Week 4 Milestone 2

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ModernPrinciplesofEconomics-Chapter33.pdf

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.

© 2021 Worth Publishers. All Rights Reserved.

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