week 6 Flashcards
Business Cycles; Keynesian Economics and IS-LM; Begin Aggregate Demand and Aggregate Supply
what are business cycles?
periods of expansion and slowdown in level of economic activity
In a recession, what happens to real incomes + unemploymnet?
A period of declining real incomes and rising unemployment.
When does a recession occur?
2+ successive quarters of negative (real) economic growth.
Depression is a _______?
severe recession.
GDP growth shows patterns of ______ and ____,
Peaks + Troughs
Periods where growth is accelerating, decelerating and in some cases declining.
business cycle: what is a peak?
A peak is where economic activity reaches a high and real output begins to decline.
business cycle: what is a trough?
Trough is where economic activity reaches a low and the decline ends.
business cycle: what is a contraction?
Contraction is when real output is lower than the previous time period.
business cycle: what is an expansion?
Expansion is when real output is greater than the previous time period.
Time series data records observations of … ?
a variable over time
what does this figure show?
- The GDP of both the UK and the EU has risen since the 1960ies.
- GDP appears to fluctuate around a trend
- There are similarities in these fluctuations between the UK and the EU data
- Fluctuations are highly irregular
What are the 2 data concepts (variables) of the business cycle?
- Procyclical variable
- Countercyclical variable
What is a pro-cyclical variable?
A variable that is above trend when GDP is above trend.
e.g Real wages
What is a countercyclical variable?
Countercyclical variable A variable that is below trend when GDP is above trend.
e.g Unemployment since unemployment tends to fall as GDP grows.
How can we use variables as indicators? [3]
- A leading indicator
- A lagging indicator
- A coincident indicator
A leading indicator is used for what?
can be used to foretell future changes in economic activity.
A lagging indicator changes when?
changes after changes in economic activity have occurred.
A coincident indicator occurs at the same time as…?
occurs at the same time as changes in economic activity.
Example: cyclical indicators to try to predict potential turning points in economic activity
What is an example of a leading indicator?
OECDs composite of cyclical indicators
what causes short run variations in economic activity?
– Shocks to the economy thru changes in C and G.
– Last year (and also this year), external shocks e.g. due to geopolitical events are especially relevant
– Rigidities in markets.
– Other:
changes to productivity levels: monetary policy: the ability of workers to seek increases in real wages; government policy; irrationality…
6 potential causes of short run variation in economic activity
①Household spending decisions.
②Firms’ decision making.
③External sources.
④Government policy
⑤Confidence and expectations
⑥Technological shocks
There are a number of different business cycle models, e.g.
New Classical, New Keynesian, Real Business Cycles
Different models rely on different _________
rely on different underlying causes + different transmission mechanisms
A very important separation between different business cycle views is …
whether policy is called for or not
“Keynesians” Business cycles reflect ______?
Keynesian business cycles reflect “imperfections” of Capitalism that we can and should try to fix
“Marxists”: Business cycles reflect _______?
Marxist business cycles:
reflect “imperfections” of
Capitalism. The only real fix is to replace Capitalism with something else.
“Hayekians/von Misesians” (a rather diverse group to be sure): Business cycles are a __________
are a natural feature of capitalism – so there is nothing to fix. Fixing something that is not broken can only make matters worse
“Hard monetarists” Business cycle says:
There is something to fix, but governments invariably will get it wrong. (=> do not try)
What dose the IS-LM model describe?
The short-run equillibrium in the goods market + the money market
What does the IS-LM model determine? [2]
- Interest rate i
- Income Y
What is the “Investment-Saving curve” (IS)?
IS Shows the relationship between Interest Rate and income that ensures equilibrium in the GOODS MARKET
– Describes the general equilibrium in the economy that results when both the goods market and the money market clear
What is the “Liquidity Money curve”? (LM)
LM is relationship between interest rate and income representing equilibrium in the MONEY MARKET
What’s the key assumption in the IS-LM model?
general price level (P) of the economy is constant (model of the short run)
What does general price level P being constant imply?
only quantities and the rate of interest can vary to clear the markets, not prices
why is constant price a reasonable description of the (v) short-run?
because prices are fixed or costly to change
How can we re-interpret Y = C + I + G + NX for the Keynesian cross?
- Y is actual production or national income
Think of this as “what is actually produces and firms want to sell”
- C + I + G + NX is planned expenditure** or **spending
Think of this as “what people actually are going to buy”
- Increasing in incomes. MPC: How much more bought for every unit increase in income
What is equilibrium of Keynesian cross?
Actual production = planned expenditure
What is the keynesian cross?
The Keynesian Cross is like a balancing act between what people plan to spend and what businesses plan to produce. It helps us figure out how much stuff (goods and services) will be bought and sold in the economy. If what people plan to spend matches what businesses plan to produce, we have balance or equilibrium. But if there’s a mismatch, it can lead to changes in production levels and overall economic activity.
Planned expenditure (spending) depends on the …?
Interest rate
How does the interest rate influence planned expenditure?
It directly influences TWO main components of planned expenditure
Which components of planned expenditure does interest rate influence? [2]
- Consumption
- Investment
how do interest rates directly influence consumption ?
- Households spending decisions depend on interest rate levels
- Higher interest rates mean higher returns on savings, hence households save more and consume less
how do interest rates directly influence investment ?
- Firms investment decisions are based on borrowing costs (interest rate)
- Higher interest rates imply that higher borrowing costs, hence firms will drop less profitable investments. That is, investment drops at high interest rates.
The investment-savings curve shows…?
The equilibrium for different levels of interest
Draw the Investment saving curve deriving from the keynesian cross
There’s a negative relationship between the interest rate (i) and national income/production (Y)
Demand for money depends on?
-
Value of transactions in the economy
- Higher income (Y) is associated to a higher level of transactions, hence more money needed
-
Preference for liquid assets (money)
- Higher interest rates (i) make the prospect of holding money less appealing, hence households will shift their portfolio towards less liquid assets and demand less money.
Money supply is assumed to be _______ (exogenous).
constant
What does the Liquidity Money curve show?
shows the interest rate that clears the money market for each level of income
Draw the Liquidity Money Curve
Slopes up (positive relationship between the interest rate (i) and income (Y))
Where is equilibrium on the IS-LM model?
Level of the interest rate (ie) and income (Ye) such that both markets are in equilibrium at the same time.
How to draw IS + LM curve in a single graph?
What relationship does the AD curve show us?
The AD curve shows us the relationship between the general/aggregate price level and national income/output.
How to derive AD from the IS-LM model?
The IS-LM model gives us the equilibrium level of interest rate and income for a given price level (P0).
Consider another price level (P1), higher than the original price level (P0):
- **Real ** money supply has decreased due to the higher price level
- This shifts the LM curve to the left (precisely: MS shift to left which causes LM curve to shift left)
- The economy transitions to a new equilibrium with higher interest rates and lower income/production.
- This corresponds to two different points on the AD curve (key point: higher price level is associated to a lower level of output).
3 key facts about economic fluctuations
- Economic fluctuations are irregular and difficult to predict
- Most macroeconomic quantities fluctuate together
- Recessions and booms are economy-wide phenomena
- As output falls, unemployment rises
2 main building blocks of classical economic theory
- Classical dichotomySeparation of variables into real and nominal variables
- Monetary neutralityChanges in the money supply affect nominal variables, but do not affect real variablesHence, we could examine the determinants of real variables, like real GDP and unemployment, without reference to nominal variables like money and prices
Short run US fluctuations
For economic fluctuations… in the short-run what differs from the long run?
- Assumption of monetary neutrality no longer appropriate
- Real and nominal variables are highly intertwined
The AD-AS model explains…?
Short-run fluctuations in economic activity.
Relationship between prices + real GDP - under the classical dichotomy there would be NO relationship between these 2 variables
What does the AD curve show?
Shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level.
What does AS curve show?
Shows the quantity of goods and services that firms are willing to produce and sell at each price level.
Why does the AD curve slope downward? [3]
- Wealth effect (c)
- Interest-rate effect (I)
- Exchange-rate effect (NX)
what is the wealth effect? how does it influence AD?
A decrease in price level:
- Increases real value of money
- Consumers feel wealthier and increase their spending → aggregate demand increases.
what is the IR effect? how does it influence AD?
A decrease in price level:
Reduces interest rate
→ As price level decreases, real money supply increases + makes the IR drop
(this is required to induce households to increase money demand so that demand again equals supply). Refer to IS-LM model
a) Stimulates spending on investment goods
b) Increases aggregate demand
what is the exchange rate effect? how does it influence AD?
A decrease in U.K. price level:
Reduces interest rate
→ U.K. pound depreciates
- Stimulates U.K. exports (X) and suppresses U.K. imports (M)
- Increases net exports (NX = X – M), and thus aggregate demand
If UK £ depreciates?
NCO↑ and supply of pounds on FX markets increases
if instead, price level rises then, a _______ in Q of goods + services demanded
A reduction
- Consumers are poorer ⇒ depresses consumer spending
- Higher interest rates ⇒ depresses investment spending
- Currency appreciates ⇒ depresses net exports
Shape of AS curve depends on?
Time horizon..
- LRAS is a vertical line (price don’t affect long-run GDP
- SRAS is upward sloping
why price don’t affect long run GDP?
In the long run, the aggregate supply curve (LRAS) is vertical because prices and wages are flexible, resources adjust efficiently, there are no shortages or surpluses, and expectations are fulfilled. This means changes in the price level don’t affect real GDP since resources are fully employed and production isn’t impacted by price changes.
In the long-run, GDP is determined by…?
- Capital (physical and human)
- Labour
- Natural resources
- Technology
CELL
The price level does not affect the long-run determinants of GDP, hence:
The long-run value of output is the same regardless of the price level
In the long-run, the _________ thus holds
classical dichotomy
What is the classical dichotomy in long run?
1💡. Real and nominal variables are independent from each other
2💡. A real variable (LR GDP) cannot be influenced by a nominal one (aggregate price level)
The LRAS curve is a vertical line positioned at the “natural rate of output”, this means…?
- Output level when all existing factors of production are fully utilized
- Unemployment is at its natural rate
draw the classical LRAS
What SHIFTS LRAS?
PINTSWC
Productivity
Indirect Taxes
Number of Firms
Technology
Subsidies
Weather
Costs of Production
Labour
Unemployment etc
how to explain real GDP growth with our model?
Long run growth: AD + LRAS
> > > In LR, both AD and LRAS curve shift
- Continual shifts of LRAS curve to right→ Technological progress
- AD curve shifts to right→ Monetary policy (central bank increases money supply over time)
Result:
–Continuing growth in output
–Continuing inflation
LR growth + inflation diagram
What influences Short run aggregate supply?
The general price level will influence SRAS.
Raw material/labour/wages
IN THE SHORT RUN: An increase in overall level of prices in economy…
→ Tends to raise the quantity of g and s supplied
Conversely, a decrease in overall level of prices in economy…?
→ Tends to reduce quantity of g and s supplied
3 theories explain why the AS curve slopes upward in short-run:
- Sticky-wage theory
- Sticky-price theory
- Misperceptions theory
Each theory explaining why AS slopes upwards is based on some form of market imperfection, and focuses on the difference between:
- The expected price level
- The actual price level
The short run or “surprise” AS curve, when the price level rises above expected price level…
output rises above its natural rate
The short run or “surprise” AS curve, when the price level falls below expected price level…
output falls below its natural rate
What’s the STICKY WAGE THEORY?
Nominal wages are slow to adjust to changing economic conditions.
Nominal wages are based on expected prices: Wages don’t respond immediately when actual price level is different from what was expected, they adjust with a lag!
Labour contracts are FIXED in the medium term
Theory suggests that wages are “sticky” downwards, meaning they do not easily decrease even when economic conditions warrant a reduction, such as during a recession!
Sticky wage theory implies an upward sloping SRAS curve because…?
Sticky wage theory implies an upward sloping short-run aggregate supply (SRAS) curve because firms set wages based on expected price levels. When the actual price level rises, real wages (W/P) fall, reducing firms’ marginal costs of labor. This incentivizes firms to increase production and hire more workers, raising overall output. Conversely, if the actual price level falls, real wages increase, leading to higher-than-expected marginal costs, prompting firms to cut production and reduce hiring, thereby decreasing output.
explain what happens to wages + production
→ Real wages (hence costs) now lower than firms expected
→ So now firms increase production and output increases
What is Sticky-price theory?
Prices of most goods and services are fixed or slow to adjust in the short term
- E.g., prices are costly to change due to menu costs
How does Sticky-price theory
imply upward sloping SRAS?
Sticky-price theory implies an upward sloping short-run aggregate supply (SRAS) curve because firms set prices based on expected price levels. If the actual price level is lower than expected (Pactual < Pexpected), firms’ actual revenues fall below expectations, forcing them to cut production, which reduces aggregate supply. Conversely, if the actual price level is higher than expected (Pactual > Pexpected), firms’ revenues exceed expectations, leading them to increase production, thus raising aggregate supply.
What is the misperceptions theory?
Changes in the overall price level can temporarily mislead suppliers about price changes in relevant relative prices…
How does misperceptions theory imply upward sloping SRAS?
Firms may misinterpret changes in the overall price level.
If the actual overall price level falls below the expected level, firms might mistakenly perceive this as a decline in the prices of their own products, leading them to reduce production due to perceived lower marginal revenues.
Conversely, if the overall price level is higher than expected, firms might misinterpret this as an increase in their prices, prompting them to increase production.
All three explanations can be summarized as follows:
where:
- Ysupply is the quantity of output supplied
- Ynatural is the natural rate of output (= LRAS)
- a determines how much output responds to unexpected changes in the price level
In the long-run, Pactual = Pexpected, therefore in the long-run supply is Ynatural. This is in fact a definition.
Draw the Summary Graph
SRAS curve shifts with…?
- Labour, capital, natural resources, or technological changes
- Changes in Expectations
Changes to COP
How do changes in expectations shift sras?
All theories discussed above (sticky-wages, sticky-prices, misperceptions) are based on the expected price level differing from the actual one ex post
- If expectations change ex ante, the SRAS will shift accordingly (e.g., P(expected) ↑, SRAS ←)Example: higher expected prices mean that higher nominal wages will be negotiated, which implies increasing production costs and reduced output if the actual price change remains the same
