that acts as insurance against the default of a debt instrument, such as a bond or mortgage-backed security.
Who are the two main parties in a credit default swap?
The CDS buyer (who seeks protection) and the CDS seller (who provides insurance).
What does the CDS buyer do?
The CDS buyer pays a regular fee to the seller in exchange for protection against a possible default on a financial asset.
What does the CDS seller agree to do?
The CDS seller agrees to cover losses if the underlying debt (e.g., a bond or mortgage-backed security) defaults.
What types of institutions were involved in trading CDS?
Investment banks and insurance companies were major players in the CDS market, with firms like AIG selling large amounts of CDS contracts.
Why did credit default swaps play a major role in the 2008 financial crisis?
Many financial institutions issued CDS without holding sufficient capital reserves, leading to massive losses when mortgage-backed securities collapsed.
What is a subprime mortgage?
A subprime mortgage is a home loan given to borrowers with low credit scores, limited income verification, or high debt levels, making them riskier to lenders.
What is mortgage securitisation?
It is the process by which financial firms bundle mortgages (including subprime loans) into securities and sell them to investors.
What are mortgage-backed securities (MBS)?
MBS are financial instruments created from pools of mortgages, which generate returns for investors from homeowners’ mortgage payments.
How did financial firms use subprime mortgages in securitisation?
They bundled low-quality (subprime) mortgages with other assets to create securities that were then sold to investors.
What role did credit rating agencies play in the financial crisis?
Credit rating agencies (like Moody’s, S&P, and Fitch) assigned high ratings (often AAA) to mortgage-backed securities, underestimating their risk.
Who were the main buyers of mortgage-backed securities?
Investors, including hedge funds, pension funds, and banks, seeking high returns.
What was the role of credit insurers in the mortgage crisis?
Credit insurers, like AIG, sold credit default swaps (CDS) that guaranteed MBS against default but lacked sufficient reserves to cover massive losses.
How did financial firms contribute to the crisis through securitisation?
By repackaging risky subprime mortgages into complex securities, they spread financial risk throughout the global economy.
