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Flashcards in Growth I Deck (19)
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What can real GDP over time be decomposed into?

The trend componenent (medium to long run) and the cyclical component (short-run)

There is a need to separate cycles from trend
When looking at GDP over a long period of time e.g. a century, the average yearly growth rate is typically positive

A similar pattern is not observed in the short term


Describe the trend component.

What is it determined and influenced by?

The trend component is equal to the potential output.
It is typically continuosly growing unlike real GDP.
It is determined by labour force, capital stock, technology etc.
Is influenced by structural policies such as labour market reforms, education policies etc.


Describe the cyclical component.

What does it indicate, what is it determined by and what is it influenced by?

The cyclical component is equal to the output gap.
It indicates positive or negative deviations from trend growth and refers to short term periods, such as a few years or quarters.

It is determined by movements in demand (consumption and investment).

Is influenced by stabilisation policies (fiscal and monetary)


Describe the output gap (negative and positive). Why are both gaps inefficient?

Output gap = actual output - potential output
If actual GDP is larger than potential GDP, the output gap is positive; in the opposite case, it is negative.

A positive output gap: demand is very high, factories and workers operate above efficient capacity -> economy is in a boom (expansion)

A negative output gap: economy is weak, spare capacity -> economy is in a recession (contraction)

Both types of gap are inefficient!
For negative we have more capacity than we are using
For positive we overuse our equipment


Describe how growth cycles yield counterintuitive interpretations (think about the output gap)

Output gap can still be positive even though real GDP is contracting.

Output gap can still be negative even though real GDP is already expanding


Explain what constitutes a business cycle and business cycles compared to growth cycles

Business cycles (classical cycles) are based on absolute fluctations of real GDP.

The turning points are called peaks and throughs.

A boom is the period from through to peak.

Recession is the period from peak to through.

Full business cycle: through - peak - through

The disadvantage of classical cycles is that they do not capture slowdowns. Growth cycles do.


Describe the relationship between the output gap and inflation

Positive output gap: prises rise in response to high demand i.e. there is an upward pressure on inflation

Negative output gap: downward pressure on inflation

Potential output is the level of output consistent with stable inflation


Describe the relationship between the output gap and unemployment

Both output and unemployment gap are central to the conduct of monetary and fiscal policies

Deviations of the unemployment rate from the NAIRU are associated with deviations of output from its potential level. Theoretically, if policymakers get the actual unemployment rate to equal the NAIRU, the economy will produce at its maximum level of output without straining resources - no output gap and no inflation pressure. Thus full employment corresponds to an output gap of zero.

A positive output gap: unemployment below NAIRU


How can nominal wages influence GDP?

Closely associated with changes in real measures (such as output(GDP), employment and unemployment) we also observe changes in nominal variables (such as prices and wages)

In times of low unemployment and high labour demand, nominal wages tend to increase more than justified by inflation and productitity gains.

When the economy is booming there is a tendency that wage increases are also going to be high
If they grow more than is justified by productivity and inflation - Danish production becomes more expensive, we loose on competitiveness - net export goes down which makes the GDP go down.

Alternatively, if firms pass on higher wages to consumers prices will rise -> danger of inflation /wage spiral


Describe three types of stabilisation policies

Fiscal policy (taxes, public expenditures)
› Example: if output gap negative, expansionary fiscal policy through government spending or tax reductions to lift demand;
conversely, if output gap positive, tight fiscal policy though spending cuts or tax raises

2. Monetary policy (interest rates, money supply)
› Example: if output gap negative, central bank lowers interest rates to boost demand (investment and consumption) and raise inflation;
conversely, if output gap positive, central bank raises interest rates to weaken demand and lower inflation

3. Income policy (affect and regulate prices and wages) › Rather ineffective


Explain why Denmark cannot pursue a monetary policy different from that of the ECB

Fixed exchange rate between DKK and EURO - key task of the Danish central bank is to support this. To support this policy in light of free capital mobility, the Central Bank of Denmark (Danmarks Nationalbank) must set interest rates equal to the ones set by the ECB.
Since there is free capital mobility in and out of DK, and provided that the exchange rate peg is credible, interest rates in DK cannot differ from interest rates in the euro area. If there were a systematic difference in return it would release capital flow in the direction of the country with the highest interest rate, which will eliminate the difference because of the very high degree of capital mobility


Describe the two types of fiscal policy

Two types of fiscal policy:
1. Discretionary fiscal policy
› changes to government spending or taxation
› measured in terms of fiscal stance or fiscal effects

2. Automatic responses / automatic stabilisers
› increase in activity leads to higher tax revenue and lower expenditure on e.g. unemployment benefits
› automatic responses are countercyclical, i.e. they dampen macroeconomic fluctuations
› larger in countries with extended welfare state (E.g. if tax rates are higher or unemployment benefit rates are higher, the response of tax revenue and expenditures to a change in activity will be larger)
› taxes more sensitive than expenditures (government revenue is considerably more sensitive to the business cycle than government expenditures)


Describe the fiscal balance and what influences the fiscal balance

(General government) fiscal balance = current revenue – current expenditure
› Is influenced by:
• Discretionary fiscal policy
• Automatic responses -> cyclical
• One-off items -> temporary


How do we evaluate sustainability of (discretionary) fiscal policy?

• subtract from fiscal balance all cyclical and one-off items
• this is the balance when output is at level of potential output -> structural balance or cyclically adjusted budget (CAB)

Changes in the CAB are an indicator for discretionary policy changes
› negative change -> expansionary/looser fiscal stance
› positive change -> contractionary/tighter fiscal stance
• CAB close to zero: neutral fiscal stance


Explain fiscal space and deficit bias

› In a normal business cycle situation, the public balance (in this case equal to the CAB) should be close to zero › Symmetry rule: “Save in good times and spend in bad times”
› If public balance is negative not only in bad, but also in normal (and possibly good) times, public debt will accumulate dramatically
› As a consequence, there might be no fiscal space in bad times i.e. no room to pursue discretionary fiscal policy
› In practice, many countries exhibit deficit bias: systematically negative public balances


Describe the historical development of output per capita (growth) (remember Matlthusian trap)

› Output per capita stagnant for most of human history
› Malthusian trap: increase in output, decrease in mortality, increase in population -> no change in output per capita
› Leaving the trap (Europe):
• 1500-1700: growth 0.1% per year
• 1700-1820: growth 0.2% per year
• 1820-1950: growth 1.5% per year

› Recall: 2% on average since 1960! -> Sustained growth is recent phenomenon (so is climate changes)

However, slowdown in growth since the 1990's


Describe the relation between GDP and happiness

Measuring life satisfaction: “Please imagine a ladder with steps numbered from 0 at the bottom to 10 at the top. Suppose we say that the top of the ladder represents the best possible life for you and the bottom of the ladder represents the worst possible life for you. On which step of the ladder would you say you personally feel you stand at the present time?”

Life satisfaction increases with GDP
• within countries (individual income)
• between countries (both poor and rich)

Critical view:
• Looking over time, average happiness in rich countries did not seem to increase very much, if at all, with income.
• the scale is a logarithmic scale, so a given size interval represents a given percentage increase in GDP
• other factors matter as well and might be cheaper
It is not the absolute level of income that is important, but the level of income relative to others.


What is discretionary fiscal policy and how does it interact with the output gap?

Discretionary fiscal policy refers to discretionary policy measures that change government spending or taxation. [This contrasts with automatic responses,
which refer to changes in government spending or taxation that happen automatically in response to the business cycle development.]

If the output gap is negative, the government typically increases spending and/or cuts taxes to stimulate demand and close the output gap, i.e. make it less negative. This is called expansionary fiscal policy. If the output gap is positive, the government typically decreases spending and/or increases taxes to lower demand and reduce the output gap. This is called contractionary or tight fiscal policy


What is the CAB?

CAB = Actual balance – cyclical component – one-off items where cyclical component = budget sensitivity × output gap