R14: Business Cycles

Question 1

Co-Movement across countries

Accepted Answer

The key feature of business cycles is that they are an aggregate phenomenon. Co-movement characterizes them; that is, many economic variables from different sectors and regions of the economy, and also from different countries, display similar behavior at roughly the same time. National economies are also linked together—when the U.S. economy is growing fast, it generates demand for non-U.S. goods sectors within an economy tend to share a common business cycle. If the manufacturing sector is doing well, it will generate demand for new buildings that will encourage the construction industry Changes? Business cycles may have grown less volatile since 1950 Have shown longer periods of expansion with shorter contraction during the same time period. Declining volatility since 1950 (1960-1983 = 2.7%, 1984-2001 1.6%) Reason 1:from 1950 onwards, many governments used fiscal and monetary policy to try to reduce business cycle volatility Reason 2: good luch in form of TFP and Commodity price shocks

Question 2

Are Business Cycles Bad?

Accepted Answer

One study finds that every 1% increase in business cycle volatility leadsto a 0.2% reduction in growth.5 Lucas: Benefits from boosting long-run growth are large relative to the gains from removing business cycles (But Aggregate) Argument 1: Consumption does not vary much over business cycle Argument 2: Investors do not need to be compensated much for bearing risk Aggregate is Bad ! Business cycle volatility affects some sectors more than others. For some individuals, consumption volatility may be greater than Lucas’ calculations They hit certain households disproportionately hard. Impact of recession on consumption by age. The impact of recession is felt the most by the young and the least by those of prime working age Other Reasons: Cycles are linked to long-term growth metrics Profits, CF↓ Business cycles create volatility not just in output but also in corporate profits and firm cash flow. This volatility may retard investment. I ↓ Therefore the greater the magnitude and duration of recessions in an economy, the lower the investment rate and, potentially, the lower the long-run growth rate. TFP ↓ During recessions, unemployment increases -> decline of HK, TFP Decline Other Reasons: Cycles may be good for long-term growth TFP ↑: Recessions like a pit stop for the economy during which efficiency and productivity improve, so that growth can accelerate when the economy recovers. Efficiency ↑: New machines, new production process, Restructuring HK ↑: Training

Question 3

The Frisch-Slutsky Paradigm

Accepted Answer

Debate: Which shocks are most important and what economic factor converts these shocks into the business cycles we observe? 3 components in Business Cycle Fluctuations: 1) impulse or a shock that triggers business cycle fluctuations Monetary or Fiscal Policy Shocks Shift in desired consumption and investment Terms of Trade Showcks (i.e. oil price) Technology shocks Shocks toFinancial structure 2) Propagation mechanism: Produced fluctuation may have a different pattern from impuls that started them -> Determines how policymakers should respond 3) Business Cycles:

Question 4

Viewpoint on Business Cycle 1: Real Business Cycle Theory

Accepted Answer

Recessions are an optimal response by the market to bad technology shocks 1) Shocks: TFP cuase Business cycles (rejects that demand shows,, uses same model to explain growth and business cycles) 2) Propagation mechanism: Profit maximizing decisions of consumers and firms convert TFP shocks into business cycle. TFP -> MPL, MPK rise -> hire more L and K -> instant increase of K -> higher wages -> higher consumption. Econ. Expnsion happens because t is a good time to be economically active - Boom = time of high TFP and good technology shocks ->. Output grows, Investment, Wages - E Recession: Poor TFP, low wages, low TFP, low consumption.

Question 5

Quantity vs. Price Variable Volatility in a Business Cycle

Accepted Answer

Over the business cycle High volatility in output, employment, and investment Less volatility in interest rates, inflation, and wages. --> quantity variables are more volatile than price variables

Question 6

Viewpoint on Business Cycle 2: Keynesian Viewpoint - General Theory

Accepted Answer

Malfunctioning of markets: in certain circumstances, market mechanism may not work (prices and wages do not adapt) For various reasons, prices, wages, and interest rates might be unable to change, or to change enough, to prevent the economy getting caught in a period of low output and high unemployment. Normally: prices and wages should fall until demand and employment increase. Difference to - Recessions are caused not by adverse supplu shocks, but by low level of demand - Market does not work properly, leading to suboptimally low output - Market cannot restore on its own - Recessions are bad, and governments should and can improve things Different strands: L market that does not function well and that wages do not change, so unemployment can become too high. Monopolies keep prices too high and output too low, so that unemployment is too high. Credit markets and banking sector produce fluctuations and recessions

Question 7

Aggregate Demand & Aggregate Supply Model

Accepted Answer

When demand varies output does not change, only prices fluctuate (upward sloping Supply curve instead of vertical) Price stickiness means that short-run aggregate supply curves are unlikely to be vertical. Aggregate Demand: C, I, G, X-Y The aggregate demand curve shifts right when, at a given price, the level of demand increases. Reasons: optimism of firms regarding investment prospects change of government to a party that favors increased government expenditure sudden shift in world demand towards the products a country produces Aggregate Supply: K, L., TFP, fixed prices = vertical Supply Curve With a vertical long runsupply curve, an increase in demand only raises prices and leaves output unaffected. However, when demand shifts out, a given price the economy has more demand Firms cannot provide any more output to meet this extra demand—they can only produce their full capacity output and no more, and capital, labor, and TFP pin this level of output down. The extra demand only pushes up prices—from P(0) to P(1). As prices rise, they choke off demand until demand equals the output that firms can produce.

Question 8

Response of firms to Shift in demand

Accepted Answer

Increase Overtime Hire Workers Increase prices Increase capacity Subcontract Increase Delivery lags Why would companies rather adjust output than increase prices? (1) firms only periodically review prices, so that for significant periods prices are fixed. - prices are sticky (i.e. restaurant, mail order) 28% review annually 20% review quarterly 22% Daily - but only 6% change their price more than 12 times a year (2) Loss of customers and revenues (3) Competition - firms maximize their profits when they set price equal to a markup over their marginal cost, where the markup depends on how much monopoly power the firm has. According to this formula, firms should only change prices when either the markup they demand, or their costs, change. Behavior of marginal costs is crucial in determining the slope of the supplycurve. If marginal costs do not alter much when the firm increases output, then it should increase output, not change its prices.

Question 9

Why is Short-Run Supply curve increasing and long-run supply curve vertical?

Accepted Answer

Machines may be lying idle, and employees may nothave enough work to keep them fully occupied. In these circumstances, when a firm receivesnew orders, it has the spare resources to boost output without increasing costs—the machines and workers are already there and are not being used. As a result, thesupply curve will be flat, and as Figure 14.18 shows, any increases in demand boost outputrather than prices.

Question 10

Do Supply Shocks cause Business Cycles?

Accepted Answer

1) Real Business Cycle theory, we mentioned one source of supply shock: technological innovations. 2) Increase in commodity prices (oil, indirect taxes) -> anything that lowers profit margin Oil is an important input into the production process of many commodities If the price at which firms sell their product does not change, but their input costs have risen, then the profit margin will decline and the firm will start to scale back production Supply Curve shifts in while a demand shock moves the economy into recession, a negative supply shock also increases prices

Question 11

Conclusion: What causes Business Cycles?

Accepted Answer

While economists accept a role for supply side shocks in the business cycle, they see fluctuations in demand as the major source of business cycle volatility. 1973-1995: Supply Shocks: Italy, France, Canada Nominal Demand Shocks (due to variations in the money supply) Germany, UK Real Demand Shocks (shifts in consumption, investment or fiscal policy not related to monetary policy): US, France

2 The Global Macroeconomy (Fach) / R14: Business Cycles (Lektion)