Week 3: Introduction to Business Cycles

Question 1

What are business cycles?

Answer 1

Fluctuations in economic activity characterized by expansion and contraction phases.

Business cycles include periods of economic growth (expansions) and decline (recessions).

Question 2

Def of Boom and Receession

Answer 2

Boom; Real GDP above trend

Recession; two consecutive quarters of negative real GDP growth

Question 3

List the main phases of a business cycle.

Answer 3

• Expansion
• Peak
• Contraction
• Trough

Each phase represents a distinct stage in the economic cycle.

Question 4

How do you just focus on the fluctuations in economic data

Answer 4

Long-term trends dominate macro data

So detrend the time series line:
- Estimate a trend line, then remove is

Business cycle component of a variable is a deviation from trend line

Hodrick Prescott (HP) filter used to make a trend line that smoothes over time

Question 5

After detrending real GDPP what do we document for macroeconomic variable relationships

Answer 5

Relative volatlity: size of fluctuations in x relative to real GDP

Co-movement: Correlation of x with real GDP

Leads or lags: dynamics of x relative to real GDP

Question 6

What occurs during the expansion phase of a business cycle?

Answer 6

Increase in economic activity, rising GDP, and higher employment rates.

Businesses invest more, consumer confidence grows, and spending increases.

Question 7

What is a peak in a business cycle?

Answer 7

The point at which economic activity reaches its highest level before declining.

It signifies the end of an expansion phase.

Question 8

Define contraction in the context of business cycles.

Answer 8

A period of decreasing economic activity, often leading to a recession.

Characterized by falling GDP, rising unemployment, and reduced consumer spending.

Question 9

What is a trough in a business cycle?

Answer 9

The lowest point of economic activity before recovery begins.

It marks the end of a contraction phase.

Question 10

True or False: Business cycles are predictable.

Answer 10

False

Business cycles are influenced by various factors and can be difficult to forecast accurately.

Question 11

What factors can influence business cycles?

Answer 11

• Changes in consumer confidence
• Government policies
• Interest rates
• Global events

These factors can lead to fluctuations in economic activity.

Question 12

Fill in the blank: A _______ is a significant decline in economic activity spread across the economy lasting more than a few months.

Answer 12

recession

Recessions are often identified by falling GDP and rising unemployment.

Question 13

What is the role of government policies in business cycles?

Answer 13

To stabilize economic fluctuations through fiscal and monetary measures.

Governments may adjust spending and tax policies, while central banks may change interest rates.

Question 14

How do interest rates affect business cycles?

Answer 14

Lower interest rates can stimulate borrowing and investment, while higher rates can slow economic activity.

Interest rates influence consumer and business spending.

Question 15

Values of consumption relationsship to Real Y

Answer 15

• Procyclical
• Less volatile than GDP (Consumption Smoothing)
• Coincident (Current)

Question 16

Values of investment relationship to Real Y

Answer 16

• Procyclical
• Much morre volatile than GDP (Consumption Smoothing)
• Coincident (Current)

Question 17

Values of employment relationship to Real Y

Answer 17

• Procyclical
• Less volatile than GDP (puzzling due to dim. returns to labour)
• Slightly lagging

Question 18

Values of real wages to Real Y

Answer 18

• Procyclical (weakly)
• Less volatile than GDP
• No clear lag or lead

Question 19

Values of average labour productivity relationship to Real Y

Answer 19

• Procyclical (potentially puzzling if there are diminishing returns to labour)
• Less volatile than GDP
• No clear lag or lead

Question 20

Values of real interest rate relationship to Real Y

Answer 20

• Countercyclical (weekly, on average,, behaviour switched from countercyclical in 70s and 80s to procyclical in recent decades)
• Less volatile than GDP
• No clear lag or lead

Question 21

What does ‘general equilibriuim’ incolce

Answer 21

Equilibrium in all relevant macro-level markets (goods, labour, financial)

Assume closed economy

Question 22

What is the production function with neoclassical assumptionsq

Answer 22

Y = zF(K,N)

positive, but diminishing marginal products

MPK positive, decreasing in capital K
MPN, positive but decreasing in labour N

Prod function overall has constant returns to scale

Question 23

What is the profit maximising labour demand for firms

Answer 23

MP of Labour (N) = w

Question 24

Draw the Production Function graph with the solution where w=MPN holding K constant

Answer 24

Question 25

How is AD determined

Answer 25

C + I + G no X,M due to closed economy

Question 26

What determines the optimal amount of investment in the economy

Answer 26

MPK is extra output from investment Marginal cost = Depreciation (d) + IR (from cost of financing) also R if self financed due to opportunity cost of postponing distribution of dividends (assumed to =r) Investmend demand determined by MPk - d plotted against Investment with r as price

Question 27

What determins household consumption choices

Answer 27

- Current and future income - Interest rate r for saving and borrowing - Desire to 'smooth' consumption

Question 28

How are household consumption choices portrayed through the two period consumption model

Answer 28

* Convex to irigin indifference curv (smoothing pref) * Position of budget constraint depends on current and future income * Gradient of budget constraint is -(1+r) where r is real interest rate

Question 29

draw temporary vs permanent changes in income in 2 period consumption models

Answer 29

Question 30

Draw changes in interest rates for savers and borrowers

Answer 30

New budget line at original indiff --> splits into IE and SE Change along new red line + old budget is SE Increase in budget is shift in IE

Question 31

How does the real interest rate effect consumption

Answer 31

Sub effect --> leads to fall in consumption if interest rate r rises Income effects are redist. among borrowerss and saverss; overall iincome effect is 0 Substitution effects (SE) dominate income effectts overall

Question 32

What is Saving determined by

Answer 32

Saving = Income - Consumptionnnn

Question 33

Draw consumption and investment demand curves with r on y

Answer 33

Question 34

How do households choose participation in tthe labour market

Answer 34

real wage (w) = MRS between leisure and consumptio

Question 35

How does Wage and income afffect labour supply

Answer 35

W increases Ns through SE If households worse off, raise Ns as leisure is a 'normal' good Saving = Income - Consumption can raise saving by Ns Real interest rate t affects saving so also Nss

Question 36

Draw labour demand and supply graphs

Answer 36

Question 37

Budget constraint of the government

Answer 37

PDV of expenditure = PDV of taxes

Question 38

Draw the output demand curve with r on Y axis

Answer 38

Summing up the components of AD implies a downward sloping curve for goods Shifs with wealth effects, changes in G or other determinants

Question 39

How does the labour market clear and how does that impact the production function

Answer 39

Labour market clears to w * with a given r --> equil. employment N* thus Y=zF(K,N * )

Question 40

draw this scenarioa cross goods, labour and output models

Answer 40

Question 41

How does goods market clear

Answer 41

- upward sloping Ys and downward sloping Yd - Interest rate r clears the market - Simultaneous equilibrium in labour and goods market since Ys curve also represents labour market equilibrium

Question 42

What is Walras' Law

Answer 42

Logically if free market, if 2 markets in equilibrium, the 3rd will also be. So financial market (bond market) in equilibrium once good and labour markets are in equilibrium

Question 43

What are Real Business Cycle theory (RBC)

Answer 43

Supply shocks in a model can provide an empirically consistent account of business cycles business cycle are simply economy efficient response to variations in ability to produce goods --> policy intervention is futile

Question 44

What are supply shocks

Answer 44

exogenous changes in TFP, z, in production function Y = zF(K,N) Focus on transitory supplpy shocks

Question 45

What are the effects and overall effects are of a negative shock in the RBC model

Answer 45

Effects: - Prod. function shifts downwards - Lower MPL shifting Nd to the left: Ys shifts further left - Lower Investment (from falling expected MPK) - Lower Cd and higher Ns ffrom -ve wealth effect Overall effect: Yd and Ys move to the left, so GDP Y falls Wealth effect smaller than direct impact of shock on Ys --> smoothing for a shock that is not permanent

Question 46

Draw the effects sof a negative supply shock on a goods market, labour markets and production function

Answer 46

**1. Goods Market:** - Real Interest rate rises if Ys shifts more than Yd - Yd shift larger if fall in TFP lasts longer (effects smooting of C and I) **2. Labour Market** - Effect on N ambiguous (Nd falls but Ns can rise) - wealth effect smaller when TFP temporary shock - Rea; wage increases

Question 47

Explain the mechanics in each market

Answer 47

**1. Goods:** YS: - fall in z1 and Nd causes shift left of YS - Rise in NS offsets fall of Ys YD: - Falls due tot a fall in C(d) and I(d) from -ve welath effect and falling MPK - demand impact determined by expectation of longevity if **2. Labour:** ND: shifts left due to falling MPL from shock to z NS: shift out due to -ve wealth effect, another shift out from higher r (interest rate) effect on employment ambiguous; dep on magnitude of -ve wealth effect short term impacts so demand side less impacted than supply S>D fall so R increases

Question 48

How do the model predictions of how macroeconomic variables interact with Real GDP match up to the data

Answer 48

* Matches evidence well * But not all recession feature an obvious shock * Shocks must be transitory so employment model is prrocyclical * Ns must be sufficiently wage elastic so effect on N large and w smal

Question 49

What does the RBC model say about government intervention

Answer 49

Model predicts that policy intervention, even if succeeds in raising GDP, make households worse off * Raisisng Y is inefficient as it leads people to work more when productivity is low MPn = w * = marginal value of time (MRS) Monetary Policy has no impact on real GDP because money, nominal prices and IR are irrelevant in RBC model