MACROECONOMICS

Macroeconomics

Macroeconomics

Section A

Question 1

The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y-Y* where Y is actual output and Y* is potential output. If this calculation yields a positive number it is called an inflationary gap and indicates the growth of aggregate demand is out pacing the growth of aggregate supply—possibly creating inflation; if the calculation yields a negative number it is called a recessionary gap—possibly signifying deflation. [1]

The percentage GDP gap is the actual GDP minus the potential GDP divided by the potential GDP.

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Okun's Law is based on regression analysis of US data that shows a correlation between unemployment and GDP. Okun's law can be stated as: For every ß% decrease in potential GDP, the actual employment rate exceeds the natural rate of employment by 1% of the potential GDP.

%Output gap = -ß x %Cyclical unemployment

This can also be expressed as:

(Y-Y*) / Y* = -ß(u-u)

where:

Y is actual output

Y* is potential output

u is actual unemployment

u is the natural rate of unemployment

ß is a constant derived from regression show the link between deviations from natural output & natural unemployment.

Question2

The recent global financial crisis centres the regulatory authorities spotlight on the rapid rise in credit, which preceded it; Hume and Sentence (2009) provide an empirical and theoretical analysis of the credit boom and the macroeconomic context in which it developed. Their findings suggest that the boom was unusually long having no association with strong growth or rising inflation in the economies in which it began, rather they argue that the credit expansion was rooted in the conduct of monetary policy particularly in the United States and the perceptions of declining macroeconomic risk from 2005 onwards. Their study enumerates how existing economic theories failed to provide an adequate account for many of the key empirical features characterising the recent credit and financial cycle. Mishkin's (2009) explanation of the recent financial crises is confined to an explanation of severe contraction in the capital markets characterised by financial institutions failures and sharp decline in asset prices. Asymmetric information3 resulting in 'adverse selection' and 'moral hazard' explain the freezing of credit markets once a crisis has been set in motion. Starting in mid-2007, defaults in the sub-prime mortgage market sent 'bad news' signals to the financial markets, ultimately ending up in the worst financial crises since the Great Depression of the 1930s. Although, low in intensity compared to the most recent global financial crises (GFC), the world has experienced quite a number of crisis in the past 20 years. Therefore, what exactly is different about the recent GFC is a question, and one of particular importance, that academics and central bank authorities are now trying to answer. With many financial institutions going bust along with significant stalls in credit markets, the sub-prime crisis completely changed the outlook of money and financial markets (Mishkin 2009). Various studies have been carried out in this domain including that by Jakubik and Schmieder (2008) who investigate ...