Question

Intermediate Macroeconomics

3. Provide an intuitive explanation of the general ineffectiveness of policy in counteracting business cycles in the RBC model.

4. Describe the two main channels of crowding out.

5. Show what happened to output, consumption and investment if the Federal Reserve contracts the money supply.

6. If the government decides to shrink in size (decline in G), what will happen to GDP? What will happen to consumption? Show this using the graphs of the RBC model.

Could you please answer questions 3-6? I would really appreciate it.

Answer 1

Policy measures, either fiscal or monetary are generally ineffective in dealing with changes in business cycles in the Real Business Cycle model.

Let us take monetary policies. In the real business cycle model money has no effect on the changes taking place in the economy since it is believed that the "invisible hand" is responsible for it. The invisible hand is the interaction between self-interested individuals in a free market. This means government regulation or ability to influence changes is very limited. It is technological changes that drive the output and employment in an economy and not money. In fact, government's intervention in the play of market forces will be of little effect or even harmful as it gets in the way of the invisible hand.

Fiscal policy too has little to no effect in a free market economy according to the real business cycle model. This is because business cycles occur in order to stabilise the economy after a favourable or unfavourable shock situation. It is the invisible hand that leads the economy and hence limits the role of the government. A fiscal policy such as taxation will negatively affect output and employment as people reduce consumption and also the economy is subject to unexpected supply shocks.

6. If the government decides to shrink in size that is cut spending the GDP is likely to grow as the market forces guided by the invisible hand rightly allocate the resources as opposed to some government policies and programs that could have a damaging effect on the economy especially if it is against the movement of the cycle. The market forces, which are influenced by factors such as demand and supply naturally adjust themselves and allocate resources in the most appropriate areas, which the government cannot do. This would increase consumption as it balances out investment and income by shifting factors of production and markets of different commodities. This is to say that markets are like an evolving organism that constantly adapts to changes in its environment.