Connecting Short Run and Long Run
Fighting economic crises and recessions has become one of the well-recognized functions of government. But are the fluctuations around the trend really important? In most recessions, the fall in GDP is not more than 3-4 % and the return to the trend is relatively quick. Moreover, one may argue that what is lost in a recession, may be recovered during a boom. In contrast, a one-percentage-point increase in the rate of economic growth can accumulate into a severalfold rise in GDP over the years. So shouldn't we abandon fighting recessions and concentrate fully on long-term growth instead? This task asks you to explore some connections between short run and long run and discuss if recessions are necessarily worth fighting.
a) (10 rp) Argue why recessions may have a long-term negative effect on labor market and therefore may slow down long-term growth.
5 rp: Recessions feature a decline in the aggregate demand, and as a result, a reduction in the demand for labor force. While salaries are mostly fixed contractually and are hard to change, some workers are fired, while others, mostly temporary workers, are hired for a smaller number of hours. This leads to higher rates of unemployment and a reduction in the disposable income of households.
5 rp: Unemployment and a reduction in the disposable income can have a long-lasting negative effect on the human capital stock in the economy. Some workers might lose motivation to look for a job or faith and confidence in their ability to find one, and leave labor force. Others can chose to leave the country and search for employment in another country with better economic prospects. A decline in the disposable income can negatively affect parents' ability to invest in their kids' education. Government's tax revenues are declining at the same time, so it is also constrained in its spending on education, further reducing the productivity of labor force in the country.
b) (10 rp) Suppose that banks require a minimum level of collateral for loans, and it limits a lot of entrepreneurs from getting loans. Argue why recessions may have a negative effect on the rate of long-term innovation, while booms don't have the opposing positive effect
5 rp: During recessions asset prices fall. So houses or any other tangible properties are worth less, and therefore, it is harder for entrepreneurs to pass the collateral hurdle imposed by banks. Entrepreneurs with bright innovation ideas can not implement them because they are credit-constrained. This hurts the innovation process, and slows down economic growth.
5 rp: Booms do not have a fully-offsetting positive effect. Innovation ideas that were very relevant at the time of recession might become obsolete two or three years later, when the boom period comes. This could be because entrepreneurs in other countries have implemented them already. Entrepreneurs that had the innovation ideas in recession might have gotten discouraged and pursued a different career path. In addition, profitable companies have less incentives to do risky cost-cutting innovations. Hence, they might be hesitant to do significant business restructurings in booms, opting for safer but less innovative growth strategies.
c) (10 rp) Alternatively, suppose that banks do not know the quality of the investment projects of entrepreneurs and offer all applicants the same loan rate, such that it allows banks to at least break even. Argue why recessions might be stimulating long-run economic growth.
5 rp: When banks can not differentiate between good and bad projects, they have to offer all borrowers the same rate. Because among the potential borrowers some are very risky, banks have to charge a very high loan rate to compensate for the potential losses on bad projects. Both good and bad projects face high cost of borrowing, since bank can't tell the two apart. Entrepreneurs with good innovations face high, potentially prohibitively high, loan rates and are deterred from implementing their projects.
5 rp: Recessions put out of business a lot of firms, but it hits first the least profitable firms. Once they go out of business, banks have a better pool of borrowers, and can offer better loan rates to everyone. Including entrepreneurs with good innovation projects, which increases economic growth rate. This is similar to the phenomenon of creative destruction - crisis is a time when resources are reallocated towards more productive firms through defaults of less productive ones.
Important, please note: Many students wrote that since the bank offers the same loan rate to all applicants, it means that entrepreneurs get cheap funding. It is false, and the opposite is true. The same rate does not by any means imply a low rate. To break even on a pool of borrowers, some of which are very risky, the bank has to charge a very high loan rate. Think about payday loans vs mortgages — payday loans are extremely expensive because a lot of borrowers default on their loans, and to cover these losses lenders charge all borrowers high rates, sometimes as high as 1 % a day. Mortgages, on the other hand, have smaller loan rates.
This is because banks first of all screen all borrowers and make sure only credit-worthy borrowers get the loan, and second, they use the house as a collateral. In case the mortgage is not repaid, the bank can seize the house and sell it to cover the losses on the loan. Therefore, the bank can offer a very low rate for mortgages.
Because banks do not know which projects are good or bad, they charge all projects the same rate. Good projects could have gotten a much smaller rate if the bank could see the quality of their project, but it can not. Recessions help the good entrepreneurs reveal to the bank that they are in fact of good quality, and once low quality entrepreneurs exit the market, high quality entrepreneurs receive loans at a smaller rate.