Econ 3 - Module 5 Learning Objectives

Module 5: Fluctuations, Unemployment, Inflation, and Macroeconomic Policies

Learning Objectives

By the end of Module 5, students should be able to:

• Understand economic fluctuations and the phases of business cycles.

• Identify business cycle phases: recession, recovery, expansion, contraction.

• Explain Okun’s Law and the reasons why recessions are undesirable.

• Define 'shocks' in economics and the strategies individuals use to cope with income fluctuations.

• Understand the Permanent Income Hypothesis and its implications.

• Evaluate consumption paths for permanent income consumers with and without credit access.

• Compare investment fluctuations to income fluctuations, understanding why investment is more volatile.

• Discuss the effects of business and consumer confidence on income fluctuations.

Economic Fluctuations

Phases of Business Cycles:

1. Recession: A decline in economic activity across the economy. Identified when GDP contracts for two consecutive quarters.

2. Recovery: A period in which economic activity starts to increase after a recession, marked by rising GDP and improved employment rates.

3. Expansion: A phase where economic activity is rising and the economy is growing, leading to increased consumer spending and investment.

4. Contraction: A period of economic decline, characterized by decreasing GDP.

Okun’s Law:

• Establishes the inverse relationship between unemployment and economic output. For every 1% increase in the unemployment rate, GDP is likely to be roughly an additional 2% lower than its potential.

Reasons Recessions Are Undesirable:

• High Unemployment: Leads to loss of income and diminishes quality of life.

• Loss of Income: Affects consumer spending power and reduces household consumption.

• Decline in Consumer Confidence: A drop in confidence can lower economic activity as households and businesses postpone spending.

Economic Shocks:

• Unexpected events, such as natural disasters or geopolitical tensions, that negatively impact the economy.

• Examples include oil price shocks that can increase production costs across various industries.

Coping with Income Fluctuations:

• Households adapt by:

  • Savings: Setting aside funds during good times to cushion against downturns.

  • Borrowing: Using credit when unexpectedly low income occurs.

  • Adjusting Consumption: Reducing expenditures in non-essential areas.

Permanent Income Hypothesis:

• Individuals base consumption on expected long-term average income rather than current income.

• This explains why consumers may maintain spending despite short-term income shocks.

Investment Fluctuations vs. Income Fluctuations:

• Investment tends to be more volatile than income. This volatility is influenced by:

  • Expectations: Future profit increases can lead to higher investment.

  • Confidence (Animal Spirits): Business confidence can drastically influence investment decisions.

Practice Problems:

1. Identify the Phase: If the GDP has declined for three consecutive quarters, what phase of the business cycle is the economy currently in?Answer: Recession

2. Using Okun's Law: If the unemployment rate increases from 5% to 7%, what is the estimated decline in GDP?Answer: GDP is estimated to be 4% lower than its potential (2% * 1% increase).

3. Impact of Economic Shocks: Consider a sudden increase in oil prices. How might this affect consumer confidence?Answer: Increased oil prices may drive inflation and reduce consumer spending, leading to lower consumer confidence.

4. Coping Strategies: If a household has faced an unexpected loss of income of $1,500 per month, what strategies might they employ?Answer: They might cut non-essential spending, dip into savings, or seek a temporary loan to manage expenses.

The Multiplier Model and Fiscal Policy

Multiplier Model:

• Illustrates how a change in spending (expenditure) can lead to a more than proportional change in income.

• The formula:Multiplier = 1 / (1 - MPC)where MPC = Marginal Propensity to Consume.

Aggregate Demand Components:

• Components include consumption, investments, government spending, and net exports.

Consumption Function:

• Defines the relationship between consumption and income through the consumption function.

• Autonomous Consumption: Minimum consumption regardless of income.

• Marginal Propensity to Consume (MPC): Measures the change in consumption due to a change in income.

Equilibrium Income Determination:

• Use the multiplier model and graph to delineate income levels and outputs.

Fiscal Policy Impact:

• Changes in government spending or taxes can significantly influence overall economic activity, adjusted through the multiplier effect.

Inflation

Costs of Inflation:

• Diminishes purchasing power, creates uncertainty, leads to distorted spending and saving decisions.

Sources of Inflationary Pressures:

1. Costs of Inputs: Increased costs of materials and labor.

2. Demand Pressures: Higher consumer demand than the economy can supply.

3. Market Power Dynamics: Monopolies can set prices above competitive levels.

Bargaining Gap Explanation:

• Relates to wage negotiations not keeping pace with inflationary expectations, leading to increased demands for higher wages.

Inflation Mechanics:

• Inflation can occur when increased production costs (such as labor) lead to higher prices unless mitigated by productivity increases.

Demand Shock Effects:

• Positive demand shocks can lead to increased inflation as aggregate demand outstrips supply.

• Negative Demand Shock: Can lead to deflationary pressures and higher unemployment rates.

The Phillips Curve

Understanding the Phillips Curve:

• Demonstrates the inverse relationship between inflation and unemployment, illustrating that lower unemployment typically corresponds with higher inflation.

Bargaining Gap Theory:

• Consistent with the Phillips Curve, indicating that wage negotiations are influenced by unemployment levels and inflation expectations.

Impact of Aggregate Demand Shock:

• Shock influences income, which in turn impacts unemployment and inflation in a cyclical manner.

Central Banks and Monetary Policy

Mandates of Central Banks:

• Commonly include controlling inflation and managing employment levels, aiming for stable prices and maximum employment.

Federal Reserve’s Dual Mandate:

• Focuses on promoting maximum employment and ensuring price stability.

Interest Rate Adjustments:

• Central banks manipulate interest rates to manage inflation and encourage or discourage investment.

Transmission Mechanism:

• Steps include:

  1. Policy rate changes impact short-term interest rates.

  2. Changes in rates affect borrowing costs for consumers and businesses.

  3. Influences spending and investment decisions, feeding back into income and inflation.

Monetary Policy Implementation

Multiplier Model Application:

• Analyzes how shifts in monetary policy influence aggregate demand, shaping economic growth and inflation.

• Practice Problem: If the Fed increases the money supply, describe the likely effect on interest rates and consumption.Answer: The increase in money supply typically lowers interest rates, encouraging more consumption and investment.

Supply Shocks and Monetary Policy

Definition of Supply Shock:

• Unexpected events, like natural disasters, that dramatically alter supply conditions.

Historical Examples:

• Oil shocks during the 1970s led to widespread economic disruption.

Stagflation Explained:

• The phenomenon of simultaneous rising inflation and unemployment following a supply shock, complicating economic policy responses.

Monetary Policy Responses:

• Analyze strategies to control inflation while supporting employment amid supply shifts.

Answers to All Practice Problems:

1. Identify the Phase: Recession

2. Using Okun's Law: GDP is estimated to be 4% lower than its potential.

3. Impact of Economic Shocks: Decreased consumer confidence and spending.

4. Coping Strategies: Cut non-essential spending, dip into savings, or seek a temporary loan.

5. Monetary Policy Problem: Increased money supply will lower interest rates and encourage consumption and investment.