Business Cycle Exercise

Exercises

1. What are short-term fluctuations? Explain the concept.
2. What is potential output? Explain the concept.
3. What are the four phases of the business cycle? Briefly explain all the phases.
4. What is the difference between real output and potential output?
5. What is the difference in unemployment between potential output and real output?
6. What can banks do to combat inflation and deflation?
7. What can the government do to shorten or reduce the intensity of a recession.

ANSWERS

• These answers are just guidelines, and yours should be correct as long as they are similar.

1. Short term-fluctuations are irregular and are shown as a wavy line that goes up and down. This is due to the changes in economic situations affected by internal and external factors in a state. For example a crisis in the country or a neighboring country being in war could both cause a contraction.
2. Potential output is shown as a straight line and it shows the steady growth we would see if the fluctuations would be flattened out. This is because sometimes the economy performs exceptionally and other times poorly, getting their average allows us to see a more steady growth.
3. An expansion is when the line moves upwards, indicating economic growth and low unemployment.
   The peak is the point in which this expansion reaches its highest point, after which it begins to decrease.
   The decrease is called the contraction, where economic output begins to decrease and unemployment increases.
   The trough is the lowest point of the contraction, unemployment levels are very high and the level of real GDP is low.
   After the trough a recovery begins, and the expansion occurs once again, restarting the cycle.
4. This fluctuating line shows real output. It is the true measured GDP. However, potential output shows the average output in an economy, averaging both expansions and recessions. The actual economic is shown as real GDP and the average growth over long periods of time is shown as potential GDP.
5. Potential output has full employment, where the level of unemployment is the same as the natural rate of unemployment. Real GDP changes often and thus the rate of unemployment can either be above or below the natural rate of unemployment.
6. Central banks can increase or decrease interest depending on the economic situation. Because interest is applied to loans, it effectively determines the price of money. When there is inflation, the price of money is lowered, and central bank increase inflation to combat this. Likewise, when there is deflation, it means that the price of money is more valuable than resources, and thus central banks decrease interest to encourage people to spend money.
7. The government can increase or decrease taxing rates. The government can influence demand with budget spending. During an expansion, the government can reduce their spending because of demand from private firms and save up money.
   Saving up money and projects for a recession increases employment and allows the recession to end sooner.