Week 4 Milestone 2
k.warren5
MODERN PRINCIPLES OF ECONOMICS Fifth Edition
Chapter (33) Transmission and
Amplification Mechanisms
© 2021 Worth Publishers. All Rights Reserved.
© 2021 Worth Publishers. All Rights Reserved.
Outline
• Intertemporal Substitution
• Uncertainty and Irreversible Investments
• Labor Adjustment Costs
• Time Bunching and Network Effects
• Collateral Damage
• Takeaway
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Introduction (1 of 2)
• Economic forces can amplify shocks and transmit them across sectors and through time.
• A mild negative shock can be transformed into a serious reduction in output.
• A positive shock can be transformed into a boom.
• Real shocks and aggregate demand shocks can interact, with one leading to the other.
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Introduction (2 of 2)
• This chapter focuses on five transmission mechanisms:
1. Intertemporal substitution
2. Uncertainty and irreversible investments
3. Labor adjustment costs
4. Time bunching and network effects
5. Collateral damage
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Intertemporal Substitution (1 of 4)
• People are most likely to work hard when hard work brings the greatest return.
• As a test approaches, you probably study harder and give up opportunities to have fun.
• Once the test is over, you study less and have more fun.
• During a boom, people are less likely to retire or take early retirement.
• Substituting effort across time is called intertemporal substitution.
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Definition (1 of 6)
Intertemporal substitution: The allocation of consumption, work, and leisure across time to maximize well-being.
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Intertemporal Substitution (2 of 4)
Intertemporal substitution: percentage deviation from trend in GDP and the employment–population ratio, 1950–2010
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Intertemporal Substitution (3 of 4)
• When there is a downturn, people work less and invest less.
• The ripple effects turn an initial shock into a broader recession.
• Intertemporal substitution can also feed an economic boom and make it more intense.
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Intertemporal Substitution (4 of 4)
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Self-Check (1 of 3)
Intertemporal substitution of effort:
a. amplifies only positive shocks.
b. amplifies both positive and negative shocks.
c. dampens the effect of shocks.
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Self-Check (1 of 3) (Answer)
Intertemporal substitution of effort:
a. amplifies only positive shocks.
b. amplifies both positive and negative shocks.
c. dampens the effect of shocks.
Answer:
b. Intertemporal substitution amplifies both positive and negative shocks.
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Irreversible Investments
• Many investments involve sunk costs—that is, they are irreversible investments, or very costly to reverse.
• Once a building is built, it is difficult to redeploy the materials to different economic uses.
• The more uncertain the world appears, the harder it is for investors to read signals about where they should invest.
• Uncertainty usually slows investment and keeps resources in less productive uses.
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Definition (2 of 6)
Irreversible investments: Have high value only under specific conditions—they cannot be easily moved, adjusted, or reversed if conditions change.
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Self-Check (2 of 3)
Investments involving sunk costs are called:
a. sunk investments.
b. intertemporal investments.
c. irreversible investments.
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Self-Check (2 of 3) (Answer)
Investments involving sunk costs are called:
a. sunk investments.
b. intertemporal investments.
c. irreversible investments.
Answer:
c. Investments involving sunk costs are called irreversible investments.
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Labor Adjustment Costs
• Once a negative shock hits, workers must look for new jobs, move to new areas, and sometimes change their wage expectations.
• This induces more searching and thus causes more search- related unemployment.
• The high cost of reversing job decisions can lead to unemployment.
• When faced with uncertainty, many workers will wait, increasing unemployment and magnifying the negative real shock.
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Definition (3 of 6)
Labor adjustment costs: The costs of shifting workers from the declining sectors of the economy to the growing sectors.
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Time Bunching
• Many economic activities cluster in time because it pays to coordinate your economic actions with those of others.
• We want to invest, produce, and sell at the same time as others.
• The clustering of economic activity in time makes buying and selling more efficient.
• It also causes shocks to spread through the economy and to spread through time.
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Definition (4 of 6)
Time bunching: The tendency for economic activities to be coordinated at common points in time.
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Collateral Damage (1 of 3)
• Banks are more concerned about downside risk because if a customer does poorly, the bank could lose the entire value of its loan.
• If the firm does incredibly well, the bank simply gets its loan back plus interest.
• Banks don’t often invest in start-ups or firms with debts that exceed assets.
• This behavior amplifies booms and busts for the economy as a whole.
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Definition (5 of 6)
Collateral: A valuable asset that is pledged to a lender to secure a loan. If the borrower defaults, ownership of the collateral transfers to the lender.
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Definition (6 of 6)
Collateral shock: A reduction in the value of collateral. Collateral shocks make borrowing and lending more difficult.
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Collateral Damage (2 of 3)
• During a boom, asset prices go up and firms have cash flow.
• Banks are willing to approve more loans, making the boom even bigger.
• In a downturn, asset prices fall, cash flow is reduced, and firms have lower net worth.
• Lenders see loans as being riskier, so they cut off or restrict credit.
• This drives more firms under, increasing joblessness and making the bust worse.
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Collateral Damage (3 of 3)
• Real shocks and aggregate demand shocks can reinforce and amplify each other.
• When the nominal owner of a property doesn’t have much equity in the property, very often he or she doesn’t do a good job of taking care of the property.
• When the bank itself is “underwater” or nearly so, the bank managers don’t do a very good job of taking care of the bank.
• The net result: When asset prices fall, there is a lot of collateral damage.
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Self-Check (3 of 3)
A reduction in the value of an asset pledged to a lender is called:
a. a reversible investment.
b. collateral shock.
c. time bunching.
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Self-Check (3 of 3) (Answer)
A reduction in the value of an asset pledged to a lender is called:
a. a reversible investment.
b. collateral shock.
c. time bunching.
Answer:
b. A reduction in the value of an asset pledged to a lender is called collateral shock.
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Takeaway
• At least five factors amplify economic shocks:
1. Labor supply and intertemporal substitution
2. Uncertainty and irreversible investment
3. Labor adjustment costs
4. Time bunching and network effects
5. Collateral shocks
- MODERN PRINCIPLES OF ECONOMICS
- Outline
- Introduction (1 of 2)
- Introduction (2 of 2)
- Intertemporal Substitution (1 of 4)
- Definition (1 of 6)
- Intertemporal Substitution (2 of 4)
- Intertemporal Substitution (3 of 4)
- Intertemporal Substitution (4 of 4)
- Self-Check (1 of 3)
- Self-Check (1 of 3) (Answer)
- Irreversible Investments
- Definition (2 of 6)
- Self-Check (2 of 3)
- Self-Check (2 of 3) (Answer)
- Labor Adjustment Costs
- Definition (3 of 6)
- Time Bunching
- Definition (4 of 6)
- Collateral Damage (1 of 3)
- Definition (5 of 6)
- Definition (6 of 6)
- Collateral Damage (2 of 3)
- Collateral Damage (3 of 3)
- Self-Check (3 of 3)
- Self-Check (3 of 3) (Answer)
- Takeaway