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CFA Level I · CFA Level I Exam · Understanding Business Cycles

An analyst observes that after a large rise in energy costs, an economy's output falls, while real wages and employment decline together, with no change in central bank policy. Which interpretation is most consistent with the new classical and real business cycle views, as opposed to the Keynesian view?

The shock lowered productivity, so households and firms rationally reduced work and output, making demand stimulus unnecessary. This is the real business cycle and new classical interpretation. The sticky-wage story is Keynesian, and the money-growth story is monetarist and inconsistent with unchanged central bank policy.

  1. AWeak aggregate demand and sticky nominal wages are causing involuntary unemployment that fiscal stimulus could remedy
  2. BExcessive earlier money growth has created unsustainable output that is now being corrected
  3. CThe shock lowered productivity, so households and firms rationally reduced work and output, with no need for demand stimulusCorrect

Explanation

RBC and new classical views treat output and employment declines as rational, efficient responses to real supply-side shocks, such as higher energy costs lowering productivity, so stimulus is unnecessary. The first option is Keynesian. The second reflects a monetarist explanation, which conflicts with unchanged central bank policy.

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