Practice

Free response question

Macroeconomics · Hard · 30 marks

IEO past paper: 2019 International Economics Olympiad, open questions

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 several-fold 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)Argue why recessions may have a long-term negative effect on labor market and therefore may slow down long-term growth.[10](b)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.[10](c)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.[10]

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