Question

1) Describe the historical response of (1) real wages and (2) employment to business-cycle fluctuations in GDP. Relate this evidence to the predictions of Keynesian models and real-business-cycle models of the cycle.

2) Asset-price crashes, banking crises, and macroeconomic depressions seem often to occur together. How does each contribute to the other two?

Thank you in advance!

Answer 1

Answer:

Q.1

Keynesian theory of the business cycle

• The Keynesian impulse is changes in firms’ expectations about future sales and profits. This change affects investment.
• The Keynesian mechanism has two aspects. First, a change in investment has a multiplier effect on aggregate demand. Second, the short-run aggregate supply curve is horizontal, so, as illustrated in the AD curve have a large effect on GDP.
• The response of money wages is asymmetric; wages do not fall in response to decreases in aggregate demand but they do rise in response to increases in aggregate demand. Hence the economy can remain stuck in a recession.

Real Business Cycle

• The real business cycle theory (RBC) regards random fluctuations in productivity as the main source of economic fluctuations.
• The impulse in RBC theory is technological changes that affect the growth rate of productivity.
• The RBC mechanism is a change in productivity that affects investment demand and labor demand. During a recession, both decrease. The decrease in investment demand lowers the real interest rate, so the intertemporal substitution effect decreases the supply of labor. As illustrated, the LAS curve shifts leftward and employment decreases. The AD curve shifts leftward because of the decrease in investment. GDP decreases and the price level falls.

A rational expectation is a forecast based on all available information. Rational expectations theories of business cycles focus on the rationally expected money wage rate. The two rational expectations theories are the new classical theory and new Keynesian theory

? The impulse in the new classical theory is unanticipated changes in aggregate demand.

? The major impulse in the new Keynesian theory is unanticipated changes in aggregate demand, but anticipated changes also play a role.

? The rational expectations mechanism is an unexpected shift in the AD curve that moves the economy along its SAS curve as real wage rates change. Illustrates the effect of an unexpected decrease in aggregate demand to AD1. AD0 is the expected aggregate demand. The recession ends when aggregate demand increases back to expected aggregate demand.

Q.2

Banking crises are not a new economic phenomenon, and similarly are not the only source of financial crises. Over the course of the past two centuries there have been a surprisingly large number of financial crises, as demonstrated in the attached figure. In understanding banking crises over time, it is useful to identify the causes in context with historic examples of banking collapses.

• A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand.
• Due to the mass interdependence of economies across the globe, a banking crisis in one nation is likely to dramatically affect other international economies.
• The Great Depression in 1929 resulted from a variety of complex inputs, but the turning point came in the form of a mass stock market crash (Black Tuesday) and subsequent bank runs.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.
• Irresponsible and unethical leveraging in these assets by the banks, and mass governmental failure to listen to economists predicting this over the past decade, caused the 2008 stock market crash and subsequent depression.

Causes of Banking Crises

• Bank Run: A bank occurs when many people try to withdraw their deposits at the same time. As much of the capital in a bank is tied up in investments, the bank’s liquidity will sometimes fail to meet the consumer demand. This can quickly induce panic in the public, driving up withdrawals as everyone tries to get their money back from a system that they are increasingly skeptical of. This leads to a bank panic which can result in a systemic banking crisis, which simply means that all of the free capital in the banking system is withdrawn.
• Stock Market Positive Feedback Loops: One particularly interesting cause of banking disasters is a similar positive feedback loop effect in the stock markets, which was a much more dynamic factor in more recent banking crises (i.e. 2007-2009 sub-prime mortgage disaster). John Maynard Keynes once compared financial markets to a beauty contest, where investors are merely trying to pick what is attractive to other investors. There is a profound truth to this, creating an interdependent and potentially self-fulfilling investment thought process. This can create dramatic rises and falls (bubbles and crashes), which in turn can throw banks with poorly designed leverage into huge losses.
• Regulatory Failure: One of the simplest ways in which bank crises can occur is a lack of governmental oversight. As noted above, banks often leverage themselves to capture gains despite extremely high risks (such as over-dependence on derivatives).