Question

ECN600-W2018-Assignment 3

1. Explain which business cycle theory subscribes to each one of the following

a) Workers are worried about their position relative to other workers, and do not accept wage cuts in recessions.

b) Recessions force relatively unproductive firms out of the economy.

c) Business cycles are caused by misguided government policies.

d) Business cycles are driven by changes in productivity.

e) Business cycles are driven by fluctuations in the expectations of the entrepreneurs regarding the future levels of business activities.

f) Business cycles are driven by changes in aggregate demand, which are, in turn, caused by fluctuations in government spending.

g) Governments should intervene to stabilize recessions; otherwise the economy will head into even more severe recessions.

2. In the real business cycle model, suppose there is a temporary increase in government spending, G. What are the equilibrium effects of this? Does the RBC model replicate the key business cycle facts, assuming temporary shocks in G? Can business cycles be explained by fluctuations in G?

3. In the coordination failure model, suppose there is a permanent increase in government spending, G. Determine how this will affect, output, the real interest rate, employment, the real wage, and the price level in the good equilibrium and in the bad equilibrium. Will real output be more or less volatile over time if there are waves of optimism and pessimism? Explain your results.

4. Suppose that the central bank observes a drop in real GDP but does not know what caused the drop.

a) How would the central bank respond if it believed that GDP dropped because of a decline in total factor productivity, and that the RBC theory is correct?

b) How would the central bank respond if it believed that GDP dropped because of a wave of pessimism, and that the coordination failure model is correct?

c) Explain your answers to a) and b) with the aid of diagrams.

5. Explain why recessions starting in the U.S. are so easily transmitted to Canada. Is Canada better insulated from these recessions with fixed or with flexible exchange rates?

Answer 1

Answer (1)

a) Workers are worried about their position relative to other workers and do not accept wage cuts in recessions.

Solution: Keynesian Theory

Explanation: Keynes thought that workers were so worried and concerned about their wages relative to those at other firms that no firm dared to cut pay

b) Recessions force relatively unproductive firms out of the economy.

Solution: Austrian Theory

Explanation: According to the Austrian Business Cycle theory the 1930s Depression was a consequence of the inflationary central bank credit expansion of the 1920s, and also that recession’s force relatively unproductive firm out of the economy

c) Business cycles are caused by misguided government policies.

Solution: Policy Induced Theory

Explanation: The policy-induced boom is unsustainable; eventually, prices will rise and finally the economy will settle back.

d) Business cycles are driven by changes in productivity.

Solution: Real Business Cycle Theory

Explanation: Real Business Cycle Theory sees all fluctuations in an economy as caused by real shocks as in this case.

Answer (2)

An increase in the government spending leads to an outward shift in the aggregate demand curve leading to an increase in the real output and real interest. money demand is a function of both real output and real interest rate and since both these variable experience an increase, the effect on the price level becomes indeterminate. the RBC model does good in replicating the key business cycle facts like that of money is neutral and that business cycles are created due to real shocks mostly fluctuations in productivity growth and in the basic real business cycle, business cycles are optimal response to economic fluctuation and nothing should be done about them as if the factors are distributed Pareto optimally then there is no scope for government intervention but in the advanced business cycle models government plays an important role in correcting market failures and distortions. hence fluctuations in G are in view of the long-term goals and not to correct short turn fluctuations in prices and wages.

Answer (3)

The coordination failure model assumes that the strategic interaction between firms causes increasing the return to scale for the firms in the economy. The increasing return to scale implies increasing marginal product of labor with increasing level of output. This gives the positively sloping demand for labor.

The model also assumes the labor demand curve is relatively steeper than the aggregate labor supply curve which is also positive sloping. The positive labor supply and demand generates downward sloping aggregate supply curve. This is because as labor employment decreases, the real wage and the output produced increases. Given the nominal wage, this also implies a fall in prices. Hence, lower prices are associated with the higher output. Hence the aggregate supply is downward sloping.

The aggregate demand curve has its usual downward sloping nature. Both downward sloping aggregate demand and supply implies there is a possibility of multiple equilibria in the economy. These two equilibria are (high, high) and (low, low). The (high) equilibria are called the good equilibrium and the other is denoted as bad equilibrium. This is given as G and B in the figure below.

The model also assumes that waves of optimism and pessimism drive the economy from one equilibrium to another. The policy that promotes optimism push the economy to good equilibrium and vice versa. This explains the business cycles in the economy.

Now suppose government increases its spending permanently. This creates a wave of pessimism in the economy as everybody suspects a rise in taxes. As future taxes increases, the agents expect a fall in lifetime wealth, they increase labor supply to compensate. As labor supply increases, given positive sloping and steeper labor demand, the real wages and labor employment falls. This shifts the aggregate supply curve downward. On the other hand, the increase in government spending increases aggregate demand and aggregate demand shifts upward.

As a result, the new equilibria occurs at G' and B'. Both the equilibria shifted upward. Then the result of the permanent increase in government spending decreases employment and real wages in the economy. If the economy is in good equilibrium, everyone is pessimistic about the policy, at the new equilibrium investment falls and real interest rises to r'g, this decreases output to y'g. In bad equilibrium, everybody become optimistic about the boost in demand and investments rises. This decreases real interest rate to r'b and output to Y'b.

The effect of both shifts widens the gap between good and bad equilibrium as shown in the figure above. As the economy has two new equilibria B' and G', the output gap between these two equilibria Y'gY'b is greater than old output gap YgYb. This implies more volatile real output over time in case of waves of optimism and pessimism.

Answer (4)

Answer (5)

The US is the largest export market for Canada. A recession in the US lowers the import demand of the US. Thus, exports from Canada to the US decline. This results in the decline in aggregate demand in Canada, leading to declining in output in Canada.
Canada is better insulated with a flexible exchange rate. A decline in export demand from Canada would lead to depreciation of Canadian dollar. This would reduce the price of Canadian goods for Americans. Thus, reducing the decline in import compared to a case in which Canada had fixed exchange rate.