Chapter 12 Economic Fluctuations and Business Cycles

medium run

forces that tend to reverse the effects of a recession in the course of a few years (2-3 years)

real wages can be interpreted as

the price level adjusted buying power of nominal wages

real wage

the real wage is nominal wage divided by a price index, like the consumer price index

3 key factors appear to have played the central roles in the recession of 2007-2009

1.) a fall in housing prices, which caused a collapse in construction of new homes 2.) a sharp drop in household consumption 3.) spiraling mortgage defaults that caused many bank failures, leading the entire financial system to freeze up

economic fluctuations display 3 key properties

1.) co-movement 2.) limited predictability 3.) persistence

many factors explain fluctuations in economic activity, most notably:

1.) technology shocks 2.) Keynesian factors 3.) monetary and financial factors

Keynesian factors

-changes in sentiments, including changes in expectations, uncertainty, and animal spirits, influence firm and household behavior. If a firm becomes pessimistic, its demand curve for labor shifts to the left. If a firm's customers become pessimistic, they reduce their purchases, decreasing demand for the firms' products and shifting the firms' labor demand curve to the left -an initial shift in the labor demand curve creates a cascading chain of events, multiplying or amplifying the impact of the initial shock. -financial factors create additional multiplier effects. Defaults, bankruptcies, and declines in asset prices lead banks to scale back there lending to firms and households, generating another round of averse shifts in the labor demand curve

additional factors that multiply the impact of an initial negative shock and their effects

-declines in asset prices such as value of stocks, bonds, and housing -rising rates of mortgage defaults which weaken banks balance sheets -rising rates of household bankruptcies generating defaults on numerous types of consumer credit (including credit card loans) -rising rates of firm bankruptcies causing their lenders to absorb large losses -falling levels of financial intermediation as banks become unwilling or unable to extend new loans, even to their existing customers

the labor demand curve shifts back to the right due to market forces

-labor demand partially recovers when excess inventory has been sold off -labor demand partially recovers when households that have postponed expenditures eventually grow frustrated with the inconvenience of the delayed purchase and come back into the market -when physical and human capital shift from firms that went bankrupt during the downturn to healthier firms -technological advances encourage firms to expand their activities -as the banking system recuperates and businesses are again able to use credit to finance their activities

co movement

-many aggregate macroeconomic variables grow or contract together during economic booms and recessions

the labor demand curve shifts back to the right due to expansionary government policies

-the central bank can use monetary policy to shift labor demand to the right. lowering interest rates stimulates both firm investment and household consumption -labor demand also shifts to the right as overall inflation raises firms output prices. A rise in output prices makes production, and thus increasing employment, more profitable at a given wage -fiscal policy; increasing government spending increases the demand for the products that firms produce, decreasing taxes gives firms and consumers more after-tax income

persistence in the rate of economic growth

-when the economy is growing, it will probably keep growing the following quarter; likewise when the economy is contracting, the economy will probably keep contracting the following quarter

shifts in the labor demand curve:

1) changing output prices 2)changing output demand 3) changing technology and productivity 4) changing input prices

economic fluctuations have 3 key properties:

1) co-movement of many aggregate macroeconomic variables 2) limited predictability of turning points 3) persistence in the rate of economic growth

What are the 3 schools of thought:

1) real business cycle theory 2) Keynesian theory 3) Financial and monetary theories

because real wages are the ratio of nominal wages to a price index, and because inflation raises the prices index, real wages fall when

1) the price index rises 2) nominal wages are fixed

changing input prices

Business use labor and other factors of production, like physical capital and energy, to produce goods and service. When the cost of these other factors goes up, firms purchase less of them. This usually decreases the marginal product of labor, shifting the labor demand curve to the left

an increase in a negative sentiment leads to

a fall in investment; triggering a leftward shift in firms' labor demand curves and reducing unemployment and GDP

monetary and financial factors

a fall in the price level is contractionary, because firms face downward rage rigidities-that is, they are unable or unwilling to cut wages. Employment declines by more than it would have with flexible wages. In addition, Monterey contractions cause the real interest rate to rise, reducing investment. Finally, financial crises reduce the credit available to firms and households

disruptions in the credit marker will reduce the amount of investment and consumption thereby lowering real GDP and employment hence what type of shift

a leftward shift in the supply of credit will shift the labor demand curves to the left

nominal wages

actual wages which distinguishes them from wages adjusted for inflation, or real wages

falling labor demand leads to

additional declines in employment and GDP, further weakening the economy and generating additional rounds of multiplier effects

multipliers

are economic mechanisms that amplify the initial impact of a shock

recessions

are periods (lasting at least 2 quarters) in which real GDP falls

animal spirits

are physiological factors that lead to changes in the mood of consumers or businesses, thereby affecting consumption, investment, and GDP

economic expansions

are the periods between recessions. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession

technology shocks (the theory of real business cycles)

changes in firm's productivity translate into shifts in the demand curve for labor, causing fluctuations in employment and real GDP. When the labor demand curve shifts to the left, employment and real GDP fall. When the labor demand curve shift to the right, employment and real GDP rise

co-movment

consumption, investment, GDP, and employment generally fall and rise together. Unemployment moves in the opposite direction

employment fluctuations

correspond to changes in the labor-market equilibrium

phillips curve

describes the empirical relationship between employment growth and inflation, showing that employment growth tends to produce more inflation, especially when an economy is near full employment

percentage deviation

difference between the real GDP and the trend line/trend

Limited Predictability

economic fluctuations are not pendulum-like with regular up and down cycles. It is difficult to predict in advance when an economy will enter a recession (a peak) and when a recession will end (a trough)

limited predictability

even with the tools of modern economics, it is impossible to predict far in advance when a recession or expansion will end

all economies experience economic fluctuations

growth rates fluctuate from year to year; during recessions, real GDP contracts and unemployment increases

increases in labor demand will tend to raise

household income, causing households to start consuming more

accordingly, in most instances, consumption and investment move

in the same direction

sentiments

include changes in expectations about future economic activity, changes in uncertainty facing firms and households, and fluctuations in animal spirits. Changes in sentiments lead to changes in household consumption and firm investment

proponents of real business cycle theory tend to also emphasize the importance of changing what

input prices

self-fulfilling prophecy

is a situation in which the expectations of an event induce actions that lead to that event

aggregate demand

is the economy's overall demand for the goods and services that firms produce. Aggregate demand drives the hiring decisions of firms and consequently determines the labor demand curve

peak

is the high point of real GDP, just before a recession begins

trough

is the low point of real GDP during the recession, which corresponds to the end of the recession

real business cycle theory

is the school of thought that emphasizes the role of changes in technology in causing economic fluctuations

depression

is typically used to describe a prolonged recession with an unemployment rate of 20% or more

upside down or under water

owing more on your home than it is worth

downturns, contractions, or recessions

period of negative growth in GDP

expansions or booms

periods of positive growth in GDP

a shock to consumption causes firms to

reduce labor demand, shifting the labor demand curve to the left the leftward shift in labor demand leads to layoffs, reducing the household income and further reducing household consumption

a leftward shift in the labor demand curve

reduces the equilibrium quantity of labor employed

Great Depression

refers to the severe contraction that started in 1929, reaching a low point for real GDP in 1933. The period of below-trend real GDP did not end until the buildup to World War II in the late 1930's.

economic fluctuations or business cycles

short run changes in the growth of GDP

Since 1929, a recession has occurred about once every 6 years, and the average recession length has been about 1 year true or false

true

certain types of technological improvements can lead to increases in labor demand and increases in aggregate economic activity, including investment and consumption true or false

true

countries that consistently develop new technologies will attain high rates of growth true or false

true

employment an GDP also move together with consumption and investment, and unemployment moves negatively with GDP ex) during contractions, real consumption, real investment, employment, and real GDP all fall, while unemployment rises true or false

true

growth, even for the most developed economies, is never completely steady true or false

true

investment is more volatile than consumption true or false

true

limited predictability is important to acknowledge, because many early theories of business cycles assumed that economic fluctuations had a pendulum-like structure with systematic swings in economic growth true or false

true

multipliers can amplify the effects of any economic shock, regardless of whether the shock arise from changes in technology, sentiment, or financial markets true or false

true

the most important source of fluctuations are shifts in the demand for labor true or false

true

the rate of technological progress is at the root of long-run variation in economic growth true or false

true

there is a large amount of persistence in economic growth true or false

true

when consumption growth is high, investment growth tends to be high as well; when consumption growth is low (or negative), investment growth tends to be low (or negative) in other words, consumption and investment tend to either grow together or shrink together true or false

true

when percentage deviation is negative, real GDP is below its trend line true or false

true

when percentage deviation is positive, the Real GDP is above its trend line true or false

true

with downward wage rigidity, firms are unable or unwilling to cut nominal wages because of contractual restrictions or because they are concerned that wage cuts would reduce worker morale and adversely affect productivity true or false

true

when firms are turning pessimistic and cutting back employment and investment households are

unlikely to increase their consumption

labor market equilibrium

wage and employment levels given by the intersection of the labor supply and labor demand curves

changing output demand

when demand for the product the firm produces shifts to the left, its price and this the value of the marginal product of labor goes down, also shifting the labor demand curve to the left

persistence

when the economy is growing, it will probably keep growing the following quarter. Likewise, when the economy is contracting-when growth is negative- the economy will probably keep contracting the following quarter

changing output prices

when the price of the output good does down, the value of the marginal product of labor also declines; this implies that the firm would like to hire fewer workers at any given wage, shifting the labor demand curve to the left vice versa for positive