Macro Theory Final Review

8/13/2019 Macro Theory Final Review

1/19

Chapter 8Business Cycles1. Business Cyclesare fluctuations of aggregate economic activity, not a specific variable.

a. Recession: period of time during which aggregate economic activity is falling. A longcontraction.

b. Contraction: See recession.c. Depression: a severe and prolonged downturn in economic activity.d. Expansion: period of time during which aggregate economic activity is rising.e. Boom: See expansion.f. Peak: when economic activity stops increasing and begins to decline. Local maximum of

economic activity.Known as a turning point.

g. Trough: when economic activity stops falling and begins rising. Local minimum ofeconomic activity.Also known as a turning point.

2. The graph below plots aggregate economic activity over time.

3. Characteristics of a Business Cyclea. Aggregate Economic Activity: Business cycles are defined broadly as fluctuations of

aggregate economic activity rather than as fluctuations in a single, specific economic

variable such as real GDP.


2/19

b. Expansions and Contractions: After Contractions, aggregate economic activity reaches alow, a Trough, and then aggregate economic activity increases (Expansion), and begins

to decline again after it reaches a Peak.

c. Comovement: Many economic variables tend to move together in a predictable wayover the business cycle.

d. Recurrent but not Periodic: The business cycle isnt periodic, i.e. it does not occur atregular, predictable intervals, and doesnt last for a fixed or predetermined length of

time. However, it is recurrent: the standard pattern of contraction-trough-expansion-

peak recurs again and again in industrial economies.

e. Persistence: The business cycle tends to have declines in economic activity followed byfurther declines, and growth in economic activity tends to be followed by more growth.

4. Prior to WWI:a. Recessions were common from 1865 to 1917.b. Longest recession was 65 months from October 1873 to Match 1879.c. Longest expansion was 46 months from June 1861 to April 1865.

5. Between WWI and WWII:a. Great depression was the worst economic contraction. GDP fell nearly 30% from the

peak in August 1929 to the trough in March 1933.

b. Unemployment rate rose from 3% to nearly 25%.c. Thousands of banks failed, the stock market collapsed, many farmers went bankrupt,

and international trade was halted.

d. Great Depression ended with the start of World War II.i. Wartime production brought the unemployment rate below 2%

ii. Real GDP almost doubled between 1939 and 1944.e. The longest slowdown was 43 months between August 1929 and March 1933.

6. After WWII:a. From 1945 to 1970 there were five mild contractions.b. A very long expansion (106 months from February 1961 to December 1969) made some

economists think the business cycle was dead.

c. The OPEC oil shock of 1973 caused a sharp recession, with real GDP declining 3%, theunemployment rate rising to 9%, and inflation rising to over 10%.

d. The 1981-1982 recession was also severe, with the unemployment rate over 11%, butinflation declining from 11% to less than 4%.

e. The recessions between November 1973 and March 1975 and between July 1981 andNovember 1982 were the longest recessions after WWII at 16 months.

f. The highest unemployment rate was 11% in the early 1980s.g. The highest inflation rate after WWII was in the mid-1970s and it reached 11%.h. The highest nominal interest rate after WWII was in the early 1980s and it reached

about 16%.

7. The volatility of the US business cycle has declined since 1984. The quarterly growth rate of GDPhas been more stable since then.

8. Variable types:a. Procyclical: an economic variable that moves in the same direction as aggregate

economic activity (down in contraction, up in expansion).


3/19

b. Countercyclical: an economic variable that moves in the opposite direction as aggregateeconomic activity (down in expansion, up in contraction).

c. Acyclical: Variable that does not display a clear patter over the business cycle.d. Leading: Variable that tends to move in advance of aggregate economic activity.e. Coincident: Variable with peaks and troughs occurring at same times as those of the

business cycle.f. Lagging variable: Variable whose peaks and troughs occur after those of the business

cycle.

9.


4/19

Chapters 9-111. The FE line is the Full-employment output explained by the real interest rate. The real interest

rate is on the vertical axis and output is on the horizontal axis. It is vertical at Y = Y-bar (Y-bar is

full level of employment) because when the labor market is in equilibrium, output equals its full

employment level, regardless of the interest rate.

2.

3. For any level of output (or income, Y, the IS curveshows the real interest rate, r, for which thegoods market is in equilibrium. At all point on the curve, desired investment (Id) = desired

national saving (Sd).

4. Deriving IS curve:a. Saving curve slopes upward because an increase in the real interest rate causes

households to increase their desired level of saving. An increase in current output

(income) leads to more desired saving at any real interest rate, so Y = 5000 is to the right

of Y=4000.

b. Desired investment isnt affected by current output so the investment curve is the samewhether Y=4000 or Y=5000.

c. Each level of output implies a different market equilibrium point, and so a differentmarket-clearing real interest rate. This forms the IS curve. Real interest rate on y-axis

and current output on x-axis.


5/19

5.

6. How IS curve shifts:


6/19

7.

8.


7/19


8/19

9.10.LM Curve

a. Represents asset market equilibriumi. When Real Money supply (nominal supply of money M / price level P) equals

the real demand for money, L(Y, r + e).

ii. It is upward sloping.1. The nominal money supply, M is fixed by the central bank, thus the real

money supply is fixed, a vertical line and unaffected by levels of output,

Y.

2. Real money demand slopes downward because money is demandedmore when interest rates for nonmonetary assets are lower.

3. The LM curve has level of output Y on the x-axis and the equilibriuminterest rate (increases as output increases) on the y-axis.


9/19

11.12.

13.The labor market is in equilibrium along the full-employment line.14.The aggregate demand curve shows the relation between the aggregate quantity of goods

demanded, Cd + Id + G and the price level P.


10/19

15.


11/19

16.

17.


12/19

18.19.Look at handout.20.Federal Reserves bonds impact on whole economy

a. Buying Bonds (increasing money supply)i. When Price level, P is fixed:

1. IS-LM-FE DIAGRAM: Money supply increases implies real money supplyincreases, meaning real interest rate decreases. Shifting LM to right.

Output, Y goes up

2. AD-SRAS-LRAS DIAGRAM: Money supply increases shifts AD to right. SoY goes up because r going down increases C and I (Y = I + C + G).Expenditure also increases as demand for goods rises.

ii. When Price level, P adjusts1. Price goes up because higher demand for goods (since AD shifted to

right) means firms produce more by hiring more workers to meet

demand. Higher demand for goods and for workers push wage upwards,

and so costs of production increases, eventually increasing the price

level.

2. Increase in price level lowers money supply, which lowers real interestrate, which lowers consumption (C), investment (I), and expenditure (E),

therefore output (Y) decreases. Because demand for goods has fallen,

firms cant sell the goods and production will fall.

3. IS-LM-FE DIAGRAM: Increase in price level lowers real money supplywhich increases real interest rate. Therefore LM shifts left, back to its

original level.

4. AD-SRAS-LRAS DIAGRAM: Because money supply is lowered, realinterest rate goes up, lowering investment and consumption, therefore

aggregate demand (AD) for goods shifts left back to its original level.


13/19

b. Selling Bonds (decreasing money supply): OPPOSITE EFFECT21.Self-Correcting Mechanism: Price level adjusts depending on the change in Y.

a. If Y > Y-bar: Demand is increased, so firms hire more workers to meet productiondemand, driving up wages and eventually forcing firms to increase price level.

b. If Y < Y-bar: Demand has decreased, so firms hire less workers because they cannot sellto much, lowering production and total wage, and eventually firms lower prices.

22.A change in P always shifts the LM curve in the IS-LM-FE model (since a change in P alters thereal money supply), but a change in P causes a MOVEMENT along the curve in the AD-SRAS-

LRAS model.

23.Timing of price level adjusta. Classical Theory

i. Prices adjust quickly/rapidly.1. Economy returns quickly to full employment after a shock.2. If firms change prices instead of output in response to a change in

demand, the adjustment process is almost immediate.

3. Hence, LM shifts inwards quickly, and the general equilibrium is reachedquickly (intersection of IS, LM, and FE)

b. Keynesian Theoryi. Prices adjust slowly

1. It may be several years before prices and wages adjust fully2. When not in general equilibrium, output is determined by aggregate

demand at the intersection of the IS and LM curves, and the labor

market is not in equilibrium.

24.Money Neutrality: if a change in the nominal money supply changes the price levelproportionately but has no effect on real variables.

a. Classical View: a monetary expansion affects prices quickly with at most a transitoryeffect on real variableshence, money is neutral in the short run and the long run.

b. Keynesian View: Think the economy may spend a long time in disequilibrium, so amonetary expansion increases output and employment and causes the real interest rate

to fall. They believe in monetary neutrality in the long run but not in the short run.


14/19

25.26.


15/19

27.KEYNESIAN THEORY OF ALTERING OUTPUT THROUGH FISCAL POLICY

28.


16/19

29.The only difference between the effects of a tax cut and the increase in government purchasesis that, instead of raising the portion of full-employment output devoted to government

purchases, a tax cut raises the portion of full-employment output devoted to consumption.

30.As shown above, policies are effective in altering output under Keynesian Theory.31.BELOW IS KEYNESIAN THEORY OF ALTERING OUTPUT THROUGH MONETARY POLICY

32.BELOW IS CLSSICAL METHOD FOR ALTERING OUTPUT THROUGH FISCAL POLICY

33.

34.35.ABOVE is what happens in the short run but in the long run, price will readjust.


17/19

36.

37.


18/19

38.


19/19

39.

Documents

Macro Theory Final Review