Block22 Answers

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EC1002 Introduction to economics

Block 22 Answers
Activity SG22.1
Draw a quick sketch showing an upward sloping smooth line for trend output and a wavy line showing
actual output – mark the phases of the business cycle on the actual output curve.

Answer:

Activity SG22.2
The table below is based on Maths 27.1 and includes consumption as a further element of the system.
Use the formulas provided for each column, assuming a = 5/4 and c = 2/3, to complete the table (do
calculations to the nearest whole number): Assume that Y = 0 prior to period 1 (hint: this makes
investment = 38 in period 2). This example shows how the multiplier-accelerator interaction can
produce cycles. In other respects, the actual numbers are somewhat unrealistic. Think about why this
is.

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EC1002 Introduction to economics

Answer:
Pse insert here the Excel spreadsheet as well as the scatter diagram of output over time.

Period Autonomous Induced Induced Income Business Cycle Phase


(1) Consumption Consumption Investment /Output
(2) (3) (4) (5) =
(2+3+4)

A=30 cY-1, I = a (Y-1 - Y -2), Y=C+I


c=2/3 a=5/4
1 30 0 0 30 Expansion
2 30 20 38 88
3 30 58 72 160
4 30 107 91 228
5 30 152 84 266 Boom
6 30 177 48 256 Contraction
7 30 170 -13 187
8 30 125 -86 69
9 30 46 -147 -71
10 30 -48 -176 -193 Recession
11 30 -129 -152 -251 Slump
12 30 -167 -72 -210 Recovery / Expansion
13 30 -140 52 -58
14 30 -39 189 181
15 30 121 299 449
16 30 299 335 665
17 30 443 270 743 Boom
18 30 495 98 623 Contraction
19 30 415 -150 295
20 30 197 -410 -183

Income /Output (5) = (2+3+4)


800
600
400
200
0
-200 0 5 10 15 20 25

-400

The actual numbers are somewhat unrealistic because income/output assumes negative values which
are difficult to interpret. Also, cycles are of ever-increasing magnitude which contradicts real world
experience.

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EC1002 Introduction to economics

Activity SG22.3
In your own words, briefly summarise the discussion of how fluctuations in stockbuilding and
competitiveness can lead to business cycles.

Answer:
A key point to make is that in a recovery, firms must increase their output more slowly than the rate
of increase in aggregate demand, in order to restore the equilibrium level of stockholding. The story
about competitiveness depends on the country having a fixed exchange rate.

Activity SG22.4
Answer the following multiple choice questions on real business cycles:

1) Real business cycles are cycles in:

a) Potential output
b) Actual output
c) Real output
d) International trade

Answer: (a)
2) Real business cycle theorists argue that _________ can explain short and long-term fluctuations in
output.

a) imperfect labour markets


b) rational expectations
c) intertemporal decisions of households, firms and governments
d) variations in mood, caused for example by the weather.

Answer: (c)
3) Real business cycle theories suggest that ___________ to correct departures from the optimal
growth path

a) there is a role for fiscal policy


b) there is a role for monetary policy
c) there is a role for supply-side policies
d) there is no case for stabilising output over the business cycle.

Answer: (d)
Explanation: Supply-side policies are not aimed at correcting departures from the long-run growth
path. In the next chapter we will see that such policies are designed to change the long-run growth
path itself.

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EC1002 Introduction to economics

Activity SG22.5
To help you work through this material, summarise it by filling out the table. Then check your
responses by comparing it to the summary table the authors have created (Table 27.2).

Answer:
Once you have filled in the table, you should check it against to the summary table (Table 27.2) in the
textbook.

Sample examination questions


Multiple choice questions
For each question, choose the correct response:

1) The accelerator assumes:

a) the marginal propensity to consume is constant


b) the economy is at full employment
c) there is a constant relationship between net investment and the rate of change of output
d) the rate of growth of output continues in increase over time.

Answer: (c)
2) Investment depends mainly on:

a) past levels of income


b) future expected profits
c) present national income levels
d) historic data.

Answer: (b)
3) If an increase in investment leads to a bigger increase in national income, this is the:

a) accelerator
b) aggregate demand
c) real business cycle
d) multiplier.

Answer: (d)
4) The impossibility of negative gross investment provides a _________ to fluctuations in _______

a) ceiling; stockbuilding
b) Ceiling; capital prices
c) floor; output
d) Floor; the capital-output ratio

Answer: (c)

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EC1002 Introduction to economics

Long answer question


a) The diagram below shows the world GDP growth rate from 1980 to 2015 – label the diagram
to show the different phases of a business cycle. (This will be quite approximate – what is
important is to show the key phases.)

GDP growth rate (world)

Answer: Labels have been inserted into the diagram above.


b) Describe at least two possible reasons for the pattern of actual output you have depicted.

Answer:
You could discuss the following topics: political business cycles, multiplier-accelerator
model, the role of ceilings and floors, fluctuations in stockbuilding, competitiveness and
fixed exchange rates, spillover from other countries (international business cycles).

c) Potential output is often depicted as a smooth, gently rising line. However, it does not
necessarily need to increase smoothly over time. What might explain fluctuations in
potential output?

Answer:
Students should use the real business cycle theory to explain fluctuations in potential
output.

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