Business Cycles


Review Questions

1. What causes recessions?

 
2. What are the major determinants of consumption expenditures?

 
3. How does consumption behave over the business cycle?

 

  

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

 

  

 
5. What are the major determinants of investment expenditures?

 
6. How does investment behave over the business cycle?

 

 Answers
7. In a closed economy, what are the major determinants of real interest rates?

 
8. How does the real interest rate behave over the business cycle? Why?

 

  

 
9. How does the trade balance behave over the business cycle?

 

  

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

 
11. What are some arguments against countercyclical fiscal policies?


Old Exam Questions

1. The Wall Street Journal of January 14, 1994 stated that

"Retail sales increased 0.8% in December and 1993 sales jumped 6.2%, the strongest annual gain in four years. Sales of durable goods rose 1.7% last month . . .

"Bond prices fell on the stronger-than-expected retail sales report. The Treasury's 30-year issue fell almost one point."

a.
Based on your knowledge of business cycle facts, does the pattern of total retail sales and durables sales for December 1993 make sense? What could account for this pattern?
b. A fall in bond prices implies higher interest rates. Why might news of stronger-than-expected retail sales lead to higher interest rates?

Answer:
a. The pattern makes sense. Overall retail sales in December increased by 0.8%, while sales of durables increased 1.7%. The economy currently seems to be in the expansion phase of the business cycle, as indicated by the fact that retail sales for the full year showed the strongest gain in four years. Durables sales are more volatile than sales of nondurables and services over the cycle, so we should expect durables sales to increase more than overall retail sales during an economic expansion.

b.
The retail sales figures are a sign that the economic expansion is stronger than previously expected. If the expansion is expected to persist for a while, it can imply a higher expected future marginal product of capital. This increases investment demand (shifts the curve to the right). If investment rises more than saving during the expansion, interest rates will increase.

 
2. Andrew Abel and Ben Bernanke (Macroeconomics, 1992) discuss the installation of a new computer system by the Internal Revenue Service in 1985, which resulted in income tax refunds being delayed for many taxpayers. They report that in "February and March, a period in which many refund checks are usually mailed out, relatively few were processed. However, as the new computer came on line, the IRS moved to catch up: Refunds were above normal in April and much higher than normal in May. By June nearly all refunds had been mailed out, as is usually the case. The upshot was that the aggregate income of U.S. consumers, including tax refunds, was noticeably below normal in February and March and higher than normal in April, May, and June. Some economic forecasters predicted that the IRS's computer problems would lead to a weakening in February and March consumer purchases." Discuss this prediction.

Answer:

The IRS computer problem caused disposable income to be lower than normal in February and March, but this income loss was made up by June. In addition, people knew the amount of their refunds when they filed their returns, so the refunds that did eventually occur were anticipated even though the refunds might have been delayed. Thus, the computer problem did not affect consumers' permanent income (apart from a trivially small effect due to the time value of money). Assuming that consumers have access to either credit markets or accumulated savings, there should have been no detectable effect on the pattern of consumption expenditures.


Selected Textbook Problems:          Answers