Week 7/8 - Keynesian Business Cycle

Question 1

What is the key feature of the Keynesian model compared to previous models?

Answer 1

• Keysnian model has a key feature that there are frictions to the adjustments of prices, which means prices do not immediately change following a shock.

Question 2

What do AD and AS represent, and what do shifts in AD and AS represent?

Answer 2

• AD: Is the link between output and prices, due to consumer and firms demand for the final good.
• AS: Is the link between the output and prices due to the firms price setting behaviour
• Shifts in either AD or AS represent business cycle shocks

Question 3

What are the potential output and Short run output ( or the output gap)?

Answer 3

• Potential output: Output which factors of production are utilized at LR levels, output which doesn’t take these shocks into account
• Output Gap: % deviation from the current and potential output

Question 4

In the Keynesian model, what is the difference between the SR and LR level?

Answer 4

• Long run: Temporary shocks throughout time have averaged to zero and have no effect.
• Short-run: Shocks this deviate the economy away from the equilibrium.

Question 5

What Is the difference between the real and nominal interest rate, and what is the fisher equation?

Answer 5

Question 6

What is the national account identity equal to?

Answer 6

• Yt = Ct + It + Gt
• We ignore net exports

Question 7

In the IS-LM model set up what is consumption equal to, and explain the terms involved , and also explain the short run effects on consumption and the long run effects on the shocks.

Answer 7

Question 8

In the IS-LM model set up what is investment equal to, and explain the terms involved, and also explain the long-run effects on the shocks.

Answer 8

Question 9

In the IS-LM model set up what is Government purchases equal to, and explain the terms involved, and also explain the long-run effects on the shocks.

Answer 9

Question 10

Describe the IS curve and explain why it shifts

Answer 10

The IS curve is downward sloping, and shifts in response to shocks in aggregate demand.

Question 11

What is the fisher equation and what are the 2 assumptions of the fisher equation

Answer 11

• Rt = it - Pie t
• Pie t ( the inflation rate) is sticky, meaning it adjusts slowly over time
• This means that changes in the nominal interest rate it affect the real interest rate in the short run due to Pie t being sticky and remaining unchanged.

Question 12

What is the MP curve and what does it represent?

Answer 12

• The MP curve captures how the central bank operates
• The MP curve simply identifies the short-run real interest rate implied by the nominal interest rate as Pie t remains unchanged in the short run.

Question 13

Explain the effect of an increase in the nominal interest rate by the central bank

Answer 13

• An increase in the nominal interest rate → Inflation remains unchanged due to sticky price → The real interest rate Rt increases → The real interest temporarily exceeds MPK → Firms investment falls → Output falls → Eventually Rt = MPK

Question 14

State the equation which the central banks use to determine the interest rate, and explain the parameters involved

Answer 14

Question 15

Derive the aggregate demand curve?

Answer 15

Question 16

What relationship does the Short Run Aggregate Supply curve represent?

Answer 16

• The SRAS curve measures the relationship between short run output and inflation determined by firms price setting behaviour.

Question 17

What are the 3 things in which firms decide on how much to change their prices by, and explain the intuition behind it?

Answer 17

• The expected inflation rate - Higher expected inflation rate, raises workers’ pressure for higher wages which increases production costs and therefore prices.
• Demand conditions Yt — Higher demand increases firms optimal prices
• Exogenous shocks to the production → e.g an increase in oil prices will increase costs of production and therefore increasing prices.

Question 19

What is the long run supply curve?

The LRAS a horizontal supply curve where inflation is at the target inflation, and output is at the long run level of output.

Answer 19

The LRAS a horizontal supply curve where inflation is at the target inflation, and output is at the long-run level of output.

Question 21

Explain what happens to AD and AS, when there is a negative demand shock?

Answer 21

• Negative AD shock shifts AD in, this is just a temporary shock that lasts one period only.
• AD shifts in at period t+1, resulting in a lower level of inflation, which means actual inflation is now less than the equilibrim level of inflation.
• Due to the shock being temporary in period t+2 the AD curve goes back to ADt.
• However the AS curve, at period t+2, the inflation rate is determined by inflation at period t+1, and inflation at period t+1 is less than the equilibrium level.
• If inflation at period t+1 < inflation at period t, then inflation at period t+2
• This results in the AS curve shifts outward.
• This process continues (AD in and AS out) until we reach the equilibrium level of inflation
  *

Question 22

If the business cycle is determined by demand shocks what does it tell us about inflation?

Answer 22

• Inflation should be procyclical
• This means inflation during a recession should fall as is the case with AD shifting in
• Inflation should increase during periods of expansion/growth which is the case with AD shifting out.

Question 23

When AD shifts inwards should inflation and the interest rate be greater than or less than the target rate?

Answer 23

• Inflation would be less than the target inflation, as AD shifting in lowers inflation.
• The interest rate should be less than the long-run interest rate, as the central bank will want to increase AD back to its equilibrium level.

Question 24

Explain what happens to AD and AS when there is a negative supply-side shock such as an increase in the price of oil

Answer 24

• A supply-side shock increases the costs of production leading to inflation increasing and being higher than the equilibrium level.
• This leads to the central bank, increasing interest rates in order to lower inflation leading to a recession.
• At period t+2, the shock is gone so the AS curve shifts downwards but doesn’t quite reach the original level due to inflation in period t+2 being determined by inflation in period t+1 which is higher than inflation at period t.
• Therefore ASt+2 is in between ASt and ASt+!, and then continues to move back to ASt due to the higher interest rates and eventually reaches it.

Question 25

How does inflation react if the business cycle is driven by supply shocks?

Answer 25

• Inflation should be countercyclical
• This means inflation should decrease in periods of growth ( Output increases and inflation decreases when AS shifts out)
• Inflation should increase in periods of recession (Output falls and inflation increases when AS shifts in)

Question 26

What is stagflation?

Answer 26

• Stagflation occurs when there is inflation and a recession, caused by supply-side shocks such as an increase in the price of oil.

Question 27

Give 2 events in history that are consistent with the Keynesian model of negative AD shocks causing deflation and negative supply-side shocks causing inflation

Answer 27

1. The great depression - Large decrease in AD and strong deflation.
2. The 1970’s oil price shock (Higher prices of oil) - Inflation and a recession (stagflation)

Question 28

What is the missing deflation puzzle?

Answer 28

• During the financial crisis, there was a very large fall in AD, but for most countries, inflation didn’t really fall.

Question 29

Give 2 possible explanations to the missing deflation puzzle

Answer 29

• A shift in of the AS curve (e.g higher oil prices, or increased wages)
• A change in the slope of the AS curve ( It becomes more flatter and inflation is affected less by changes in output)

Question 30

What is the most important explanation in explaining the missing deflation puzzle?

Answer 30

• Inflation expectations - Consumer inflation expectations were higher during the crisis than those of professional forecasters.

Question 31

What does the AD-AS model tell us about monetary policy?

Answer 31

• Monetary policy is used to help keep inflation stable
• Expansionary monetary policy (lower interest rates, and higher QE) during recessions.
• Contractionary monetary policy (higher interest rates) during a negative supply shock(Higher costs of production)
• There is a tradeoff between lower inflation and higher output.

Question 32

What is fiscal policy, and is it useful as a stabilisation policy?

Answer 32

• Fiscal policy involves changes in government spending and taxation in order to shift aggregate demand.
• Fiscal policy less actively used as a stabilization tool because it involves implementation lags, and fiscal policy has less power in countries with large national debts.
• Fiscal policy becomes useful when central banks suffer from the liquidity trap.

Question 33

Summarize the Keynesian Model

Answer 33

• Nominal and real variables are determined jointly
• Fluctuations can be caused by both demand and supply shocks, which imply different impacts on inflation.
• An explicit role for policy in stabilizing the economy