Week 3: Introduction to Business Cycles Flashcards
What are business cycles?
Fluctuations in economic activity characterized by expansion and contraction phases.
Business cycles include periods of economic growth (expansions) and decline (recessions).
Def of Boom and Receession
Boom; Real GDP above trend
Recession; two consecutive quarters of negative real GDP growth
List the main phases of a business cycle.
- Expansion
- Peak
- Contraction
- Trough
Each phase represents a distinct stage in the economic cycle.
How do you emphasise the fluctuations in economic data
Long-term trends dominate macro data
So detrend the time series line:
- Estimate a trend line, then remove is
Business cycle component of a variable is a deviation from trend line
Hodrick Prescott (HP) filter used to make a trend line that smoothes over time
After detrending real GDPP what do we document for macroeconomic variable relationships
Relative volatlity: size of fluctuations in x relative to real GDP
Co-movement: Correlation of x with real GDP
Leads or lags: dynamics of x relative to real GDP
What occurs during the expansion phase of a business cycle?
Increase in economic activity, rising GDP, and higher employment rates.
Businesses invest more, consumer confidence grows, and spending increases.
What is a peak in a business cycle?
The point at which economic activity reaches its highest level before declining.
It signifies the end of an expansion phase.
Define contraction in the context of business cycles.
A period of decreasing economic activity, often leading to a recession.
Characterized by falling GDP, rising unemployment, and reduced consumer spending.
What is a trough in a business cycle?
The lowest point of economic activity before recovery begins.
It marks the end of a contraction phase.
True or False: Business cycles are predictable.
False
Business cycles are influenced by various factors and can be difficult to forecast accurately.
What factors can influence business cycles?
- Changes in consumer confidence
- Government policies
- Interest rates
- Global events
These factors can lead to fluctuations in economic activity.
Fill in the blank: A _______ is a significant decline in economic activity spread across the economy lasting more than a few months.
recession
Recessions are often identified by falling GDP and rising unemployment.
What is the role of government policies in business cycles?
To stabilize economic fluctuations through fiscal and monetary measures.
Governments may adjust spending and tax policies, while central banks may change interest rates.
How do interest rates affect business cycles?
Lower interest rates can stimulate borrowing and investment, while higher rates can slow economic activity.
Interest rates influence consumer and business spending.
Values of consumption relationsship to Real Y
- Procyclical
- Less volatile than GDP (Consumption Smoothing)
- Coincident (Current)
Values of investment relationship to Real Y
- Procyclical
- Much morre volatile than GDP (Consumption Smoothing)
- Coincident (Current)
Values of employment relationship to Real Y
- Procyclical
- Less volatile than GDP (puzzling due to dim. returns to labour)
- Slightly lagging
Values of real wages to Real Y
- Procyclical (weakly)
- Less volatile than GDP
- No clear lag or lead
Values of average labour productivity relationship to Real Y
- Procyclical (potentially puzzling if there are diminishing returns to labour)
- Less volatile than GDP
- No clear lag or lead
Values of real interest rate relationship to Real Y
- Countercyclical (weekly, on average,, behaviour switched from countercyclical in 70s and 80s to procyclical in recent decades)
- Less volatile than GDP
- No clear lag or lead
What does ‘general equilibriuim’ incolce
Equilibrium in all relevant macro-level markets (goods, labour, financial)
Assume closed economy
What is the production function with neoclassical assumptionsq
Y = zF(K,N)
positive, but diminishing marginal products
MPK positive, decreasing in capital K
MPN, positive but decreasing in labour N
Prod function overall has constant returns to scale
What is the profit maximising labour demand for firms
MP of Labour (N) = w
Draw the Production Function graph with the solution where w=MPN holding K constant
How is AD determined
C + I + G
no X,M due to closed economy
What determines the optimal amount of investment in the economy
MPK is extra output from investment
Marginal cost = Depreciation (d) + IR (from cost of financing)
also R if self financed due to opportunity cost of postponing distribution of dividends (assumed to =r)
Investmend demand determined by MPk - d plotted against Investment with r as price
What determins household consumption choices
- Current and future income
- Interest rate r for saving and borrowing
- Desire to ‘smooth’ consumption
How are household consumption choices portrayed through the two period consumption model
- Convex to irigin indifference curv (smoothing pref)
- Position of budget constraint depends on current and future income
- Gradient of budget constraint is -(1+r) where r is real interest rate
draw temporary vs permanent changes in income in 2 period consumption models
Draw changes in interest rates for savers and borrowers
New budget line at original indiff –> splits into IE and SE
Change along new red line + old budget is SE
Increase in budget is shift in IE
How does the real interest rate effect consumption
Sub effect –> leads to fall in consumption if interest rate r rises
Income effects are redist. among borrowerss and saverss; overall iincome effect is 0
Substitution effects (SE) dominate income effectts overall
What is Saving determined by
Saving = Income - Consumptionnnn
Draw consumption and investment demand curves with r on y
How do households choose participation in tthe labour market
real wage (w) = MRS between leisure and consumptio
How does Wage and income afffect labour supply
W increases Ns through SE
If households worse off, raise Ns as leisure is a ‘normal’ good
Saving = Income - Consumption can raise saving by Ns
Real interest rate t affects saving so also Nss
Draw labour demand and supply graphs
Budget constraint of the government
PDV of expenditure = PDV of taxes
Draw the output demand curve with r on Y axis
Summing up the components of AD implies a downward sloping curve for goods
Shifs with wealth effects, changes in G or other determinants
How does the labour market clear and how does that impact the production function
Labour market clears to w * with a given r –> equil. employment N*
thus Y=zF(K,N * )
draw this scenarioa cross goods, labour and output models
How does goods market clear
- upward sloping Ys and downward sloping Yd
- Interest rate r clears the market
- Simultaneous equilibrium in labour and goods market since Ys curve also represents labour market equilibrium
What is Walras’ Law
Logically if free market, if 2 markets in equilibrium, the 3rd will also be.
So financial market (bond market) in equilibrium once good and labour markets are in equilibrium
What are Real Business Cycle theory (RBC)
Supply shocks in a model can provide an empirically consistent account of business cycles
business cycle are simply economy efficient response to variations in ability to produce goods –> policy intervention is futile
What are supply shocks
exogenous changes in TFP, z, in production function Y = zF(K,N)
Focus on transitory supplpy shocks
What are the effects and overall effects are of a negative shock in the RBC model
Effects:
- Prod. function shifts downwards
- Lower MPL shifting Nd to the left: Ys shifts further left
- Lower Investment (from falling expected MPK)
- Lower Cd and higher Ns ffrom -ve wealth effect
Overall effect:
Yd and Ys move to the left, so GDP Y falls
Wealth effect smaller than direct impact of shock on Ys –> smoothing for a shock that is not permanent
Draw the effects sof a negative supply shock on a goods market, labour markets and production function
1. Goods Market:
- Real Interest rate rises if Ys shifts more than Yd
- Yd shift larger if fall in TFP lasts longer (effects smooting of C and I)
2. Labour Market
- Effect on N ambiguous (Nd falls but Ns can rise)
- wealth effect smaller when TFP temporary shock
- Rea; wage increases
Explain the mechanics in each market
1. Goods:
YS:
- fall in z1 and Nd causes shift left of YS
- Rise in NS offsets fall of Ys
YD:
- Falls due tot a fall in C(d) and I(d) from -ve welath effect and falling MPK
- demand impact determined by expectation of longevity if
2. Labour:
ND: shifts left due to falling MPL from shock to z
NS: shift out due to -ve wealth effect, another shift out from higher r (interest rate)
effect on employment ambiguous; dep on magnitude of -ve wealth effect
short term impacts so demand side less impacted than supply
S>D fall so R increases
How do the model predictions of how macroeconomic variables interact with Real GDP match up to the data
- Matches evidence well
- But not all recession feature an obvious shock
- Shocks must be transitory so employment model is prrocyclical
- Ns must be sufficiently wage elastic so effect on N large and w smal
What does the RBC model say about government intervention
Model predicts that policy intervention, even if succeeds in raising GDP, make households worse off
- Raisisng Y is inefficient as it leads people to work more when productivity is low
MPn = w * = marginal value of time (MRS)
Monetary Policy has no impact on real GDP because money, nominal prices and IR are irrelevant in RBC model
