Business Cycle

Question 1

Business cycle:

Answer 1

periodic fluctuations in macroeconomic variables, particularly GDP

• Mainly fluctuations in output around its trend (potential output)
  Trend level of output (natural gdp): Y = AF (K, L). The economy is working at full capacity
  The difference between the trend and the actual GDP
  (V1 - V0) / TREND
  We measure business cycles based on gaps (trend vs. real value)

Question 2

Output-Gap (%):

Answer 2

real GDP - natural GDP (trend / natural GDP)
- If negative: all factors of production are not used efficiently/intensively
- If positive: overtime of workers and machines working at full capacity
- Output gap is the difference between how much we are growing and how much we should grow if we want to be in that ideal place (potential gdp)

Question 3

Expansion/Boom

Answer 3

Output above trend
Longer than contractions

Question 4

Recession

Answer 4

Output below trend (negative grwoth
for two consecutive qs)
Sharper than expansions

Question 5

Business cycle facts:

Answer 5

-Expansions are longer than recessions
-Recessions are sharper than expansions
-Cycles are correlated across regions and across countries
-GDP is less volatile in more industrialized countries
-The growth rate of wages fluctuates less than the growth rate of GDP (sticky wages)
All sectors rise and fall together

Question 6

To make the economy healthier.

Answer 6

Increase exports, diversify the economy, and try to produce products with the highest added value.

Question 7

Procyclical

Answer 7

Deviations from the trend go in the same direction as deviations of GDP
-Consumption
-Investment
-Employment
Most volatile sector is construction

Question 8

Countercyclical

Answer 8

Deviations from the trend go in the OPPOSITE direction as deviations of GDP
Unemployment (Okun’s law)
(Y - Y)/Y= -B(u-u*)
Natural level of unemployment, never disappears
The Okun’s Law states that for every -2% output falls below trend, the unemployment rate rises by 1% (deviations from the natural rate of u)

Question 9

Okun’s Law

Answer 9

For every -2% output falls below the trend, une,ployment goes up by 1%

Question 10

Why BC are bad

Answer 10

it generates vicious circles
Lower Y → Lower I → Lower Y
Lower Y → higher u → Lower skills → lower Y/L → Lower Y
Y = income, demand, and production

Question 11

Why BC are good

Answer 11

It lowers opportunity costs
1. Restructuring costs
2. Boosting productivity costs
3. Improving skills costs
Are lower in recessions and enhance expansions

Question 12

The Frisch Slutsky Paradigm

Answer 12

Economic impulse - a shock that triggers business cycle fluctuations
Monetary policy
Fiscal policy
Consumption
Terms of trade
Technology shocks
Supply shocks (oil, agriculture)
Financial shocks

Question 13

Keynesian Theory:

Answer 13

business cycles are the sign that the market is failing to operate

Question 14

Demand Shocks in Keynesian Theory

Answer 14

Aggregate demand determines output
Recessions are caused by low demand
B-C are the negative response to a failed economy, working below is potential
Market mechanism may not work so governments must step in to shore up demand… economic policy can alter the business cycle

Question 15

AD - AS model:

Answer 15

Increase in demand (fiscal & monetary policy)
Increase in consumption
Increase in investment
Increase in government expenditure
Decrease in saving

Decrease in supply (labor market and technology endowment)
Decrease in labor (L), in capital (K), technology or total factor production (A=TFP)
Increase in oil prices
Increase in indirect taxes that affect production
Decreases the power of workers, new legislation
Credit crunches and lower physical investment

Question 16

AD-AS model graph

Answer 16

Vertical axis: inflation rate
Horizontal axis: GDP growth rate
LRAS: vertical line because economy’s long run growth rate should not depend on inflation but on the factors of production (technology, capital and labor)
LRAS is long run aggregate supply is always inelastic