Questions - econ1.altervista.orgecon1.altervista.org/econ/edu/samek/lit/facit/ch26.docx · Web view2.What does it mean to say that an economic fluctuation involves the co-movement

Chapter 12Economic FluctuationsQuestions1. What are economic fluctuations? What is the difference between an economic expansion and a

recession?

Answer: Short-run changes in the growth of GDP are referred to as economic fluctuations or business cycles. Recessions are periods in which the economy contracts, while economic expansions are defined as the periods between recessions, characterized by positive growth in GDP. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession. In the United States, recessions are informally defined as two consecutive quarters of negative growth in real GDP. (The term depression is used for a prolonged recession that features unemployment in excess of 20 percent of the labor force.)

2. What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables? Name four variables that exhibit co-movement during an economic expansion.

Answer: Co-movement of aggregate macroeconomic variables implies that these variables grow or contract together during booms and recessions. Employment and GDP move together with consumption and investment, while unemployment varies inversely with GDP. Thus, during an expansion, consumption, investment, employment and GDP all rise, while unemployment falls.

3. The duration of an economic fluctuation is completely unpredictable. Explain why this statement is only partially true.

Answer: Economic fluctuations have highly variable lengths—a fact that makes it difficult to precisely predict when an expansion will turn into a recession or when a recession will turn into an expansion. However, by using sophisticated statistical techniques, economists can achieve some degree of predictive power. For example, economists are able to predict the end of a recession roughly a month or two before the actual end. As a result, economic fluctuations are said to have “limited predictability” rather than “no predictability.”

4. Does the Great Depression illustrate the three characteristics of economic fluctuations? Explain your answer.

Answer: The Great Depression does illustrate the three key properties of economic fluctuations.

It featured strong co-movement in economic aggregates. Exhibit 12.5 in the chapter shows that real GDP, real consumption, and real investment started to fall in 1929 and bottomed out in 1932 and 1933. Simultaneously, unemployment moved in the opposite direction.

It featured limited predictability. The Great Depression came as a surprise to leading economists, policymakers, and business leaders, none of whom foresaw this event.

It featured a great deal of persistence. The period of negative growth in real GDP lasted for four years, starting in 1929 and ending in 1933.

5. How do wage flexibility and downward wage rigidity affect the extent of unemployment in the economy when the demand for labor shifts to the left?

©2018 Pearson Education Ltd.

Chapter 12 | Economic Fluctuations 140

Answer: Suppose the labor demand curve shifts to the left when wages are flexible. A new equilibrium will be established at a lower wage (assuming a downward-sloping labor demand curve). Although the level of employment will have declined, everyone who wants to work at the new, lower wage will be able to find a job, so there is no unemployment.

However, if wages are downwardly rigid, a shift to the left of the labor demand curve has an amplified effect, as shown in Exhibit 12.6(c) in the chapter. The overall level of employment declines more than if wages had been able to adjust. Moreover, the quantity of labor supplied at the rigid wage is now higher than the quantity of labor demanded. Hence, there is now unemployment.

6. How does real business cycle theory explain economic fluctuations?

Answer: Real business cycle theory emphasizes the effect of changing productivity and technology on economic fluctuations. Certain types of technological improvements can lead to increases in investment and consumption. Although technological regress seems an unlikely explanation for recessions, the rate of technological progress is believed to play a key role in long-run variation in economic growth. Real business cycle theory also emphasizes the importance of changing input prices—especially the price of oil. Because oil price changes can be abrupt, this factor does help to explain recessions.

7. How did John Maynard Keynes use the concepts of animal spirits and sentiments to explain economic fluctuations?

Answer: Animal spirits are what Keynes called the psychological factors that lead to changes in the mood of consumers or businesses and affect consumption, investment, and GDP. Animal spirits represent the overall level of optimism or pessimism in the economy and affect expectations of how future events will play out. For example, suppose firms are pessimistic about the future and cut back employment and investment. Households will face a heightened risk of losing their jobs because of the fall in investment and are likely to decrease their consumption and save for a rainy day. This translates into a decline in the current demand for the products of many firms, shifting the labor demand curve at those firms to the left, thereby reducing production and employment. Animal spirits are an example of changing sentiments, which include changes in expectations and changes in the (real or perceived) uncertainty facing firms and households. Changes in sentiments lead to changes in household consumption and firm investment, which affect aggregate expenditure and output.

8. The concept of multipliers was one of the key elements of John Maynard Keynes’s theory of fluctuations. What is a multiplier? Explain with an example.

Answer: The working of a multiplier magnifies a modest negative or positive shock to the economy and generates a cascade of follow-on effects that ultimately causes a larger contraction or expansion, respectively. Multipliers are the economic mechanisms that cause an initial shock to be amplified by follow-on effects. For example, suppose a drop in consumer confidence reduces households’ willingness to spend. Firms will cut back production and lay off employees. Those newly unemployed workers will be unable to buy goods and services, leading firms that previously sold goods to these consumers to scale back production even more. Such cascades of effects will amplify the impact of the initial shock.

9. How can contractionary monetary policy lead to an economy-wide recession?

Answer: Contractionary monetary policy causes the money supply to fall. A decline in the money supply causes the price level to fall. Wages will be downwardly rigid because firms typically avoid cutting wages to prevent morale problems at work. So when the aggregate price level falls, firms will cut their output prices but won’t cut the wages that they pay their workers. Firms will reduce employment, as the fall in their output prices causes their labor demand curve to shift to the left. Contractionary monetary policy also causes the real interest rate to rise. This increases production costs for firms and also causes a leftward shift in the demand for labor, lowering the quantity of labor hired at the downward rigid wage. These effects put together cause a fall in employment and GDP, leading to a recession.



10. What are two important mechanisms that reverse the effects of a recession in a modern economy?

Answer: In the medium run, two factors tend to reverse the effects of a recession.

The labor demand curve shifts back to the right.

This can happen for several reasons: Excess inventory has been sold off in the course of the recession; technological advances create new business opportunities that enable firms to expand their activities; or the banking system and other financial intermediaries recuperate, increasing the credit available to finance expanded business operations.

Government pursues expansionary monetary and fiscal policies to stimulate the economy.

Expansionary monetary policy can be used to lower interest rates, stimulating both consumption and investment. Likewise, government spending can be increased, or taxes reduced, as part of expansionary fiscal policy. The inflationary pressures that can result from either of these policies serve to raise the prices for firms’ products, thus making their operations more profitable at a given wage. This also acts as a stimulus to increased employment.

11. How can the 2007–2009 recession be explained?

Answer: When housing prices fell sharply from 2006 to 2009, homebuilders reduced their rate of new construction because they already held a large inventory of new homes and the falling prices made new construction unprofitable. Consequently, their labor demand curves shifted sharply to the left. The fall in housing prices reduced consumers’ wealth, and most households curtailed spending. The labor demand curves for firms that produced goods and services that consumers buy shifted to the left. Home owners also defaulted on mortgages, which adversely affected bank balance sheets. Credit to the private sector fell. The decline in credit to households and firms reduced consumption and investment and triggered another round of adverse labor demand shifts.

12. Between 2000 and 2006, housing prices in the United States increased by about 90 percent. As detailed in the chapter, this increase abruptly reversed.

a. What caused the housing bubble in the first place?

b. When the bubble burst, what was the impact on banks and the financial system?

Answer:

a. The symptom of the bubble was the increase in house prices by almost 90 percent between 2000 and 2006. Many people decided to take mortgages (which is natural); however, their annual income only allowed a very long-term maturity loan. This was coupled with the property itself being collateral. Since the price of the collateral was also increasing, many people obtained homes they would not have been able to own under normal circumstances. In addition, banks were granting mortgages based on the current value of the property and not the pre-boom value. This meant that, should people lose their jobs they would have to default on their mortgage.

b. When the bubble burst, banks tried to cash in on the collateral, which they were only able to sell at a discount. This meant that banks very quickly became insolvent and had to shut down. When a bank fails, money is being drawn out of the financial system. This in time creates lack of access to credit and loans and/or significantly increases the interest rate slowing down business and plunging the economy into a recession.



Problems1.

2. Go to the Trading Economics website and view the unemployment rate section. Click on the max button, and a graph will show the unemployment rate in the European Union (EU) since 2000. In order to check GDP growth rates select GDP from the column on the right hand side.

a. Does the behavior of the unemployment rate illustrate the principle of co-movement discussed in the chapter? Why or why not?

b. Economic variables are sometimes divided into “leading indicators” and “lagging indicators.” Leading indicators are variables that start to change before an economic expansion or contraction. Lagging indicators change only when an expansion or contraction is well underway. Based on the graph of the unemployment rate, is unemployment a leading or lagging indicator of recessions? Explain.

Answer:

a. When unemployment declines, it means that the disposable income of people increases; people spend more, which in turn can cause inflation.

b. The unemployment rate is typically a “lagging indicator.” If you look closely at the graph, unemployment only begins to increase after a recession is underway. Moreover, in the last few recessions, unemployment has tended to keep rising after the official end of the recession, peaking after the recovery in real GDP has already begun. This is typical of a “lagging” economic indicator. Furthermore, unemployment will increase if the growth prospects within an economy decline. Business owners may feel a need to lay off workers in order to stay competitive.

3. The Conference Board publishes data on Business Cycle Indicators (BCI). The Composite Index of Leading Economic Indicators is one of the three components of the BCI. Changes in leading economic indicators usually precede changes in GDP. Some of the variables tracked by the index are listed below.

i. The average weekly hours worked by manufacturing workers

ii. The average number of initial applications for unemployment insurance

iii. The amount of new orders for capital goods unrelated to defense

iv. The number of new building permits for residential buildings

v. The S&P 500 stock index

vi. Consumer sentiment

Consider each variable and explain whether it is likely to be positively or negatively correlated with real GDP.

Answer: All of the variables that are listed are likely to be positively correlated with GDP except the average number of initial applications for unemployment insurance.

i. The average weekly hours worked by manufacturing workers depends on the quantity of goods that are being manufactured. This is likely to be low in a recession and high during a boom or expansion, when output is high.



ii. Unemployment is negatively correlated with real GDP. Unemployment falls when GDP rises, and unemployment rises when GDP falls. The number of applications for unemployment insurance will rise when unemployment rises. Therefore, the average number of initial applications for unemployment insurance is negatively correlated with real GDP.

iii. An increase in the amount of orders for capital goods unrelated to defense indicates an increase in investment and is usually undertaken when firms are optimistic about future demand for the goods and services that they produce. As real GDP rises, firms will increase capital investment in anticipation of future sales and revenue. Defense is excluded from this indicator as defense orders are usually undertaken by the government irrespective of changes in real GDP.

iv. Firms that construct residential buildings are likely to request new building permits when they expect demand for housing to be strong. The demand for housing is usually strong in a growing economy in which increasing incomes allow consumers to invest in residential housing. Therefore, this variable moves positively with real GDP.

v. Stock prices tend to move positively with other measures of economic activity. Therefore, the S&P 500 stock index is also likely to be positively correlated with real GDP.

vi. Consumer sentiment is likely to be positively correlated with real GDP. When real GDP and incomes are rising, consumers are optimistic about the prospects of the economy.

Data on BCI taken from: http://www.investopedia.com/university/conferenceboard/conferenceboard2.asp



4. Suppose that the mythical country of Moricana has a downward rigid wage. Moricana is in a recession; capacity utilization in the economy is at an all-time low, and surveys show that firms do not expect economic conditions to improve in the coming year.

a. Firms in the country are cutting back on capital spending and investment. Use a graph to show how this would affect the labor demand curve (ignore the effects of multipliers).

b. Is unemployment in Moricana likely to be classified as voluntary or involuntary? Explain your answer.

Answer:

a. Given the information in the question, wages in Moricana are likely to be rigid. When firms cut back on capital spending and investment, the demand for labor will fall. This shifts the labor demand curve to the left. As shown in the following graph, the economy is initially in equilibrium at point 1, where the level of employment is L. The demand curve for labor shifts from D1 to D2. Because wages are rigid and cannot adjust, the economy moves to point 2 on D2. The level of employment falls from L to L". Had wages been flexible, employment would have only fallen to L'.

b. When wages are rigid, a left shift of the demand curve leads to involuntary unemployment. At the going wage W in the graph, the number of workers who are willing to work at the going wage exceeds the number of jobs that firms are willing to fill. The number of workers who would like to work at the market wage but can’t find a job is equal to the gap between L and L" in the graph from part a.

5. Answer the following and illustrate your answers on a graph.

a. Assuming flexible wages, how will wages react to a fall in labor demand?

b. What options do workers have in this case?

Answer:

a. Labor demand can fall significantly during a period of recession. There is a decreased demand for workers, and companies can choose among the best workers. Therefore, companies are in a good negotiating position to lower wages.

b. The choices for workers are limited. They can remain unemployed, or they can retrain themselves if they have money to spare. If workers decide to increase their labor supply, for instance, by



working extra hours, that would further reduce the wages. However, if workers can go on strike, in an effective manner, and threaten to decrease their labor supply, which on its own might increase wages, then companies will be forced to reconsider their labor demand and increase wages for more people.

6. Assume that labor supply and labor demand are described by the following equations:

Labor Supply: LS = 5 × w

Labor Demand: LD = 110 – 0.5 × w

where w = wage expressed in dollars per hour, and LS and LD are expressed in millions of workers.

a. Find the equilibrium wage and the equilibrium level of employment.

b. Assume that there is a shock to the economy, such that the labor demand curve is now described by the equation: LD = 55 – 0.5 ×w. If wages are flexible, what will be the new equilibrium wage and level of employment? Show your work.

c. Now assume that wages are rigid at the level you found in part (a). What will employment be at this wage? How many workers will be unemployed?

Answer:

a. LS = 5w

LD = 110 – 0.5 × w

In equilibrium:

LS = LD

5 × w = 110 – 0.5 × w

Solving for the equilibrium wage, w*:

5.5 × w = 110

w* = 20

Plug in w* to find L* using either LS or LD:

LS = 5w* = 5 × 20 = 100 = L*

LD = 110 – 0.5 × w

= 110 – 0.5 × 20

= 100

= L*

b. LS = LD

5 × w = 55 – 0.5 × w

Solving for the equilibrium wage, w*, assuming the wage is flexible:

5.5 × w = 55

w* = 10

Plug in w* to find L* using either LS or LD:

LS = 5 × w* = 5 × 10 = 50 = L*



LD = 55 – 0.5 × w

= 55 – 0.5 × 10

= 50

= L*

c. From part (a), we already know that the wage will be 20, and LS at 20 = 100. However, labor demand at the previous wage of w = 20 will be:

LD = 55 – 0.5 × 20

= 55 – 10

= 45

Given that LS = 100, unemployment will be:

LS – LD = 100 – 45 = 55

7. In 1973, the major oil-producing nations of the world declared an oil embargo. The price of oil, a key source of energy, increased. In many countries, this led to a fall in real GDP and employment. Which of the three business cycle theories explained in the chapter – real business cycle theory, Keynesian theory, and monetary theory – would best fit this explanation of the 1973 recession?

Answer: Real business cycle theory emphasizes the role of technology in causing economic fluctuations. Proponents of real business cycle theory tend to emphasize the importance of changing input prices on aggregate output. Because almost all firms use oil in one form or another, oil price changes function like technology changes. An increase in the price of oil in 1973 led to a decrease in the productivity of firms that used oil. Large and abrupt increases in oil prices can cause a recession. Thus, the real business cycle theory best fits the explanation given in the problem.

8. An old saying goes: “Nothing succeeds like success.” Explain how this could relate to Keynes’s animal spirits view of economic fluctuations.

Answer: Keynes’s theory of animal spirits highlights the psychological elements that are important determinants of everyone’s decisions, including their economic and financial decisions. Optimism and pessimism are inevitable components of our thinking and, in the aggregate, can affect the macroeconomy.

In periods when a majority of consumers and business people are optimistic about the economy, their actions will reflect that optimism. Consumers increase their spending, businesses increase their investment, and this, in turn, stimulates the economy. This is the “self-fulfilling prophecy” phenomenon mentioned in the chapter. Furthermore, this success can stimulate further success. As the chapter points out, the multiplier process can be linked to this interplay of attitudes and results. Optimism about the economy leads businesses to increase output and thus their demand for labor. Wages rise, and employment increases, which increases workers’ incomes. As workers spend their increased income on consumption goods, demand rises further and feeds back into another round of increases in labor demand. The initial boost to the economy resulting from a more optimistic view of the future spurs further optimism and, via the multiplier, a further boost to the economy. Success stimulates further success.

9. Use a detailed graph to show the effect of a negative shock on the labor demand curve in an economy. Assume that wages in the economy are rigid and cannot fall in the short run. Compare the point of trough employment on the graph with the point of trough employment if wages were flexible.

Answer: The following graph shows how a negative shock affects the economy’s labor demand curve. The economy is initially in equilibrium at point 1 at the employment level L. Following the shock, the demand curve shifts to the left from D1 to D2. Because wages are rigid, the economy is at a new



equilibrium at point 2, where the level of employment is L'. Had wages been flexible, the economy would have moved from point 1 to point A where the level of employment is higher than L'. Given that a negative shock is likely to be amplified by multiplier effects, the labor demand curve could shift even farther leftward from D2 to D3. The equilibrium level of employment in the economy further falls from L' to L" and the economy is now at point 3. L", corresponding to point 3, is the level of trough employment. Had wages been flexible, the economy would have moved to point B instead, where the level of trough employment would be higher than L".

10. Republicans and Democrats fiercely debate the economic legacy of President Obama’s presidency: Republicans point to low GDP growth during his presidency, while Democrats laud improvements in labor markets since the great recession. Recall that President Obama took office in January 2009, a few months after the collapse of Lehman brothers in September 2008. Does it make sense to attribute the deepening of the recession—or, ultimately, its end—entirely to the actions of the president? Explain, for example, how the recession might have been alleviated in the absence of any governmental action at all.

Answer: No, it doesn’t make sense to attribute macroeconomic fluctuations entirely to the actions of the president. While governmental actions, like tax cuts, may impact the macroeconomy, we saw in this chapter how recessions can form and recede without any governmental intervention at all. Labor demand can increase due to a variety of market forces. For example, company inventories may run down, leading them to, once again, boost production; capital might be finally transferred from weak companies to more resilient ones. (the student should mention two or three of the market-driven factors discussed on p. 648-649). Even with government stimulus, we can’t attribute all of a recovery or downturn to the government: the impact of these policies is magnified through multipliers, which the government cannot easily control.

11. In the early 1980s, the unemployment rate in the United States rose above 10percent. The United States was in a severe recession. Both fiscal and monetary policies were used to stimulate the economy. Government spending increased by 18.9percent, while the Federal Reserve cut interest rates by nearly 11 percentage points. How would these policies affect the labor demand curve and the overall labor market? Assuming wages are rigid, use a graph to explain your answer. Be sure to show the pre-recession equilibrium, the situation at the trough of the recession, and the effect of the government policies.

Answer: Both policies will shift the labor demand curve to the right, leading to higher equilibrium employment and wage. As shown in the following figure, the economy is initially in equilibrium at L level of employment where the labor demand curve, D1, intersects the labor supply curve, S. A shock to the economy moves the labor demand curve from D1 to D2, reducing employment to L". Because wages



are rigid, the D2 curve intersects S at point 2. L" is the level of trough employment. Policy interventions by the government and the Federal Reserve shift the labor demand curve from D2 to D3, partially reversing the impact of the shock. Although the employment level is not fully restored, the partial recovery in the labor demand curve takes the economy from point 2 to point 3, where employment is at L'.

Data from: http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/

12. The Evidence-Based Economics feature in the chapter identifies three key factors that caused the recession of 2007–2009.

a. How would Keynes’ concept of animal spirits explain the creation of a housing bubble?

b. Explain how the recession of 2007–2009 affected the consumption and investment components of the national income identity.

Answer:

a. According to Keynes, animal spirits is a psychological phenomenon. It represents the overall level of optimism or pessimism in the economy. In the book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, George Akerlof and Robert J. Shiller explain that the idea that everyone should own a house and that a house is a worthwhile investment played a part in creating a bubble. This belief, which gained momentum in the 1990s and the early 2000s, pushed housing prices up and also led many to ignore the possibility of a decline in housing prices. The housing bubble showed that animal spirits in an economy can fluctuate sharply even as the underlying fundamental features of the economy change relatively little.

b. The national income identity is: Y = C + I + G + NX. The Great Recession primarily affected the C and I components of the national income identity. The fall in housing prices reduced consumers’ wealth and led to a drop in consumption. Because falling prices made new construction unprofitable, construction of new houses dropped, which reduced I. The decline in housing prices also led to millions of mortgage defaults. These mortgage defaults led to bank failures. Bank lending fell sharply, causing further reductions in C and I.

Based on: http://chronicle.com/article/How-Animal-Spirits-Wrecked/15656

13. Some economists stress the role of monetary policy in the period leading up to the recession of 2007–2009. Between 2001 and 2003, the Federal Reserve lowered the target Fed Funds rate from 6.5 percent to 1 percent and kept it there through much of 2004. This resulted in a substantial decline in real interest rates throughout the economy, including mortgage rates.



Based on the chapter’s discussion of monetary and financial factors, explain how the Federal Reserve’s policies could have contributed to the economic “bubble” of the pre-recession years of 2000–2006.

Answer: The historically low interest rates that resulted from Fed policy from 200 –2004 were mirrored by very low mortgage rates. This, in turn, stimulated the housing market as families took advantage of low rates to finance home purchases. Demand for real estate increased, which drove up real estate prices throughout the United States. Moreover, partially in response to government initiatives to increase home ownership, mortgage lending standards were relaxed, which, coupled with the very low rates on mortgages, contributed to the “bubble” mentioned in the chapter.


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Questions - econ1.altervista.orgecon1.altervista.org/econ/edu/samek/lit/facit/ch26.docx · Web view2.What does it mean to say that an economic fluctuation involves the co-movement