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MacroEconomics > Week 5 Business cycle model with flexible prices and wages > Flashcards

Week 5 Business cycle model with flexible prices and wages Flashcards

1
Q

What are business cycles?

A

Fluctuations in economic activity

around its long-term trend.

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2
Q

Are business cycles regular/cyclical?

A

No

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3
Q

We can think of the economy (output) growing at its

long-term trend but then what happens to it?

A

The economy is hit by temporary shocks

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4
Q

What empirically is the main driver of the business cycle?

A

Technology (Total Factor Productivity)

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5
Q

What are the “cycles”

A

Movements around the trend, eg the trend of growth since WW2.

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6
Q

What two things do Real Business Cycles assume?

A
  • Perfectly competitive markets

* The absence of externalities

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7
Q

What do these assumptions imply?

A

These assumptions imply that the economy is always behaving optimally

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8
Q

What does Prof. Pangloss always state?

A

“we are in the best of all possible worlds”

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9
Q

What is the significance of the belief that the economy is always behaving optimally?

A

There is no role for government stabilisation policy in a recession, and that this will actually be welfare-reducing!

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10
Q

What is the Solow Residual and what does it do in comparison to aggregate real GDP?

A

The Solow Residual is a measure of total factor productivity and tracks aggregate real GDP quite closely.

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11
Q

What does an increase in z (TFP) do to marginal product of labour and thus the labour demand curve??

A

↑z → ↑MPN → labour demand curve shifts rightward

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12
Q

What does an increase in z (TFP) do to the output supply curve??

A

↑z → ↑MPN → demand curve shifts rightward → ↑ production function → output supply curve shifts rightward

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13
Q

What happens to z’ when z increases?

A

↑z → ↑z’

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14
Q

What does an increase in z (TFP) do to the output demand curve??

A
  • ↑z → anticipated ↑z’ → ↑ anticipated MPN’ → ↑ demand for investment goods → ↑ output demand → output demand curve shifts rightward
  • ↑z → anticipated ↑z’ → ↑ future income ↑ demand for consumption goods → ↑ output demand → output demand curve shifts rightward
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15
Q

What does an increase in z (TFP) do to the real interest rate?

A
  • ↑z → anticipated ↑z’ → ↑ anticipated current & future income for consumers
  • However shock is part temporary (aka ↑z > ↑z’), so consumers expect their real income to fall
  • Therefore consumer tries to smooth consumption → ↓c &↑c’, which leads to ↓real interest rate.
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16
Q

What does an increase in z do to the labour supply curve?

A

↑z → ↓real interest rate → leftwards shift in labour supply curve due to intertemporal substitution

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17
Q

What does an increase in z do to wages?

A

• ↑z → leftwards shift in labour supply curve
• ↑z → labour demand curve shifts rightward
However as the intertemporal substitution effect on labour supply from the real interest rate is small, the labour supply curve shifts less than the demand curve.
• ↑z → ↑wages

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18
Q

Why does labour supply contract when interest rate falls?

A

As when interest rates rise, people work more in the present so then they can consume more in the future. If interest rates then fall there is less incentive for people to work now.

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19
Q

What does an increase in z do to the nominal money demand curve?

A
  • ↑z → ↑ real equilibrium output & ↓real interest rate

* Therefore money demand↑ & the nominal money demand curve shifts to the right.

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20
Q

What does r stand for in the function: PL(Y1, r1)

A

The nominal interest rate

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21
Q

What is the Fisher equation?

A
  • Nominal interest rate = real interest rate + expected inflation
  • R = r + π^e
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22
Q

What is a critical assumption we need to remember form the Fisher equation?

A

There is no inflation, and that any changes in the price level are just a one off change. 0 = π = π^e

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23
Q

So when π=0, what can we derive from the nominal and the real interest rates?

A

That they are equal to each other.

24
Q

Who should we assume sets the value of the money supply?

A

Central banks

25
Q

What is wage flexibility?

A

Wage flexibility is defined as the speed with which real wages react to macroeconomic condition and it is measured as the responsiveness of real wages to shocks.

26
Q

What does an increase in z do to the price level?

A
  • ↑z → ↑ real equilibrium output & ↓real interest rate
  • ∴ money demand↑ & the nominal money demand curve shifts to the right.
  • ∴ as money supply doesn’t shift, prices ↓
27
Q

But wouldn’t we expect an increase in the demand for money cause prices to rise?

A

No, as the increase in demand for money results in the increase of the value of money, which is shown through lower prices.

28
Q

Why does money demand increase after a reduction in real interest rates?

A

As it makes borrowing far cheaper, eg for mortgages on houses or other forms of loans.

29
Q

What effect does an increase in z have on Average Labour Productivity?

A

↑z → ↑Average Labour Productivity

30
Q

What does Procyclical mean?

A

Procyclical refers to a condition of a positive correlation between the value of a good, a service, or an economic indicator and the overall state of the economy.

31
Q

Are Consumption, Investment, Employment, Real Wage and Average Labour Productivity procyclical or counter cyclical and why?

A

Procyclical as they all increase as the economy improves.

32
Q

What does an increase in z do to the nominal money supply curve?

A
  • ↑z → ↑ aggregate output → ↑ activity in all sectors of the economy → ↑ banking activity → ↑ quantity of bank deposits → ↑ money supply → rightward shift(this is endogenous money supply)
  • ↑z → ↓ price level ∴ as central banks want to stabilise the price level, they ↑ money supply → rightward shift
33
Q

What is endogenous money?

A

Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously by an external authority such as a central bank.

34
Q

What are strategic complementarities?

A

One person’s willingness to engage in some form of activity increases with the number of other people engaged in such an activity, eg if lots of people are going to a party, I am more willing to go.

35
Q

What does the presence of strategic complementarities in a Keynesian Coordination Failure Model imply about the aggregate production function?

A

That the aggregate production function has increasing returns to scale.

36
Q

What happens to the labour demand schedule in a Keynesian Coordination Failure Model?

A

The labour demand schedule can be upward sloping.

37
Q

Can multiple equilibria exist in a Keynesian Coordination Failure Model?

A

Yes

38
Q

In the Keynesian Coordination Failure Model, which curve is steeper, labour demand or labour supply?

A

The labour demand curve is steeper than the labour supply curve Keynesian Coordination Failure Model.

39
Q

If real interest rates rise, what happens to the labour supply curve?

A

↑r → ↑labour supply → rightward shift in the labour supply curve

40
Q

In the Keynesian Coordination Failure Model, what happens to output when real interest rates increase?

A

↑r → ↑labour supply → rightward shift in the labour supply curve → ↑r → employment → ↓ output

41
Q

Which way does the Ys curve slope in the Keynesian Coordination Failure Model?

A

The Ys curve is downward sloping in the Keynesian Coordination Failure Model (ie ↑r → ↓ output)

42
Q

Why are business cycles cause by self fulfilling beliefs?

A

Partly because if everyone thinks something is going to happen, it will. Eg if everyone thinks London is a good place to invest, it will be a good place to invest.

43
Q

What would an RBC theorist say that recessions are caused by?

A

A decrease in technology.

44
Q

Why do we often have 2 equilibria?

A

Because of people’s emotions, which leads to different self fulfilling equilibria as they follow what they believe others will do. Therefore if there are differing beliefs there can be differing equilibria.

45
Q

Does the Keynesian Coordination Failure Model tell you which equilibrium is going to prevail?

A

No

46
Q

Following the principle of 2 equilibria, why in a recession would we have low employment?

A

Because we would have high leisure.

47
Q

Will the economy be in the good or bad equilibrium?

A

We do not know, as although everyone would prefer the good equilibrium, if everyone if pessimistic the bad equilibrium could arise.

48
Q

What is similar to Keynes’ “animal spirits”

A

The economy alternating between good and bad equilibrium due to consumer and firm’s pessimism and optimism.

49
Q

What is it that economists call “sunspots”?

A

Sunspots are extraneous events in the coordination failure model which are completely unrelated to economic fundamentals that can cause business cycles

50
Q

In the “good” equilibrium, what happens to output, employment and average labour productivity?

A

In the “good” equilibrium:
• Output is high
• Employment is high
• Average labour productivity is high

51
Q

If money is a sunspot variable in the coordination failure model, then what may money appear to be and why?

A

Money may appear to be non-neutral because people believe it to be. High money supply may make people optimistic and increasing output.

52
Q

Is money neutral in the coordination failure model?

A

Yes, although it could be a sunspot variable

53
Q

In the RBC model is there a role for government stabilisation policy? Yes/No and why

A

No, as decreases in output and unemployment are seen as optimal responses to a decrease in the TFP.

54
Q

In the coordination failure model is there a role for government stabilisation policy? Yes/No and why

A

Yes, as the good equilibrium is seen as an opportunity available to the aggregate economy when the bad equilibrium is realised. Therefore government policies that promote optimism could be beneficial.

55
Q

What kind of ways can governments promote optimism?

A

Encouraging statements from public officials, such as the chairman of the FED or the treasury secretary.

56
Q

How can decreasing government spending eliminate/smooth business cycles?

A

Decreasing government spending can shift the output demand curve left and output supply curve right, leading to a new unique equilibrium which has eliminated the multiple equilibria

57
Q

What are 2 weaknesses of the coordination failure model?

A
  • It relies on increasing returns to scale for aggregate production and evidence for this is weak
  • The underlying shocks which cause business cycles are expectations, which are largely unobservable, so therefore it’s difficult to use this theory to understand historical recessions and booms

MacroEconomics (8 decks)

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