Buisness Cycle

Question 1

At what point do firm hire workers

Answer 1

MPN = w.
In other Marginal Benefit of an extra worker = the cost of employing

Question 1

Does consumption have leads or lags

Answer 1

There is no leads or lags with Real GDP and consumption but consumption moves by less than GDP, consumers don’t like fluctuations on the spending of goods.

Question 2

Is investment procyclical/ have leads or lags

Answer 2

Investment is procyclical, with no obvious leads or lags however investment is more volatile than GDP

Question 3

What do firms consider when investing ? (3)

Answer 3

• Addition of capital stock in the future
• Marginal product of capital
  -Maintenance cost of capital (depreciation), and cost of financing, e.g. interest rate 𝑟 paid on borrowing, or if self-financed, the opportunity cost 𝑟 of postponing distribution of dividends

Question 4

What is the demand for interest rate

Answer 4

It is the Marginal product of capital with is r + depreciation rate

Question 5

What is consumption influenced by ? (3)

Answer 5

1. Current and expected future income:
   
   • Households consume more if they are better off, either due to higher current income or expectations of higher future income.
2. Wealth effect:
   
   • If expected future growth increases, it can boost consumption today as households feel wealthier.
3. Consumption smoothing:
   
   • Temporary changes in income have a smaller impact on consumption, as households save or borrow to smooth out the effect on their consumption over time.

Question 6

How does real interest rate r effect consumption ? (3)

Answer 6

1. Substitution effect:
   
   • When the interest rate rises, consumption declines as it becomes more attractive to save rather than consume.
2. Income effect:
   
   • When the interest rate rises, it redistributes income from borrowers (who are worse off) to savers (who are better off). This can have an ambiguous overall effect on consumption.

The key assumption is that the substitution effect dominates the income effect overall, meaning a higher interest rate leads to lower consumption.

Question 7

What is savings

Answer 7

Income - consumption

Question 8

When do savings increase ?

Answer 8

1. The interest rate (r) rises, due to the substitution effect.
2. There is a temporary rise in current income, as households save some of the extra income.

Question 9

Why is consumption demand downward sloping

Answer 9

Because SE of interest rate 𝑟 is dominant

Question 10

What is wage equal to

Answer 10

The marginal rate of substitution between leisure and consumption is equal to “w,” it means that the extra income you’d require to give up an hour of leisure is exactly equal to your hourly wage.

Question 10

Why is investment demand downward sloping

Answer 10

diminishing returns to capital

Question 11

How is labor supply affected if households are worse off eg increased taxes

Answer 11

Raises Ns

Question 12

What does fiscal policy involve

Answer 12

Involves government spending (𝐺) as a component of aggregate demand.
- The government’s budget constraint dictates that the present-discounted value of its expenditure must equal the present-discounted value of taxes.

Question 13

What does the Ricardian equivalence say

Answer 13

According to Ricardian equivalence, the timing of taxes doesn’t affect aggregate demand because households adjust their savings based on future tax expectations.

Question 14

Why do government use bonds

Answer 14

Sells bonds to fund during budget defecit

Question 15

Why do firms use bonds

Answer 15

Sells to fund investment

Question 16

Why do households use bonds

Answer 16

Buy bonds as a form of saving

Question 17

What is the wealth effect

Answer 17

The consumption demand shifts outward if households become wealthier, a phenomenon known as the “wealth effect.”

Question 18

What factors can shift the AD curve

Answer 18

Changes in wealth effects, fiscal policy (government expenditure), or other determinants of consumption and investment demand can shift this curve.

Question 19

What is AD

Answer 19

consumption, investment, government expenditure

Question 20

Why is labor demand downward sloping

Answer 20

The labor demand (Nd) is downward-sloping, based on the marginal product of labor.

Question 21

Why is labor supply upward sloping

Answer 21

Depends on the interest rate r but also as w increases, opp cost is higher for leisure and consumption

Question 22

What do effects of a negative shock in the RBC model include ? (6)

Answer 22

• The production function shifts down, moving 𝑌𝑠 (output supply) to the left.
• The reduced marginal product of labor shifts 𝑁𝑑 (output demand) to the left, further shifting 𝑌𝑠.
• Lower investment (𝐼𝑑) due to the expected decline in future output.
• Decreased consumption (𝐶𝑑) and increased labor supply (𝑁𝑠) from the negative wealth effect.
• Overall, both 𝑌𝑑 and 𝑌𝑠 shift leftward, resulting in a decrease in GDP 𝑌.
• The wealth effect is smaller than the direct impact of the shock on 𝑌𝑠, leading to consumption smoothing for non-permanent shocks.

Question 23

what happens when wages increase

Answer 23

When wages increase, people tend to work more due to the substitution effect (SE). This means they're substituting leisure time for work because work becomes more valuable.

Question 24

Why will workers work more to compensate if households are worse off than leisure

Answer 24

Leisure is considered a "normal" good, meaning people want more of it when they're better off financially.

Question 25

Why is the labor supply curve upwards

Answer 25

Labor supply is upward-sloping if the substitution effect (SE) of the wage dominates. This means that people are willing to work more when wages increase. It shifts to the right when the real interest rate (𝑟) increases, which also affects people's incentive to save and, consequently, their willingness to supply labor.

Question 26

Current government budget

Answer 26

present value of its spending equals the present value of its taxes.

Question 27

The bond market for government, firm, household

Answer 27

In the bond market, the government sells bonds to cover budget deficits, while firms sell bonds to fund investments in new equipment, and households buy bonds as a form of saving.

Question 28

Factors shifting the demand curve

Answer 28

It shifts due to changes in wealth effects, fiscal policy (𝐺), or other factors affecting consumption and investment demand.

Question 29

RBC theory and public intervention

Answer 29

Real Business Cycle (RBC) theory argues that supply shocks in such a model can offer a consistent explanation of business cycles. In RBC theory, business cycles are seen as the economy's efficient response to changes in its ability to produce goods. According to this view, policy intervention is either futile or counterproductive.

Question 30

In a recession caused by lower z, should government intervene according to the RBC model

Answer 30

The model suggests that even if policy intervention succeeds in increasing GDP, it ultimately makes households worse off. For example, increasing government expenditure 𝐺 might boost GDP, but it's inefficient because it encourages people to work more when productivity is low. In equilibrium, the marginal product of labor (𝑀𝑃𝑁) equals the marginal value of time (𝑀𝑅𝑆).

Question 31

Does monetary policy have an impact on real GDP according to the RBC model

Answer 31

Monetary policy has no impact on real GDP in the RBC model because money, nominal prices, and interest rates are considered irrelevant.

Question 32

Temporary reduction in total factor productivity 𝑧. Assume the duration of the shock is expected to be sufficiently short, so wealth effects are small. Find the implications for employment, real wages, and the real interest rate.

Answer 32

Lower total factor productivity 𝑧 reduces MPN, causing the labour demand curve to shift to the left. The output supply curve 𝑌𝑠 shifts to the left because of the direct effect of lower productivity and the decreased employment implied by the leftward shift of labour demand. As the duration of the shock is expected to be short, households aim to smooth consumption over time, reducing 𝐶𝑑 by less than the direct impact of the shock on income. Another way to cope with the shock and mitigate the effect on consumption is to increase labour supply 𝑁𝑠 , which offsets some of the leftward shift of 𝑌𝑠. However, these wealth effects are relatively small. The short duration of the shock also means any negative effect on investment demand 𝐼𝑑 is small because productivity is expected to recover by the time the current investment raises future capital stock.With both 𝑌𝑠 and 𝑌𝑑 shifting to the left, real GDP 𝑌 must decline. As explained above, the shifts of the output demand curve are small relative to the effects of the shock on the supply curve, so the real interest rate 𝑟 rises to clear the goods market. In the labour market, while 𝑁𝑑 shifts left, the labour supply curve shifts to the right because households are worse off and supply more labour to compensate, and second from as the rise of the real interest rate increases the incentive to build up savings, which can be done by working more. As 𝑁𝑑 shifts to the left but 𝑁𝑠 shifts to the right, the real wage 𝑤 necessarily declines, but the overall impact on employment 𝑁 is ambiguous. effect on 𝑁𝑑 is dominant and employment falls.

Question 33

Show that the fiscal policy response raises GDP according to the model. What happens to consumption 𝐶 and employment 𝑁? If the model is correct, are households better off because of the fiscal stimulus?

Answer 33

Higher public expenditure 𝐺 shifts the output demand curve to the right. The increase in the tax burden causes a reduction in consumption demand because of a negative wealth effect, but this is smaller in magnitude than the change in 𝐺 because the increase in public expenditure is only temporary. So overall, the output demand curve shifts to the right. The increase in the tax burden also increases labour supply, shifting the output supply curve to the right. Together with the rightward shift of 𝑌𝑑 , real GDP 𝑌 must therefore increase. The effect on 𝑌𝑠 smaller than the shift of 𝑌𝑑 because the extra labour is only supplied to cope with the higher tax burden. This means that the real interest rate 𝑟 rises. Higher 𝑟 reduces consumption demand, so along with the negative wealth effect already considered, consumption must fall. In the labour market, the labour supply curve shifts to the right because of the wealth effect discussed earlier and the greater incentive to save provided by the higher real interest rate. There is no shift of the labour demand curve from higher 𝐺 itself (public expenditure does not change the production function here). Hence, employment 𝑁 rises. While the fiscal stimulus raises real GDP, households end up having lower consumption because of the higher tax burden and higher real interest rate, and supplying more labour, which reduces leisure. If households value consumption and leisure, they are actually worse off as a result of the fiscal stimulus. Of course, households should directly benefit from the higher public expenditure 𝐺 but if it is optimal to sacrifice private consumption 𝐶 for higher public spending, the government could already have chosen to do that prior to the supply shock. In this analysis, it does not make sense for the government to choose higher 𝐺 because of the shock that caused the recession.

Question 34

Holding fiscal policy constant, explain why the effects of a permanently lower 𝑧 (relative to a trend) are not the same as those of the temporarily lower 𝑧 found in part (a). Do the predictions of the model for employment and real wages fit the empirical evidence on business-cycle fluctuations better for temporary or permanent supply shocks?

Answer 34

Larger effects on consumption and investment than because it lasts long enough to have a significant effect on firms’ investment plans, and because households cannot sustainably smooth consumption when future income also declines. The shifts of the output demand curve 𝑌𝑑 are therefore larger, and it is possible that the real interest rate 𝑟 declines. Since the shock is permanent, the adjustment of labour supply to cushion the blow to consumption is larger than in part (a). However, the shift of the labour demand curve is the same because this depends only on the current level of productivity 𝑧. The larger wealth effect on labour supply thus makes it more likely that employment rises overall rather than declines, and increases the size of the fall in the real wage. If such permanent productivity shocks were driving business cycles in the RBC model, employment would be less procyclical or even countercyclical, and real wages would be more procyclical. Since the empirical evidence on business-cycle fluctuations shows that employment is strongly procyclical while real wages are only weakly procyclical, the RBC model fits the empirical evidence best for temporary supply shocks such as shocks to energy costs.