Topic 6- Classical Business Analysis

Question 1

What does the real business cycle theory (RBC) argue?

Answer 1

Argues that real shocks to the economy are the primary cause of business cycles

Question 2

What are real shocks to the economy and give 4 examples of them

Answer 2

Real shocks are disturbances to the “real side” of the economy e.g:

• Shocks to the production function
• Shock to the size of the labour force
• Shocks to the real quantity of government purchases
• Shocks to the spending and saving decisions of consumers

Question 3

What are nominal shocks?

Answer 3

Shocks to money supply or money demand

Question 4

Which shock plays the largest role in TBC theory?

Answer 4

Shocks to the productivity function which we call supply shocks, and RBC theorists call productivity shocks

Question 5

Give 4 examples of productivity shocks

Answer 5

• Development of new products or production techniques
• Introduction of new management techniques
• Changes in the quality of capital or labour
• Changes in the availability of raw materials

Question 6

To what does RBC theory attribute most booms and recessions to?

Answer 6

RBC theory dictates that most economic booms result from beneficial productivity shocks; most recessions are caused by adverse productivity shocks

Question 7

What is the recessionary impact of an adverse productivity shock?

Answer 7

Real wage, FE level of employment & output, consumption and investment decline while the real interest rate and price level rise

Question 8

What effect does rapid price adjustment have in the RBC approach?

Answer 8

It ensures that actual output always equals full employment output

Question 9

Give 3 ways that RBC theory is consistent with business cycle facts

Answer 9

• If the economy is continuously buffeted by productivity shocks, the theory predicts recurrent fluctuations in aggregate output, which we observe
• The theory correctly predicts procyclical employment and real wages
• The theory correctly predicts procyclical average labour productivity

Question 10

How can a temporary increase in government expenditures affect real wage and employment in the classical model?

Answer 10

If there’s a temporary rise in government expenditures, the current or future taxes needed to pay for the government expenditures effectively reduce people’s wealth, causing an income effect on labour supply. Increased labour supply leads to a fall in the real wage and a rise in employment

Question 11

Why do classical economists oppose attempts to dampen cyclical fluctuations?

Answer 11

Because in their view, prices and wages adjust quickly to restore equilibrium

Question 12

What is a major weakness of the classical model?

Answer 12

It does not explain why unemployment rises during recessions

Question 13

How else could the government address unemployment apart from expansionary fiscal policy?

Answer 13

By eliminating barriers to labour-market adjustment by reducing burdensome regulations on businesses that raise the cost of employing additional workers

Question 14

When do classical economists believe money to be neutral?

Answer 14

Because classical economists believe that the price adjustment process is rapid, they view the period of time during which the price level is fixed- and money is not neutral- to be too short to matter. Thus, they view money as neutral for any relevant time horizon

Question 15

What is reverse causation?

Answer 15

The argument that expected future increases in output cause increases in the current money supply

Question 16

Explain the process behind reverse causation

Answer 16

If the public expect the economy to grow considerably in the near future money demand today will increase as businesses may need to increase their current transactions in preparation for the planned increase in production. Money supply will then appear to increase in advance of the increase in output even though money is neutral

Question 17

What properties of money does reverse causation explain and what does it leave ambiguous?

Answer 17

Reverse causation provides an explanation for the leading and procyclical behaviour of money.
However, it does not rule out the possibility that money is non-neutral as there’s a possibility that changes in the money supply are the casual factors of changes in output

Question 18

Explain the evidence for the nonneutrality of money

Answer 18

Friedman & Schwartz found that:

• Changes in the behaviour of money stock have been closely associated with changes in economic activity, income and prices
• The interrelation between monetary and economic change has been highly stable
• Monetary changes have often had an independent origin, they weren’t just a reflection of changes or future changes in economic activity

Question 19

What is the misperceptions theory?

Answer 19

The aggregate quantity of output supplied rises above the full-employment level (ȳ) when the aggregate price level (P) is higher than expected

Question 20

What is the key assumption of the misperceptions theory?

Answer 20

The theory assumes producers have imperfect information about the general price level so they may misinterpret changes in the price level as changes in the relative prices of the goods they produce

Question 21

What is the algebra behind the SRAS curve sloping upwards?

Answer 21

Y = ȳ + b(P - P^e)
dY/dP = b
dP/dY = 1/b

Question 22

Where does the SRAS curve intersect the LRAS curve?

Answer 22

At P = P^e

Question 23

How does the expected nominal price level (P^e) affect the SRAS curve?

Answer 23

When P^e rises, the SRAS curve shifts up and when P^e falls the SRAS curve shifts down

Question 24

What are the effects of an unanticipated increase in money supply?

Answer 24

• AD increases
• SRAS remains unchanged
• Price level rises in the short run with output above FE level
• As people get information about the true price level, their expectations change and the SRAS curve shifts left
• The conclusion is that unanticipated money isn’t neutral in the short run, but it is neutral in the long run

Question 25

What are the effects of an anticipated increase in money supply?

Answer 25

• AD increases
• SRAS increases because the public’s expected price level rises as soon as people learn of the increase in money supply
• People correctly expect the price level increase so P^e rises
• The anticipated increase in the money supply hasn’t affected output but has raised prices proportionally so anticipated money is neutral in both the short run and long run

Question 26

How does the misperceptions theory suggest the central bank should implement monetary policy?

Answer 26

If the central bank wants to use monetary policy to affect output it should use only unanticipated changes in money supply

Question 27

What is the main limitation of using unanticipated changes in monetary policy in the long run?

Answer 27

People realise that the central bank would want to increase money supply in recessions and decrease it in booms, so they won’t be fooled. Most economists believe that attempts by the central bank to surprise the public in a systematic way cannot be successful

Question 28

What is the Rational Expectations Hypothesis (REH)?

Answer 28

The public’s forecasts of various economic variables, including the money supply, the price level and GDP are based on reasoned and intelligent examination of available economic data