Business Cycles


Review Questions

1. What causes recessions? Technology shocks (sometimes called supply shocks) are important. These include changes in the prices of imported and exported raw materials.  Also, fiscal policy and monetary policy, which can affect aggregate demand.  There is debate as to the importance of other shocks to aggregate demand.

 
2. What are the major determinants of consumption expenditures?

 

 Permanent income (current plus future), interest rates, and possibly age.
3. How does consumption behave over the business cycle?

 

 It is procyclical but less volatile than GDP.

 
4. How does consumption react to temporary increases in transfer payments or temporary reductions in personal taxes?

 

 Little or no reaction.

 
5. What are the major determinants of investment expenditures?

 

 Interest rates and expectations about the future productivity of capital.
6. How does investment behave over the business cycle?

 

 It is procyclical and more volatile than GDP.
7. In a closed economy, what are the major determinants of real interest rates?

 

 Saving and investment.
8. How does the real interest rate behave over the business cycle? Why? It may be procyclical or countercyclical, depending on whether investment or saving shifts more. Empirically, it seems to be somewhat procyclical.

 
9. How does the trade balance behave over the business cycle? Theoretically, it may be procyclical or countercyclical, depending on whether investment or saving shifts more. Empirically, it seems to be somewhat countercyclical.

 
10. How do temporary increases in government purchases affect GDP?

 

 They increase GDP.
11. What are some arguments against countercyclical fiscal policies? Practical problems of implementation, such as lags.

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Answers to Selected Textbook Problems

Mankiw, Macroeconomics, fourth edition, chapter 10, problems and applications

2. b. The equilibrium condition is that the aggregate supply of output (Y) equal aggregate demand, which is given by AD = C + I + G. Noting that C = 200 + 0.75(Y - T), thus the equilibrium condition becomes

Y = 200 + 0.75(Y - 100) + 100 + 100 = 325 + 0.75Y.

Using the notation A* = 325 and solving for Y gives Y = A*/(1.00 - 0.75) = 4A* = 1300.
c. The increase in G raises A* to 350, so that equilibrium Y = 1400.
d. Output of 1600 requires A* = Y/4 = 400, which in turn requires G = 175.

 
4. a. Equilibrium output declines by 1/(1 - c) times the decline in autonomous consumption.
b. The marginal propensity to save is   (1 - c).  Thus, equilibrium saving changes by  (1 - c)   times the change in income, plus the initial decline in saving due to the increase in autonomous consumption. Adding these effects together, we see that a one-dollar decrease in autonomous consumption directly increases saving by one dollar and reduces equilibrium income by  1/(1 - c)  dollars, which reduces saving by   (1 - c)/(1 - c) = 1  dollar, thus exactly offsetting the initial increase in saving. In other words, equilibrium saving does not increase at all.
c. Because, in this simple model, equilibrium saving does not increase even if people become more thrifty. Another way of seeing this is to note that  S = I  in equilibrium, and investment spending is fixed in the simple version of the Keynesian model.
d. The paradox of thrift does not arise in the classical model, where the interest rate adjusts to equate saving and investment and where investment is a decreasing function of the interest rate. In that model, a rightward shift of the saving curve decreases the equilibrium interest rate, increasing investment spending and allowing equilibrium saving to increase.

Mankiw, Macroeconomics, fourth edition, chapter 16, problems and applications

2. a. The present value of Jill’s consumption is 100 + 100/(1+r),  and the present value of her income is   210/(1+r).  These two present values must be equal.  Equating and solving gives  100 = 110/(1+r),  or  100(1+r) = 110,   implying that r = 0.01,  or 10 percent.
b. Jack is initially neither a borrower nor a lender. Thus, he can maintain his initial lifetime consumption pattern no matter what the interest rate. At a higher interest rate, however, standard indifference curve analysis predicts that he will consume less in period 1 (because of the substitution effect) and that he will be better off as a result of the increase in interest rates.
c. Jill is initially a borrower. At an interest rate higher than 10 percent, she can no longer afford her initial lifetime consumption plan. Because of both an income effect and a substitution effect, she will reduce her period-1 consumption. As a borrower, she is worse off because of the increase in interest rates.
4. a. People who face binding borrowing constraints would like to consume more today, but they cannot because they cannot borrow more. A temporary tax cut that gives them more current income would allow them to consume more today. Thus, a temporary reduction in current taxes is more potent if people face binding borrowing constraints.
b. An announced future tax cut may make people feel wealthier and may make them want to consume more today. But if they cannot borrow against the future tax cut, they cannot increase current consumption. Thus, borrowing constraints reduce the effect of promised future tax cuts on today’s consumption.
5. If people have low income during the early portion of their careers and higher income during middle age, they will save less when young than Figure 16-13 predicts and will wait until later in the life cycle to accumulate substantial assets. If their income is low enough compared with their later, higher-earning years, and if they can borrow, they might even have negative assets when young. If they face borrowing constraints, then they cannot have negative assets, but their assets might be zero when young.
6. The life-cycle model predicts a decline in the national saving rate, because the elderly have a larger average and marginal propensity to consume out of income.

Mankiw, Macroeconomics, fourth edition, chapter 17, problems and applications

5. The promised investment tax credit would reduce the cost of investment beginning next year, so the promise (to the extent that it is credible) would encourage firms to postpone investments planned for this year. The decline in current investment demand worsens this year’s recession.