Economics 401 – Answers to Problems from Chapter 8

n Answers to Textbook Problems

Review Questions

Q1.Draw a diagram showing the phases and turning points of a business cycle. Using the
diagram, illustrate the concepts of recurrence and persistence.

1. Figure 8.7 illustrates both the recurrence and persistence of the business cycle. The business
cycle is recurrent, as there are repeated episodes of contractions and expansions over time. The
business cycle also displays persistence, as declines in economic activity tend to be followed by
further declines for some time, while growth in economic activity tends to be followed by further
growth for some time.

Figure 8.7

Q2. What is comovement? How is comovement related to the business cycle facts presented in
this chapter?

2. Comovement means that many economic variables move together in a predictable way over
the business cycle. The business cycle facts presented in the chapter illustrate comovement
among all the variables listed in text Summary Table 10 that are either procyclical (moving in
the same direction as aggregate economic activity) or countercyclical (moving in the opposite
direction as aggregate economic activity). Only those variables listed as acyclical do not show
comovement.
Q3. What is the evidence for the view that the U.S. business cycle has become less severe over
time? Why is the question of whether the cycle has moderated over time an important one?

3. There is some question as to whether or not the business cycle has become less volatile over
time. Originally it was thought that the cycle had been moderated, especially since World War II,
but Romer challenged this notion. Further examination of the data by Balke and Gordon,
however, shows that there has been some moderation of the business cycle.
Whether the business cycle has become less severe or not is important, especially to
economic policymakers. Since World War II, both fiscal policy and monetary policy have been
used to try to smooth out business cycles to reduce their severity. If it were found that business
cycles are no less severe than they used to be, it would point to the failure of government policy
to achieve its objectives.

Q4. What terms are used to describe the way a variable moves when economic activity is rising
or falling? What terms are used to describe the timing of cyclical changes in economic variables?

4. A variable that moves in the same direction as aggregate economic activity is said to be
procyclical, while a variable that moves in the opposite direction is countercyclical. If the peaks
and troughs of a variable occur before the peaks and troughs in aggregate economic activity, it is
said to be a leading variable. If a variable’s peaks and troughs occur at the same time as the
peaks and troughs in aggregate economic activity, it is said to be a coincident variable. If a
variable’s peaks and troughs come after the peaks and troughs of aggregate economic activity, it
is said to be a lagging variable.

Q5. If you knew that the economy was falling into a recession, what would you expect to happen
to production during the next few quarters? To investment? To aver- age labor productivity? To
the real wage? To the un-employment rate?

5. If the economy were entering a recession, you’d expect production, investment, average
labor productivity, and the real wage to decline because they are all procyclical, and the
unemployment rate to rise because it’s countercyclical.

Q6. How is the fact that some economic variables are known to lead the cycle used in
macroeconomic fore- casting?

6. The fact that some economic variables are known to lead the business cycle is used to
develop an index of leading economic indicators. The index is used to forecast economic turning
points.
Q7. What are the two components of a theory of business cycles?

7. The two components of a theory of business cycles are: (1) A description of the types of
factors (called “shocks”) that have major impacts on the economy, such as wars, new inventions,
harvest failures, and changes in government policy; and (2) a model of how the economy
responds to the various shocks.

Q8. How do Keynesians and c1assicals differ in their beliefs about how long it takes the
economy to reach long- run equilibrium? What implications do these differences in beliefs have
for Keynesian and classical views about the usefulness of antirecessionary policies? About the
types of shocks that cause most recessions?

8. Keynesians and classicals differ sharply in their beliefs about how long it takes the economy
to reach a long-run equilibrium. Classical economists believe that prices adjust rapidly (within a
few months) to restore equilibrium in the face of a shock, while Keynesians believe that prices
adjust slowly, taking perhaps several years.
Because of the time it takes for the economy’s equilibrium to be restored, Keynesians see an
important role for the government in fighting recessions. But because classicals believe that
equilibrium is restored quickly, there’s no need for government policy to fight recessions.
Since classicals think equilibrium is restored quickly in the face of shocks, aggregate
demand shocks can’t cause recessions, since they can’t affect output for very long. So classical
economists think recessions are caused by aggregate supply shocks. Keynesians, however, think
that both aggregate demand and aggregate supply shocks are capable of causing recessions.
 Analytical Problems

Q1. Figure 8.1 shows that business cycle peaks and troughs are identified with peaks and troughs
in the level of aggregate economic activity, which is consistent with current NBER methodology.
However, for business cycles before 1927, the NBER identified business cycle peaks and troughs
with peaks and troughs in detrended aggregate economic activity (aggregate economic activity
minus the "normal growth path" shown in Fig. 8.1). Show that this alternative method- ology
implies that peaks occur earlier and that troughs occur later than you would find when using the
current methodology. Compared to the current methodology, does the alternative methodology
increase or decrease the computed length of contractions and expansions? How might this
change in measurement account for the differences in the average measured lengths of
expansions and contractions since World War II compared to the period before World War I?

1. Figure 8.8 illustrates the business cycle. The current NBER method picks peaks and
troughs in the level of aggregate economic activity, which are points on the figure where
the slope of the line is zero. These are shown in Figure 8.8 as P1 (at the peak of the cycle)
and T1 (at the trough of the cycle). However, the older method picks peaks and troughs in
detrended economic activity. This means the peaks and troughs occur at points that are
the farthest away from the trend line, which means those points at which the slope of the
line showing aggregate economic activity is the same as the slope of the trend line. These
points are shown in Figure 8.8 as P2 and T2. Note that the point P2 occurs before P1,
meaning that peaks in detrended economic activity are earlier than peaks in the level of
economic activity. Note also that the point T2 occurs later than T1, which means that
troughs in detrended economic activity are later than troughs in the level of economic
activity. Since under the old method, troughs occur later and peaks occur earlier,
contractions appear to be longer and expansions appear to be shorter using the pre-1927
method than using the current method. Thus the fact that after World War II expansions
were longer and contractions were shorter than before World War I is somewhat illusory,
since it’s based on two different accounting mechanisms. If expansions and contractions
were in fact equally long in both periods, the change in accounting method would mean
that our official
dating of the business cycle would show longer expansions and shorter contractions after
World War II than before World War I.
 Figure 8.8

Q2. Consumer expenditures on durable goods such as cars and furniture, as well as purchases of
new houses, fall much more than expenditures on nondurable goods and services during most
recessions. Why do you think that is?

2. Expenditure on durable goods is more sensitive to the business cycle than expenditure on
nondurable goods and services, because people can more easily change the timing of their
expenditure on durables. When economic activity is weak, and people face the danger of losing
their jobs, they avoid making durable goods purchases. Instead, they may drive their cars a little
longer before buying new ones, get the old washing machine repaired instead of buying a new
one, and put off buying new furniture until a new expansion indicates greater income security.
So in a recession, durable purchases decline a lot, but when an expansion begins, durable
purchases pick up substantially. The exception was in the business cycle that began in March
2001, when very low interest rates supported expenditures on durable goods.

Q3. Output, total hours worked, and average labor productivity all are procyclical.

a. Which variable, output or total hours worked, increases by a larger percentage in

expansions and falls by a larger percentage in recessions? (Hint: Aver- age labor
productivity = output total hours worked, so that the percentage change in average labor
productivity equals the percentage change in output minus the percentage change in total
hours worked.)
b. How is the procyclical behavior of average labor productivity related to Okun's Law,
discussed in Chapter 3?

3. (a) In symbols, let A = average labor productivity, Y = output, and H = total hours worked.
By definition, A = Y/H, so in growth terms, DA/A = DY/Y – DH/H. Since all three are procyclical,
they all move in the same direction over the business cycle. If total hours worked varied more
than output in an expansion, then DH/H would be greater than DY/Y, so that DA/A would be
negative, and average labor productivity would be countercyclical. So it must be the case that
output varies more than total hours worked in an expansion. A similar argument holds in a
contraction.
(b) That average labor productivity is procyclical helps explain why the Okun’s Law
coefficient is 2, not 1. A one-percentage point increase in unemployment is approximately a one
percent fall in employment. Thus, if there were no change in average labor productivity, we
might expect the percentage fall in output to equal the number of percentage points that the
unemployment rate rises. But since average labor productivity moves in the same direction as
output, it magnifies the output effect of a given amount of unemployment.

Q4. During the period 1973-1975, the United States experienced a deep recession with a
simultaneous sharp rise in the price level. Would you conclude that the recession was the result
of a supply shock or a demand shock? Illustrate, using AD-AS analysis.

4. Figure 8.9 illustrates the effects of a demand shock. The economy begins in equilibrium at
point A, where the LRAS, SRAS, and AD curves intersect. The demand shock shifts the aggregate
demand curve to the left to AD¢. In the short run, the equilibrium is at point B, where AD¢
intersects SRAS. This is a point at which output has declined (a recession), but the price level is
unchanged. Over time, the short-run aggregate supply curve shifts down to SRAS¢, restoring
long-run equilibrium at point C. At this point, output is back at its full-employment level and the
price level has declined. Thus the result of a demand shock on the price level is that the price
level is unchanged in the short run and declines in the long run. Since the 1973–1975 recession
was one in which the price level rose sharply, it must not have been due to a demand shock.

Figure 8.9
Figure 8.10 illustrates the effects of a supply shock. The economy begins in equilibrium at
point A, where the LRAS, SRAS, and AD curves intersect. The supply shock shifts the long-run
aggregate supply curve to the left to LRAS¢. The new equilibrium is at point B, where AD
intersects LRAS¢. This is a point at which output has declined (a recession), but the price level
has risen. This matches what happened in the 1973–1975 recession. Thus we conclude that the
1973–1975 recession was the result of a supply shock, not a demand shock.
Figure 8.10

Q5. It is sometimes argued that economic growth that is "too rapid" will be associated with
inflation. Use AD-AS analysis to show how this statement might be true. When this claim is
made, what type of shock is implicitly assumed to be hitting the economy?

5. Growth that is “too rapid” most likely refers to a situation in which the aggregate demand
curve has shifted to the right and, in the short run, intersects the SRAS curve at a level of output
that’s greater than the full-employment level of output (Figure 8.11). This situation is associated
with inflation because, in the long run, prices will rise, shifting the SRAS curve up to intersect
with the LRAS and AD curves. The shock that is implicitly assumed to be hitting the economy is
an aggregate demand shock, since that’s the only shock that increases output in the short run and
inflation in the long run.

Figure 8.11