Economic Trends and Cycles Quiz
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Economic Trends and Cycles Quiz

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Questions and Answers

Which of the following best describes the relationship between the output gap and the unemployment gap as indicated by Okun's Law?

  • An increase in output gap leads to an increase in unemployment gap.
  • A decrease in output gap results in a lower unemployment rate.
  • The output gap and unemployment gap are inversely related. (correct)
  • There is no relationship between output gap and unemployment gap.

    • What does potential output represent in macroeconomic terms?

  • The output level that can be maintained without leading to inflation. (correct)
  • The maximum output achievable during a recession.
  • The output level required to achieve full employment.
  • The fluctuating actual output during a business cycle.

    • In the context of business cycles, which component is considered a direct factor of the economic fluctuations?

  • Aggregate supply shifts only.
  • All economic agents' expectations. (correct)
  • Aggregate demand shifts only.
  • Government expenditure adjustments.

    • Which of the following statements best describes the significance of the AD-AS model?

    <p>It combines both demand and supply for a comprehensive analysis.</p> Signup and view all the answers

    What is meant by 'natural unemployment' in economic terms?

    <p>The level of unemployment that exists when the economy is at full capacity.</p> Signup and view all the answers

    What characterizes business cycles in macroeconomics?

    <p>Fluctuations typically lasting 4-5 years</p> Signup and view all the answers

    What is the definition of potential output?

    <p>Output produced when using resources at a normal rate</p> Signup and view all the answers

    What is a peak in the context of economic cycles?

    <p>The highest point of economic activity before a downturn</p> Signup and view all the answers

    Which of the following best describes a trough in economic terms?

    <p>The lowest point of economic activity before an upturn</p> Signup and view all the answers

    What occurs during a recession according to common standards?

    <p>Two consecutive quarters of negative GDP growth</p> Signup and view all the answers

    Which term is used for predictable fluctuations within a year?

    <p>Seasonal cycles</p> Signup and view all the answers

    What does Okun’s law relate to?

    <p>The connection between unemployment rates and output gaps</p> Signup and view all the answers

    What distinguishes a trend from a cycle in economic terms?

    <p>Trends fluctuate over decades, while cycles last a few years</p> Signup and view all the answers

    What is a key idea of Classical business cycle theory?

    <p>Supply creates its own demand.</p> Signup and view all the answers

    How does Keynesian business cycle theory differ from Classical theory regarding market failures?

    <p>It argues that economies can experience a lack of demand.</p> Signup and view all the answers

    What was a significant economic event that prompted the writing of Keynes's General Theory?

    <p>The Great Depression (1929–1939).</p> Signup and view all the answers

    What does the Classical economic approach suggest regarding demand-side policies?

    <p>They can lead to further economic decline.</p> Signup and view all the answers

    Which economic theory posits that aggregate demand fluctuations drive business cycles?

    <p>Keynesian economics</p> Signup and view all the answers

    What does the output gap measure?

    <p>The deviation between actual output and potential output</p> Signup and view all the answers

    Which approach involves teaching supply-oriented Classical theory followed by demand-oriented Keynesian theory?

    <p>Sequential approach</p> Signup and view all the answers

    When is the output gap considered positive?

    <p>When actual output is greater than potential output</p> Signup and view all the answers

    What is one of the main concepts in Keynesian theory related to investment behavior?

    <p>Animal spirits can influence economic decisions.</p> Signup and view all the answers

    What did economists try to synthesize shortly after the publication of Keynes's General Theory?

    <p>Keynesian and Classical ideas.</p> Signup and view all the answers

    According to Okun's Law, what is the relationship between cyclical unemployment and the output gap?

    <p>Cyclical unemployment rises when the output gap is negative</p> Signup and view all the answers

    What does u* represent in the context of unemployment?

    <p>The natural rate of unemployment expected at potential output</p> Signup and view all the answers

    How is the unemployment gap calculated?

    <p>By evaluating the difference between actual and natural unemployment rates</p> Signup and view all the answers

    Which of the following statements about contraction and expansion is correct?

    <p>Contraction can take place even when output is positive</p> Signup and view all the answers

    What is a significant challenge in estimating natural output and unemployment?

    <p>They are not directly observable and require estimation methods</p> Signup and view all the answers

    Which of the following is NOT a supply-side factor that influences potential output?

    <p>Monetary policy settings</p> Signup and view all the answers

    The output gap is the difference between actual output and potential output.

    <p>True</p> Signup and view all the answers

    Okun's Law states that an increase in unemployment leads to a decrease in the output gap.

    <p>False</p> Signup and view all the answers

    Natural unemployment and potential output are both essential concepts in understanding the business cycle.

    <p>True</p> Signup and view all the answers

    Keynesian macroeconomics primarily focuses on supply-side factors affecting the economy.

    <p>False</p> Signup and view all the answers

    The AD-AS model puts equal emphasis on both aggregate demand and aggregate supply.

    <p>True</p> Signup and view all the answers

    Economic trends fluctuate over a period of 4-5 years.

    <p>False</p> Signup and view all the answers

    The peak marks the low-point of economic activity prior to an upturn.

    <p>False</p> Signup and view all the answers

    Recession is often defined as two consecutive quarters of negative real GDP growth.

    <p>True</p> Signup and view all the answers

    Potential output refers to the maximum output produced when resources are used at their normal rate.

    <p>True</p> Signup and view all the answers

    Seasonal cycles fluctuate over multiple decades.

    <p>False</p> Signup and view all the answers

    Okun's law relates the unemployment gap directly to trends in potential output.

    <p>False</p> Signup and view all the answers

    Seasonally-adjusted data removes the effects of predictable seasonal cycles.

    <p>True</p> Signup and view all the answers

    The trough in an economic cycle is the point before a downturn begins.

    <p>False</p> Signup and view all the answers

    The output gap is positive when actual output Yt is less than potential output Yt∗.

    <p>False</p> Signup and view all the answers

    Cyclical unemployment is negatively associated with the output gap according to Okun's Law.

    <p>True</p> Signup and view all the answers

    The natural rate of unemployment, denoted as u∗t, is a stable measure that does not fluctuate.

    <p>False</p> Signup and view all the answers

    An expansion from a trough occurs when output is growing but actual output Yt is above potential output Yt∗.

    <p>False</p> Signup and view all the answers

    Unemployment is expected to be lower than the natural rate when the economy is operating at potential output Yt∗.

    <p>False</p> Signup and view all the answers

    Estimating potential output Yt∗ and natural unemployment u∗t is straightforward and can be done directly.

    <p>False</p> Signup and view all the answers

    When actual output Yt exceeds potential output Yt∗, the economy is experiencing a recession.

    <p>False</p> Signup and view all the answers

    An output gap can be measured in both percentages and levels.

    <p>True</p> Signup and view all the answers

    Say's Law suggests that supply creates its own demand.

    <p>True</p> Signup and view all the answers

    Keynesian theory claims that severe market failures cannot occur due to fluctuations in aggregate demand.

    <p>False</p> Signup and view all the answers

    The Great Depression saw unemployment rates exceed 20% in various countries.

    <p>True</p> Signup and view all the answers

    Government interventions are viewed as counter-productive according to Keynesian business cycle theory.

    <p>False</p> Signup and view all the answers

    Classical business cycle theory claims that demand-side policies are essential for economic recovery.

    <p>False</p> Signup and view all the answers

    The synthesis of Keynesian and classical ideas initiated almost immediately after Keynes's General Theory was published.

    <p>True</p> Signup and view all the answers

    Confidence and investor sentiment are considered critical to fluctuations in aggregate supply in Keynesian theory.

    <p>False</p> Signup and view all the answers

    The two main theoretical approaches to business cycles are Classical economics and Neoclassical economics.

    <p>False</p> Signup and view all the answers

    Explain the difference between trends and cycles in macroeconomic terms.

    <p>Trends refer to long-run economic changes over decades, while cycles refer to shorter fluctuations in economic activity, typically lasting 4-5 years.</p> Signup and view all the answers

    What does potential output signify in an economy?

    <p>Potential output signifies the maximum amount of goods and services that an economy can produce when operating at normal resource utilization.</p> Signup and view all the answers

    Define what constitutes a recession in economic terms.

    <p>A recession is often defined as two consecutive quarters of negative real GDP growth.</p> Signup and view all the answers

    Describe Okun’s law and its significance.

    <p>Okun's law indicates that an increase in unemployment rates is associated with a decrease in potential output, highlighting the relationship between joblessness and economic performance.</p> Signup and view all the answers

    What is the role of seasonally-adjusted data in macroeconomic analysis?

    <p>Seasonally-adjusted data removes predictable seasonal fluctuations, allowing economists to focus on underlying trends and cycles.</p> Signup and view all the answers

    How do peaks and troughs contribute to the understanding of business cycles?

    <p>Peaks signify the high point of economic activity before a downturn, while troughs mark the low point before recovery, serving as critical indicators of economic performance.</p> Signup and view all the answers

    Differentiate between cyclical unemployment and natural unemployment.

    <p>Cyclical unemployment occurs due to economic downturns, while natural unemployment exists even in a healthy economy, reflecting normal job turnover and mismatches.</p> Signup and view all the answers

    What is meant by the output gap, and why is it important?

    <p>The output gap measures the difference between actual output and potential output, indicating economic performance and efficiency.</p> Signup and view all the answers

    What does a positive output gap indicate about actual output in relation to potential output?

    <p>A positive output gap indicates that actual output $Y_t$ is greater than potential output $Y_t^*$.</p> Signup and view all the answers

    Explain the relationship between cyclical unemployment and the output gap as stated by Okun's Law.

    <p>Okun's Law states that cyclical unemployment is negatively associated with the output gap; as the output gap becomes larger, the unemployment rate typically increases.</p> Signup and view all the answers

    What are two key types of shocks that can hit the economy according to the conceptual framework?

    <p>Global supply shocks and confidence shocks.</p> Signup and view all the answers

    How is the unemployment gap calculated in relation to the natural rate of unemployment?

    <p>The unemployment gap is calculated as $u_t - u_t^<em>$, where $u_t$ is the actual unemployment rate and $u_t^</em>$ is the natural rate of unemployment.</p> Signup and view all the answers

    What is meant by contraction from peak in the context of the output gap?

    <p>Contraction from peak occurs when output is shrinking while actual output $Y_t$ remains above potential output $Y_t^*$.</p> Signup and view all the answers

    In the context of business cycle theories, what does the Classical approach assert about demand-side policies?

    <p>The Classical approach suggests that demand-side policies are counter-productive.</p> Signup and view all the answers

    What challenges are associated with estimating potential output and natural unemployment?

    <p>Estimating potential output $Y_t^<em>$ and natural unemployment $u_t^</em>$ is challenging because they are not directly observable and require sophisticated methods for estimation.</p> Signup and view all the answers

    How does Keynesian business cycle theory view the role of aggregate demand?

    <p>Keynesian theory argues that business cycles can be driven by fluctuations in aggregate demand.</p> Signup and view all the answers

    What significant economic condition during the Great Depression prompted Keynes to write his General Theory?

    <p>Unemployment exceeding 20% in many countries.</p> Signup and view all the answers

    Describe the significance of the output gap in macroeconomic analysis.

    <p>The output gap provides insight into the economy's performance, indicating whether it is underperforming or overheating compared to its potential.</p> Signup and view all the answers

    What can be inferred if the output gap is negative?

    <p>A negative output gap implies that actual output $Y_t$ is less than potential output $Y_t^*$, suggesting economic underperformance.</p> Signup and view all the answers

    What concept did Say's Law introduce into the Classical business cycle theory?

    <p>Say's Law introduced the idea that 'supply creates its own demand'.</p> Signup and view all the answers

    What is one way in which Keynesian and Classical theories have attempted to synthesize their ideas?

    <p>Economists developed theories like Neoclassical and New Keynesian economics.</p> Signup and view all the answers

    Why is estimating the natural rate of unemployment considered controversial?

    <p>Estimating the natural rate of unemployment $u_t^*$ is controversial due to differing methodologies and economic conditions that affect its calculation.</p> Signup and view all the answers

    Which teaching approach starts with the Keynesian perspective before addressing Classical theories?

    <p>The demand-oriented Keynesian approach.</p> Signup and view all the answers

    What are propagation mechanisms in the context of economic shocks?

    <p>Propagation mechanisms are channels through which shocks transmit to the rest of the economy.</p> Signup and view all the answers

    What key difference exists between trend and cycle when analyzing economic data?

    <p>Trends refer to the long-term direction of the economy, while cycles are the short-term fluctuations around that trend.</p> Signup and view all the answers

    Explain Okun's Law in relation to unemployment and output gaps.

    <p>Okun's Law indicates that for every percentage point increase in the unemployment rate, the output gap widens by a factor of β, reflecting a negative relationship between unemployment and output.</p> Signup and view all the answers

    How does the output gap typically relate to the concept of natural unemployment?

    <p>The output gap highlights the difference between actual and potential output, which relates to natural unemployment as it measures economic performance against full employment levels.</p> Signup and view all the answers

    Describe the two main theoretical approaches to business cycles and their applicable time horizons.

    <p>The Classical approach focuses on long-run supply-side factors, while the Keynesian approach emphasizes short-run demand-side fluctuations.</p> Signup and view all the answers

    What role does the AD-AS model play in macroeconomic analysis?

    <p>The AD-AS model illustrates the interaction between aggregate demand and supply to explain price levels and output during different economic phases.</p> Signup and view all the answers

    Economic variables fluctuate at different frequencies, including trends, business cycles, and ______ cycles.

    <p>seasonal</p> Signup and view all the answers

    In the context of economic activity, a ______ is defined as the high-point of activity prior to a downturn.

    <p>peak</p> Signup and view all the answers

    ______ often refers to two consecutive quarters of negative real GDP growth.

    <p>Recession</p> Signup and view all the answers

    The ______ output represents the maximum output produced when resources are used at their normal rate.

    <p>potential</p> Signup and view all the answers

    The ______ in an economic cycle is the low-point of economic activity prior to an upturn.

    <p>trough</p> Signup and view all the answers

    Economic trends are characterized by fluctuations over multiple ______.

    <p>decades</p> Signup and view all the answers

    According to Okun's law, an increase in unemployment is associated with a decrease in the ______ gap.

    <p>output</p> Signup and view all the answers

    We focus on 'seasonally-adjusted' data to remove the effects of predictable ______ cycles.

    <p>seasonal</p> Signup and view all the answers

    Actual output Yt can be above or below potential output Yt∗, indicating a potential ______.

    <p>output gap</p> Signup and view all the answers

    The output gap is positive when actual output Yt is ______ than potential output Yt∗.

    <p>greater</p> Signup and view all the answers

    Cyclical unemployment is negatively associated with the ______ gap.

    <p>output</p> Signup and view all the answers

    Okun’s Law relates the changes in cyclical unemployment to the changes in the ______ gap.

    <p>output</p> Signup and view all the answers

    Policymakers aim to keep the unemployment rate as close to ______ as possible.

    <p>u∗t</p> Signup and view all the answers

    An economy is experiencing a ______ when actual output Yt is less than potential output Yt∗.

    <p>recession</p> Signup and view all the answers

    In classical macroeconomics, the focus is primarily on supply-side factors affecting ______.

    <p>output</p> Signup and view all the answers

    The ______ is an important theoretical question regarding what causes fluctuations in output over time.

    <p>business cycle</p> Signup and view all the answers

    The difference between actual output and potential output is referred to as the ______ gap.

    <p>output</p> Signup and view all the answers

    Unemployment is expected to be higher than normal when the output is ______ than normal.

    <p>less</p> Signup and view all the answers

    The ______ unemployment is the level of unemployment that exists when the economy is at full capacity.

    <p>natural</p> Signup and view all the answers

    The framework that considers both demand and supply in economic analysis is known as the ______ model.

    <p>AD-AS</p> Signup and view all the answers

    Estimating natural output Yt∗ and natural unemployment u∗t involves a ______ process.

    <p>complex</p> Signup and view all the answers

    Classical business cycle theory is based on the key idea of ______, which states that supply creates its own demand.

    <p>Say’s Law</p> Signup and view all the answers

    Keynesian business cycle theory suggests that the economy can experience market failure due to a lack of ______.

    <p>demand</p> Signup and view all the answers

    The theoretical framework used to assess various kinds of ______ includes evaluating shocks and their propagation mechanisms.

    <p>policy</p> Signup and view all the answers

    A major economic event that influenced the writing of Keynes's General Theory was the ______ which resulted in high unemployment and deflation.

    <p>Great Depression</p> Signup and view all the answers

    The ______ approach to teaching starts with a supply-oriented classical perspective before discussing demand-oriented Keynesian economics.

    <p>first</p> Signup and view all the answers

    According to Keynesian theory, fluctuations in aggregate ______ drive business cycles and can lead to economic instability.

    <p>demand</p> Signup and view all the answers

    The ______ mechanism refers to how economic shocks are transmitted and affect the rest of the economy.

    <p>propagation</p> Signup and view all the answers

    Hicks's work in 1937 brought forth attempts to synthesize Keynesian economics with ______ thought.

    <p>classical</p> Signup and view all the answers

    Study Notes

    Trend vs. Cycles

    • Economic variables fluctuate at different frequencies.
    • Trends: Long-run fluctuations over decades.
    • Business Cycles: Short-run fluctuations over 4-5 years.
    • Seasonal Cycles: Very short-run fluctuations within a year.
    • Seasonally adjusted data: Seasonal cycles removed.

    Potential Output

    • Potential Output: Amount of output produced using resources at a normal rate.
    • Represents the economy's natural productive capacity at a given time.
    • Determined by supply-side factors such as labor, capital, and technology.
    • Denoted as Yt*.

    Output Gap

    • Output Gap: Difference between actual output (Yt) and potential output (Yt*).
    • Positive output gap: Yt > Yt*
    • Negative output gap: Yt < Yt*
    • Example: During expansion, output is growing, but Yt < Yt*.

    Okun's Law

    • Relationship between output gap and unemployment gap.
    • Unemployment gap: Difference between actual unemployment (ut) and natural unemployment (u*t).
    • Cyclical unemployment: Part of the unemployment gap related to the business cycle.
    • Okun's Law states a negative relationship between the unemployment gap and the output gap.

    Overview of Business Cycle Theory

    • Business Cycle Theory: Explains fluctuations in output and employment.
    • Two key elements:
      • Shocks: Events that disrupt the economy (e.g., supply shocks, confidence shocks).
      • Propagation Mechanisms: How shocks spread through the economy.
    • Goals:
      • Identify causes of business cycles.
      • Evaluate effectiveness of various policies.

    Two Approaches to Business Cycle Theory

    • Classical Theory:
      • Pre-1930s
      • Based on Say's Law: Supply creates its own demand.
      • Business cycles caused by fluctuations in aggregate supply.
      • Favors limited government intervention.
    • Keynesian Theory:
      • Since 1930s
      • Argues Say's Law may not hold in the macroeconomy.
      • Business cycles caused by fluctuations in aggregate demand.
      • Supports government intervention to stabilize demand.

    Covid vs. Great Depression

    • Covid-19 pandemic and the Great Depression are significant events in economic history.
    • Both events caused widespread economic disruptions.
    • The causes and responses to these events differ significantly.

    Keynes's General Theory (1936)

    • Published during the Great Depression.
    • Offered a theoretical framework for understanding and addressing unemployment and deflation.
    • Contributed to the emergence of macroeconomics as a distinct field of study.

    New Formula(s) and Notation

    • Okun's Law:
      ut − u∗t = −β (Yt − Yt∗ )/ Yt∗ Where: u∗t is natural unemployment Yt∗ is potential output β is the sensitivity of output to changes in unemployment.
    • Economic variables fluctuate at different frequencies.
    • Trends are long-run, fluctuating over multiple decades.
    • Business cycles are short-run, fluctuating over periods of 4-5 years.
    • Seasonal cycles fluctuate at regular/predictable time periods within a year.

    Potential Output and Output Gaps

    • Potential output, or natural output, is the amount produced when using resources at the ‘normal’ rate.
    • Represents the natural productive capacity of the economy.
    • Reflects underlying supply-side factors like labor, physical capital, and technology.
    • Denotes potential output with Yt*.
    • Actual output Yt can be above or below Yt*.
    • The output gap is the deviation between Yt and Yt*.
    • Output gap is positive when Yt > Yt* and negative when Yt < Yt*.

    Okun’s Law

    • Natural unemployment (ut) is the expected rate of unemployment when the economy operates at Yt.
    • Unemployment gap is the difference in the actual unemployment (ut) and natural unemployment (u*t).
    • Policymakers aim to keep the unemployment rate close to u*t.
    • Estimating u*t is a controversial topic in macroeconomics.
    • Okun’s Law states that cyclical unemployment is negatively associated with the output gap.
    • The relationship between the unemployment gap and output gap can be shown with the equation ut − u∗t = −β tY ∗ t × 100.

    Overview of Business Cycle Theory

    • Business cycle theory provides a conceptual framework to identify key:

      • Shocks hitting the economy (e.g., global supply shocks, confidence shocks, etc.)
      • Propagation mechanisms that transmit shocks to the rest of the economy.

    • This framework evaluates the pros and cons of various policy options (e.g., monetary and fiscal policy).

    Two Main Theoretical Approaches

    • Classical (pre-1930s) business cycle theory:
      • Key idea: Say’s Law: ‘supply creates its own demand’
      • Assumes market operates well, demand-side policies are counterproductive.
    • Keynesian business cycle theory (since 1930s):
      • Key Idea: Say’s Law doesn’t always hold at the macro level.
      • Business cycles driven by fluctuations in aggregate demand.
      • Government intervention can stabilize business cycle fluctuations.

    New Formula and Notation

    • Okun’s Law: ut − u∗t = −β tY ∗ t × 100 or − β (Yt − Yt∗ )
      • u* - natural unemployment.
      • Y* - potential output.
      • β - sensitivity of output to changes in unemployment.

    Next Lecture

    • Keynesian Macroeconomics, Part One.
    • Determinants of aggregate expenditure.
    • Keynesian equilibrium (Keynesian cross).
    • Role of government expenditure.

    Trend vs. Cycle

    • Economic variables fluctuate at different frequencies.
    • Trends are long-term fluctuations over multiple decades.
    • Business cycles are short-term fluctuations over periods of 4-5 years.
    • Seasonal cycles are very short-term fluctuations at regular time periods within a year.
    • Data is usually seasonally adjusted to remove predictable seasonal cycles.

    Potential Output and Output Gaps

    • Potential output (Yt*) is the amount of output produced when using resources at a normal rate.
    • Potential output reflects underlying supply-side factors like labor, physical capital, and technology.
    • Actual output (Yt) can be above or below potential output.
    • The output gap is the difference between actual output and potential output, expressed as a percentage or in levels.

    Okun's Law

    • Cyclical unemployment is negatively associated with the output gap.
    • The unemployment gap is the difference between actual unemployment (ut) and the natural rate of unemployment (u*t).
    • Okun's Law states that there is a negative relationship between the output gap and cyclical unemployment.

    Overview of Business Cycle Theory

    • There are two main theoretical approaches to business cycles: Classical and Keynesian.
    • Say's Law, a key idea in Classical theory, states that supply creates its own demand.
    • Keynesian theory argues that Say's Law does not necessarily hold at the macro level.

    Keynes's General Theory

    • Keynes's General Theory was written during the Great Depression, when unemployment was extremely high, and there was widespread deflation.
    • The book challenged Classical theory and offered policy recommendations for addressing the economic crisis.
    • Macroeconomics emerged as a distinct field from the debates between Classical and Keynesian economists.

    Two Approaches to Teaching Business Cycles

    • There are two main approaches to teaching business cycles:
      • Long-run macro first An approach that starts with a supply-oriented classical approach and then moves to a demand-oriented Keynesian approach.
      • Short-run macro first An approach that starts with a demand-oriented Keynesian approach and then moves to a supply-oriented Classical approach.

    Learning Outcomes

    • Understand the difference between trend and cycle in economic data.
    • Understand the different kinds of fluctuations and terminology related to the business cycle.
    • Understand the difference between output, potential output, and the output gap, and the parallels with unemployment, natural unemployment, and the unemployment gap.
    • Understand how the output gap and unemployment gap relate to each other through Okun's Law.
    • Explain the two main theoretical approaches to business cycles and distinguish the time horizons for which they are most applicable.
    • Economic variables fluctuate at different frequencies: trends, business cycles, and seasonal cycles.
    • Trends are long-run fluctuations over multiple decades.
    • Business cycles are short-run fluctuations over 4-5 years.
    • Seasonal cycles are very short-run fluctuations at predictable time periods within a year.

    Potential Output and Output Gaps

    • Potential output is the amount produced when using resources at a 'normal rate'.
    • It reflects underlying supply-side factors like labor, physical capital, and technology.
    • Actual output can be above or below potential output.
    • The output gap is the deviation between actual and potential output.
    • A positive output gap means actual output is greater than potential output.
    • A negative output gap means actual output is less than potential output.

    Okun's Law

    • Okun's Law states that there is a negative association between cyclical unemployment and the output gap.
    • This means unemployment is higher than normal when output is less than normal.
    • The natural rate of unemployment is the rate we would expect when the economy is operating at potential output.

    Overview of Business Cycle Theory

    • Business cycle theory seeks to identify key shocks hitting the economy and the propagation mechanisms that transmit these shocks.
    • Two main theoretical approaches: Classical and Keynesian.
    • Classical theory assumes Say's Law: 'supply creates its own demand', meaning that there cannot be an economy-wide lack of demand.
    • Keynesian theory argues that Say's Law does not hold at the macro level.
    • Keynesian theory focuses on fluctuations in aggregate demand as the driver of business cycles.
    • Keynesian theory suggests that government interventions can help stabilize the business cycle.

    Learning Outcomes

    • Understand the difference between trends and cycles.
    • Understand the terminology related to the business cycle.
    • Understand the concepts of output, potential output, and the output gap.
    • Understand how the output gap and unemployment gap relate to each other.
    • Explain the main theoretical approaches to business cycles.

    New Formula(s) and Notation

    • Okun's Law: ut - u∗t = -β (Yt - Yt∗)/Yt∗
      • ut is the actual unemployment rate.
      • u∗t is the natural rate of unemployment.
      • Yt is actual output.
      • Yt∗ is potential output.
      • β is the sensitivity of output to changes in unemployment.

    Next Lecture

    • Keynesian Macroeconomics, Part One:
      • Determinants of aggregate expenditure.
      • Keynesian equilibrium.
      • The role of government expenditure.

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