Popular in Macroeconomics
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Date Created: 04/27/16
Ch. 1 The Economic Approach What is economics? Economics: study of how we make choices under scarcity o Scarcity: concept that there is less of a good freely available from nature than people would like Resources: input used to produce an economic good o 3 types that produce different economic good 1. Human resources (human capital) 2. Physical resources (physical capital) 3. Natural resources Capital: humanmade resources used to produce other goods and services 8 guideposts to economic thinking o 1. Resources are scarce tradeoffs Opportunity cost: highest valued alternative that must be sacrificed when choosing an option Is an hour of time worth whatever the time is being spent on? Guns and butter social welfare vs. military o 2. Individuals are rational—they try to get the most from a limited resource Greatest amount of benefits with the least possible cost Rationality is subjective o 3. Incentives matter Choice influences in predictable way in changing incentives o 4. Individuals make decisions at the margin Marginal: describes effect of a change in the current situation Costbenefit analysis: one will do something when the benefit outweighs the cost Cost (C), benefit (B) o 5. Information helps us make better choices but is costly o 6. Secondary effects: indirect impact of an event or policy that may not be immediately noticed o 7. Value of good/service is subjective because goods are subjective Voluntary trade value o 8. Test of a theory is its ability to predict Positive vs. normative economics o Positive: scientific study of what is Testable o Normative: judgments about what “ought to be” Not testable 4 pitfalls to avoid in economic thinking o 1. Violation of ceteris paribus Ceteris paribus: other things are constant o 2. Good intentions do not guarantee desirable outcomes ex. Suicide warnings on antidepressants o 3, association is not causation o 4. Fallacy of composition: belief that what is true for one might not be true for all Ch. 2 Tools of the Economist Trade Voluntary trade value o Engaging in voluntary exchange makes both parties better o Channeling goods and resources to those who value them increases wealth Property rights Involve right to exclusive use of property, legal protection against invasion, right to sell/transfer/exchange/mortgage property 4 incentives of property rights o 1. Incentive to use resources in ways that are considered beneficial to others Owners bear cost of ignoring wishes of others o 2. Private owners have incentive to care for and manage what they own o 3. Private owners have incentive to conserve for the future o 4. Private owners have an incentive to make sure their property does not damage your property Production Possibilities Curve Outlines all possible combinations of total output that could be produced assuming o Foxed amount of productive resources o Given amount of technical knowledge o Full and efficient use of resources 4 factors that shift PPC o 1. Change in economy resource base Investment: the purchase, construction or development of resources Investments require us to give up consumption goods o 2. Change in technology Technology: the knowledge available in an economy at any given time Technology amount of output we can generate o 3. Change in rules under which the economy functions o 4. Change in work habits Law of Comparative Advantage Total output of a group of individuals, entire economy, or group of nations will be greatest when the output of each good is produced by whoever has the lowest opportunity cost o Bill Gates is able to do his own dishes, but he can also pay someone to do them. He should do the latter to stimulate the economy Economic organization Every economy faces 3 questions o 1. What will be produced? o 2. How will it be produced? o 3. For whom will it be produced? Capitalism: system of economic organization where: o 1. Productive resources are owned privately o 2. Goods and resources are allocated through market prices Market organization: method of organization in which private parties make their own plans and decisions with the guidance of market prices Socialism: system of economic organization where: o 1. Ownership and control of the means of production rest with the state o 2. Resource allocation is determines by centralized planning Collective decision making: method of organization that relies on public sector decision making to resolve basic economic questions Ch. 3 Supply, demand and the market process Demand Law of demand: inverse relationship between price of a good and the quantity that buyers are willing to purchase o Downward sloping demand curve o As price increases, quantity demanded decreases Change in quantity demanded: movement along the curve o Caused by a change in the price of hat good Increase in quantity demanded: movement down the curve (to the right) Decrease in quantity demanded: movement up the curve (to the left) Change in demand: shift of the curve o Caused by: change in anything that affects demand other than the picre og the good Increase in demand: curve shifts right Decrease in demand: curve shifts left Shifters of demand o 1. Change in consumer income Normal goods Income increases demand for normal goods increases Inferior goods Income increases demand of inferior goods decrease o 2. Change in number for consumers Number of consumers increases demand increases o 3. Change in the price of a related good Substitutes Price of substitute increases demand increase Compliments: price of compliments increases demand decrease o 4. Change in expectations Expected change in price: future price increase current demand increases Expected change in incomefuture income increases current demand increase o 5. Change in consumer tastes and preferences Tastes and preference increases demand increase Supply law of supply: direct relationship between price of a good or service and the amount that suppliers are willing to produce o Upward sloping supply curve As price increases, quantity supplied increases Producer surplus: difference between the minimum price suppliers are willing to accept and the price they actually receive o Area above the supply curve but below price Change in quantity supplied: movement along the curve o Caused by change in price of good Increase: movement up the curve (right) Decrease: movement down the curve (left) Change in supply: shift of the curve o Caused by change in anything that affects supply other than the price of the good Increase: curve shifts right Decrease: curve shifts left Shifters of supply o 1. Change in resource price Resource price increase supply decrease o 2. Change in technology Technology increase Supply increase o 3. Change in nature and politics o 4. Change in taxes Taxes increase supply decrease Elasticity Inelastic changes in quantity are not sensitive to changes in price o Inelastic curves are steeper Elastic changes in quantity are sensitive to changes in price o Elastic curves are flatter Market equilibrium Economically efficient o No excess supply or demand Excess supply: quantity supplied > quantity demands Prices will fall Excess demand: quantity demand > quantity supplied Prices will rise Equilibrium price and quantity Invisible hand principle When people pursue their own interests they are promoting economic wellbeing Ch. 6 economics of collective decisionmaking Government Size of government indicated by GDP Transfer payments: transfers of income from some individuals to others o Social security, unemployment, welfare, etc. o Comprise ~ ½ total government spending Economics of voting o 1. Rational ignorance effect: rational individual can have little or no incentive to acquire the information needed to cast an informed vote Marginal benefit of voting: chance that your vote was deciding vote multiplied by how much you care Marginal cost of voting: cost of informing yourself, registering to vote, taking time out of your day to vote etc. o 2, median voter theory: 2 party system will be close to the middle so that there is little difference between candidates and preferences of median voter will be represented When the political process works o Voters pay in proportion to the benefits they receive then productive projects will be passed and unproductive projects will not o User charges: requires people who use a service to pay larger share of the cost When it doesn’t work o Special interest effect: issue that generates substantial benefits for small group by generating minimal costs to large group Losses may > benefits Done through: Logrolling: trading votes by politician to get necessary support to pass legislation Porkbarrel legislation: package of spending projects benefiting local areas financed through federal government o Shortsightedness effect: politicians favor programs that generate visible benefits even if longterm costs > benefits o Rent seeking: actions taken by individuals and groups in order to use the political process to take the wealth of others People spend time trying to gain political favors instead of producing o Lack of profit motive: unlike private firms, public sector lacks incentive to produce efficiently Ch. 7 Taking the nation’s economic pulse GDP The market value of all final goods and services produced within a country during a specific period (usually a year) Only goods and services that are produced are included in GDP not transfers 2 ways to measure o Expenditure approach Y = C + I + G + NX Y = GDP C = consumption: household spending on goods and services during current period (durable goods, nondurable goods, services), largest part of GDP I = investment: production or construction of capital goods that provide future service (fixed investment, inventory investment) G = government expenditure: spending on goods and services and capital good, not transfer payments NX = net exports: exports – imports o Resource costincome approach Y = employee compensation + proprietor’s income + rent + corporate profits + interest income + indirect business taxes + depreciation + Net income of foreigners. Limitations on GDP o 1. Excludes nonmarket production o 2. Excludes underground economy Transactions that take place outside recorded market channels o 3. Excludes leisure and human costs o 4. Difficulties measuring quality variation and introduction of new goods o 5. Excludes cost of harmful side effects Per capita o GDP/ population Broad indicator of general living standards GNP Total market value of all final goods and services produced by citizens of a country o Counts income Americans earn abroad o Ignores income foreigners earn in US Nominal values: values expressed in current dollars Real values: values that have adjusted for effects of inflation Price Index Measures cost of purchasing market basket of goods at point in time relative to the cost of purchasing the identical market basket during an earlier reference period o PI = cost of bundle in current year / cost of same bundle in base year Consumer price index: indicator of general level of prices o Compares cost of typical market basket in specific period to cost of same basket in different period o Designed to measure impact price changes on cost of typical bundle of goods purchased by households Use for specific households GDP deflator: reveals cost during the current period of purchasing the items included in GDP relative to the cost during the bas year o Broader than CPI, includes capital goods and other goods purchased by businesses and government Use for economy wide measure of inflation o Limitations of GDP 1. Excludes nonmarket production 2. Excludes underground economy Transactions that take place outside recorded market channels 3. Excludes leisure and human costs 4. Difficulties measuring quality variation and introduction of new goods Excludes cost of harmful side effects o per capita GDP GDP/population Broad indicator of general living standards Ch. 8 Economic fluctuations, unemployment and inflation Business cycle Business cycle: fluctuations in general level of economic activity Measured by o Changes in real GDP o Unemployment rate Definitions o Expansion: characterized by growing GDP and declining unemployment o Peak (boom): height of expansion o Contraction: falling GDP and rising unemployment o Trough: lowest point of contraction o Recession: decline in real GDP for 2 or more consecutive quarters o Depression: prolonged and severe recession Labor Market Employed: worked part of full time in past week or is otherwise on vacation or on sick leave o Full employment: occurs when the economy is experiencing the highest rate of output that it can sustain Exists when economy is operating at the natural rate of unemployment Unemployed: person is not currently employed but is actively seeking employment or waiting to start/return to job\ o Someone who is not employed but is also not seeking employment is not considered unemployed o 3 types of unemployment 1. Frictional: (U^f) unemployment resulting from changes in economy and imperfect information that prevents workers from being immediately matched up with existing job openings Structural unemployment (U^s): unemployment due to structural characteristics of the economy that prevent the matching of available jobs with available workers Cyclical unemployment (U^c): unemployment due to recessions and inadequate labor demand High during recession Negative during expansion o Natural rate of unemployment: (U*) normal employment rate when the economy is operating at a sustainable rate of output U* = (U^s) + (U^f) Affected by Structure of labor force Public policy o Actual rate of unemployment (U): sum of all 3 types of unemployment U = (U^s) + (U^f) + (U^c) or U= U* + (U^c) Expansion U* > U Recession U*< U Civilian labor force: number of people 16 or older who are employed or unemployed Labor force participation rate: % of population 16 or older who is in the CLF Unemployment rate: % of people in labor force who are unemployed Employment/population ratio: % of population 16 and older who are employed Output Actual vs. potential output o Expansion: actual output (Y) > potential output (Y^f) o Recession: (Y) < (Y^f) Inflation Increase in general level of prices (percentage change in prices) o Not necessarily an increase in all prices o Causes the value of the dollar to decrease o High rate of inflation are almost always associated with large swings in the inflation rate Problems o High and variable inflation cause 3 main problems 1. Reduces investment 2. Distorts the information delivered by prices 3. Results in less productive use of resources Sources of inflation o 1. Demand rises faster than supply o 2. Rapid increase in money stock Ch.9 Introduction to Basic Macroeconomic Markets The Labor Market price of labor = w employment = E labor demand o firms demand labor o labor demand curve is downward sloping decrease w increase E labor supply o workers supply labor o upward sloping increase w more people wanting to work increase E Loanable funds market Market that coordinates the borrowing and lending decisions of business firms and households o Price of loanable funds is the real interest rat = “r” r is adjusted for inflation o Quantity of loanable funds is amount saved or invested (Q s,i) Demand for loanable funds o 1. Firms demand loanable funds (investment) o 2. Downward sloping because as interest rate decreases the firm will want to borrow more money Increase in investment demand curve shift right Decrease in investment demand curve shift left o Demand curve is downward sloping Supply of loanable funds o Individuals supply loanable funds through savings Savings: aftertax income not spent on consumption Income determines taxes disposable income which will be either consumer of saved o Upward sloping because as the interest rate increases people will want to save more Increase in savings supply curve shift right Decrease in savings supply curve shift left Interest Rate Nominal: % of the amount borrowed that must be paid to the lender in addition to the repayment of the principle Real interest rate: interest rate adjusted for inflation (real cost of borrowing and lending money) o r = i – pi or real interest rate = nominal interest rate –inflation rate interest rate and inflation o actual rate of inflation > anticipated inflation: borrowers gain and lenders lose o actual rate of inflation < anticipated inflation: lenders gain, borrowers lose o inflation does not help borrowers or lenders in a systematic manner interest rate and bonds o inverse relationship when interest rate increases market value of previously issued bonds decreases interest rate decreases market value of previously issued bonds increases Foreign exchange market Market in which the currencies of different countries are bought and sold Changes in exchange rates o Appreciation: increase in value of currency relative to foreign currencies ex. Dollar can buy more euros o Deprecation: reduction in value relative to foreign currencies ex. Dollar can buy less euros Demand for foreign currency o Imports + capital outflows capital outflow: domestic money invested abroad o Downward sloping because as dollar appreciates (foreign currency depreciates) > people import more and invest more in other countries Supply of foreign currencies o Exports + capital inflow Capital inflow: foreign money invested domestically o Upward sloping because as the dollar depreciates (foreign currency appreciates) foreign countries will demand more domestic exports and will invest more domestically Demand increases quantity increases price of foreign currency increases Demand decreases quantity decreases price of foreign currency decreases Supply increases quantity increases price of foreign currency decreases Supply decreases quantity decreases price of foreign currency increases Market equilibrium o Occurs when supply = demand Imports + capital output = exports + capital input o Trade deficit: imports > exports Capital output – capital input + exports – imports Ex. 3 – 4 = 2 – 3 o Trade surplus: exports > imports Capital output – capital input = exports – imports Aggregate goods and services market A market that includes all final goods and services (all items that enter into GDP) o Ex. Not looking at supply and demand of pizza or haircuts or highways etc. it would be supply and demand of pizza AND haircuts AND highways etc. o Price of all things (PI) o Quantity of all things: real GDP (Y) Aggregate demand curve: relationship between price level and quantity of domestically produced goods/services all households business firms, governments and foreigners are willing to purchase o Downward sloping because as price level goes down, quantity demanded of al goods will increase o Decrease in price level increase in quantity demanded of all goods: 1. Increase the purchasing power of money PI increases Y increases and shifts to the right 2. Lead to a lower real interest rate increase consumption and investment Supply curve will shift to the right when you have more money in savings and the real interest rate will decreases. Real interest rate decreases, less eager to put money in bank, start saving less and spending more r decreases c increases I increases PI decreases save more r decreases c increases, I increases Y increases o WHEN PI DECREASES, Y INCREASES 3. Domestically produced goods less expensive relative to foreign goods Aggregate supply: relationship between nations price level and quantity of goods/services supplied by producers o Shortrun aggregate supply: upwards sloping because an increase in the price level will improve the profitability of the firms and cause them to increase output Profit = revenue – cost ex. PI=1 revenue ($1x100) cost ($100) = $0 Many of the costs are still fixed Equilibrium occurs at intersection of AD and SRAS AD downward sloping, SRAS upward sloping o Longrun aggregate supply: vertical line on graph because in the longrun people will have had time to adjust SO a higher price level will increase costs as much as it increases revenues Firms have no incentive to change production at any price level because in the longrun everything will balance out Indicates potential output Equilibrium occurs where AD, SRAS and LRAS all intersect AD downward sloping, RAS upward sloping, LRAS vertical line through intersection of AD and SRAS Occurs when 1. Correctly anticipate price level 2. No expansion or recession (Y = Yf) 3. Actual rate of unemployment = natural rate of unemployment If Yf is further left than Y* expansion If Yf is further right than Y* contraction Circular flows diagram The flow of output and income between the businesses and households coordinated by the four key markets Coordination of all4 markets make our system economics work o The resource market coordinates the actions and businesses demanding resources and households supplying them in exchange for income o The goods and services market coordinates the demand for and supply of GDP o The foreign exchange market brings the purchases (imports) from foreigners into balance with the sales (exports plus net inflow of capital) to theme o The loanable funds market brings the net household saving and the net inflow of foreign capital into balance with the borrowing of business and government When the flow between these 4 is moving nicely and quickly, we call it expansion When it seems to be halted, recession Ch. 10 Working with basic AD and AS model Shifters of AD 1. Changes in real wealth o Real wealth increases AD increases Shifts AD right o *** NOTE: just because value of goods increases in demand, not necessarily wealthier until you sell that item 2. Changes in real interest rate: interest rate is inversely related to how much households consume and businesses invest o decreases in IR consumption increase, IR increases AD increases shifts AD right o increase in IR consumption decreases, IR decreases AD decrease shifts AD left 3. Changes in expectations for businesses and households about the future o optimism: increase in AD shift right o pessimism: decrease in AD shift left 4. Changes in expected rate of inflation o increase: spend more money now increase AD shift right o decrease: spend less now decrease AD shift left 5. Change in income abroad o foreign income increase Ad increase shift right o foreign income decreases AD decrease shift left 6. Change in exchange rate o dollar depreciates AD increase shift right US goods are now cheaper for Europeans, Europeans are going to buy more US goods rather than European goods Europe increasing their imports Americans are going to buy more US goods rather than Europeans goods US decreasing imports o Dollar appreciates AD decrease Can shortterm retraction Shifters of LRAS Also will affect SRAS 1. Change in resource base o increase LRAS increase o decrease LRAS decrease 2. Change in technology o increase LRAS increase o decrease LRRAS decrease 3. Changes in institutional arrangements that affect productivity o positive LRAS increase o negative LRAS decrease Shifters of SRAS 1. Change in resource price o increase SRAS decrease o decreases SRAS increase 2. Change in expected rate of inflation o increase SRAS decrease o decrease SRAS increase 3. Supply shocks o negative SRAS decrease o positive SRAS increase ADAS model and business cycle 2 causes of recession o 1. Unanticipated fall in AD o 2. Unanticipated fall in SRAS 2 causes of expansion o 1. Unanticipated rise in AD o 2. Unanticipated rise in SRAS Selfcorrecting economy 3 facts that imply the economy can correct itself o 1. Consumption and demand is relatively stable Y = C + I + G + NX C is at least 2/3 of GDP Permanent income hypothesis: peoples consumption depends on their longrun expected permanent income rather than their current income If you receive a bonus, you are likely to save most and spend some People will still save during expansions and still spend during recessions o 2. Changes in real interest rates stabilize aggregate demand and redirect economic fluctuations recession: less investment lower IR increased consumption and investment and offsets recession expansion: increased investment higher IR decreased consumption o 3. Changes in real resource prices help redirect economies fluctuations recession: low demand decrease in resource price SRAS increase expansion: increase demand resource prices increase SRAS decrease Ch. 11 Fiscal policy – Keynesian view and historical perspective Classical vs. Keynesian Classical economists believe that market and resource prices are flexible and allow the economy to selfcorrect quickly o FA Hayek Believes prices are flexible, selfcorrecting economy, supply creates demand so production matters, people respond to economic calculations so incentives matter Keynesian economists believe that market and resources prices are inflexible and therefore the market will not be able to quickly correct itself o Keynes Prices are inflexible, economy cannot quickly fix itself, demand creates supply so spending matter and people respond to “animal spirits” Marginal propensity to consume (MPC) Amount of additional income that is consumed o Additional consumption/additional income 80/100 = .80 o M = 1 ÷ (1 MPC) For multiplier to be effective it must come from resources that otherwise would have been unemployed Broken window fallacy: when a window is broken, money is forced into economy to fix it. So should we just be breaking things all the time to fix them? o Story for classical o Fallacy for Keynesian Budget deficits and surpluses Balanced budget: government revenues (taxes) = government expenditures o T = tax revenue o G = government expenditures T = G balanced budget Budget deficit: government spending > than government revenue o T < G During recession we will naturally go into deficit T decreases G increases debt budget surplus: government revenue > government spending o T > G During expansion we naturally go into surplus T increase G decrease Fiscal policy Expansionary fiscal policy o 1. Increase government expenditures o 2. Reducing tax rates designed to bring economy out of recession by increasing AD increases size of budget deficit o Classical economists that when we are in recession we should leave the economy alone because it will fix itself. Keynes disagrees because IR and wages are sticky and the economy is going to stay as it is. To fix it, he suggested expansionary fiscal policy Restrictive fiscal policy o Decreasing government expenditures o Raise tax rates Designed to bring economy down from expansion by decreasing AD Reduces deficit Countercyclical policy o Keynes believed in this rather than balancing budget o Policy moves the economy in opposite direction from forces of business cycle Recession : expansionary Expansion: restrictive Timing problems o 1. Recognition lag: our ability to forecast is limited o 2. Administrative lag: change in fiscal policy requires legislative action o 3. Impact lag: change in fiscal policy will not have immediate impact Automatic stabilizers built in features that automatically promote a budget deficit during a recession and a budget surplus during an expansion o 1. Unemployment compensation recession: unemployment increases G increases, T decreases Keynes described Deficit o 2. Corporate profit tax corporations taxed on income recession: T decreases expansion: T increases o 3. Progressive income tax income increases taxes increase recession: T decreases expansion: T increases Ch. 12 Fiscal policy: incentives and secondary effects Keynesian vs. Classical crowding out: explains why fiscal policy is not as effective as Keynes thought— reduction in private spending due to higher interest rates generate by budget deficits financed through government borrowing Ricardian equivalence: new classical view of why fiscal policy is not as effective as Keynes thought—belief that tax reduction financed with government debt will exert no effect on AD because people will know that higher future taxes are coming Paradox of thrift: many people drastically increase their savings and reduce consumption total savings may decrease Politicians have a tendency to overuse expansionary policy AGREEANCE o Proper timing is crucial and hard to achieve o 2. Automatic stabilizers help redirect economy o 3. Fiscal policy is less potent than originally thought Taxes and growth high taxes tend to stunt growth because o 1. High tax rates discourage work effort and productivity o 2. High tax rates reduce capital formation o 3. High tax rates encourage people to purchase goods that are less desired, just because they are tax deducible Supplyside economics belief that changes in marginal tax rate will exert importance effects on AS o longrun growth oriented strategy Ch. 13 Money and the Banking system 3 functions of money 1. Medium of exchange: used to buy goods and services o more efficient to sue money than to barter goods o flat money: money with no intrinsic value 2. Store of value: asset that will allow people to transfer purchasing power from one period to the next o liquid asset: asset that can be easily and quickly converted to purchasing power 3. Unit of account: unit of measurement used by most people to post prices and keep track of revenues and costs M1 = currency + checkable deposits + travelers checks o More liquid form of money M2 = M1 = savings deposits + time deposits (less than $100,00) + money market mutual funds o Savings accounts: interest bearing holding account at bank o Time deposits: financial accounts with a minimum time requirement o Money market mutual funds: interest earning accounts that pool depositors funs and invest them in highly liquid shortterm securities Banks and banking systems Central bank: institution that regulates the banking system and controls the money supply o Central bank is US is the Fed Carries out regulatory policies Conducts monetary policy to promote full employment and price stability Federal open market committee: determines the feds policy with respect to the purchase and sale of government bonds Control of money supply Open market operations: buying and selling of bond on the open market by the Fed o Fed buys bonds increase in money supply o Sells bonds decrease in money supply Reserve requirements o Lower reserve requirements increase money supply o Increase in reserve requirements decrease in supply of money Extension of loan o Discount rate: IR that the fed charges banking institutions to borrow funds o Federal funds rate: IR that commercial banks charge each other Extend more loans increase money supply Less loans decrease money supply Interest paid on excess bank reserves o Reducing the IR on excess reserves increases money supply o Increasing the IR paid on excess reserves decreases money supply Fractional reserve baking: system that permits banks to hold reserves of less than 100% against depositors Required reserves: minimum amount of reserves that a bank is required by law to keep to back up its deposits o Required reserve ratio: % of deposits that banks are required to hold as reserves o Potential deposit expansion multiplier: maximum potential increase in the money supply as a ration of new reserves injected into baking system Review Session Chapter 10 Shifters of aggregate demand: o 1. Changes in real wealth Increase AD increase Decrease AD decrease o 2. Change in real interest rate Decrease C, I increase AD increase Increase C, I decrease AD decrease o 3. Change in expectations Optimism AD increase Pessimism AD decrease o 4. Change in expected rate of inflation Increase AD increase Decrease AD decrease o 5. Change in income abroad Increase AD increase Decreases AD decreases o 6. Change in exchange rate Deprecation AD increase Appreciation AD decrease Shifters of shortrun aggregate supply o Changes in resource prices Decrease SRAS increase Increase SRAS decrease o Changes in expected rate of inflation Decrease SRAS increase Increase SRAS decrease o Supply shocks Positive SRAS increase Negative SRAS decrease Shifters of long run aggregate supply (SRAS shifts with it) o Change in resource base Increase LRAS increase Decrease LRAS decrease o Change in technology Increase LRAS increase Decrease LRAS decrease o Change in institutional arrangements that affect productivity Increased productivity LRAS increase Decrease LRAS decrease How to do an AD/ AS problem o 1. Which curve is shifting? (AD, SRAS, LRAS) o 2. Is it moving the curve up or down? (Right or left) o 3. What happens to the price index and real GDP? ***If this is a SRAS problem, stop, if LRAS, keep going*** o 4. Find the long run adjustment AD/AS applies to business cycle and how economy corrects itself o 1. Permanent income hypothesis o 2. Chang in real interest rate o 3. Change in resource price In recession: r decreases C,I increases AD increase o Wages decrease SRAS increase In expansion: r increases C, I decrease AD decrease o Wages increase SRAS decrease Chapter 11 Differences between classical and Keynesian economics o Classical Prices and wages are flexible Economy can correct itself Says law: supply creates demand (production matters) People respond to economic calculation o Keynesian Prices and wages are sticky Prices and wages will stay high during a recession and economy will not correct itself Demand creates supply (spending matters) Break windows and spend money fixing them People respond to animal spirits People don’t really sit around and calculate economy Marginal propensity to consume and multiplier effect o MPC = additional consumption / additional income o Multiplier effect: M=1/(1MPC) Countercyclical policy: policy that moves the economy in the opposite direction from the forces of the business cycle o Recession: expansionary (budget deficit) o Expansion: restrictive (budget surplus) o TIMING PROBLEMS Recognition lag: recognize we are in recession its difficult Administrate lag: government has to work together to decide what to do Impact lag: whatever the government decided to do takes time to actually affect the population By the time this is all happening, we might not even be in a recession anymore Automatic stabilizers: built in features that automatically promote a budget deficit during a recession and a budget surplus during expansion o Unemployment compensation o Corporate profit tax o Progressive income tax Chapter 12 Crowding out: reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing in the private loanable funds market o Recession: expansionary fiscal policy budget deficit borrow more r increase consumption decrease and investment decreases, capital inflow increase $ appreciation NX decrease o Trying to increase Y New classical argument: Ricardian equivalence o People will save for he expected future tax increase required to offset the deficit Paradox of the thrift: when many people drastically increase their savings and reduce consumption, total savings may decease Political incentives behind discretionarily fiscal policy o License for government officials to run budget deficit o Politicians have huge likelihood to run deficits always Most macroeconomists believe o Proper timing is crucial and hard to achieve o Automatic stabilizers help redirect the economy o Fiscal policy is less potent than originally thought Relationship between taxes and growth o High taxes discourage work effort and productivity o High tax rates reduce capital information o High tax rates encourage people to purchase less desired goods Supply side economics o Lower marginal tax rate will give people the incentive to work more If the lower marginal rate is believed to be long term than it will shift the SRAS and LRAs Supply side economics is along run, growth oriented strategy, not a short run stabilization tool chapter 13 3 functions of money o 1. Medium of exchange o 2. Store of value o 3. Unit of account difference between M1 and M2 o M1 = currency + checking accounts + travelers checks o M2= M1 = savings accounts + time deposits + money market mutual funds QUESTIONS 1. Using the AD/AS graph, what changes to the equilibrium output and the equilibrium price level in the US will result from the depreciation of the US dollar in the shortrun? (hint: actually shift the curves on an ADAS graph?) A. Both equilibrium price level and output will increase B. Both the equilibrium price level and output will decrease C. The equilibrium price level will increase, but output will return to tis full employment level D. Equilibrium rice level will decrease, but output will return to its full employment level Answer: A US dollar depreciation shifts AD, depreciation AD increase which is a shift to the right. If AD increases then SRAS decreases 2. Using the AD/AS graph, what changes to the equilibrium output and the equilibrium price level in the US will result from an extended period of unfortunate weather (negative supply shock) in the longrun? (hint: actually shift the curves on an AD/AS graph?) A. No change, price level and output will return to its original level B. Both the equilibrium price level and output will decrease C. Equilibrium price level will increase, but output will return to its full employment level D. Equilibrium price level will increase and actual output will decrease below potential output Answer: A Negative supply shock shifts SRAS to the left, PI increases, output decreases and we are in contraction… BUT the question asks for LRAS. When SRAS shifts, it will shift back in the long run. Bad weather does not last forever Whenever AD shifts SRAS shifts in opposite direction SRAS shift SRAS shift back LRAS shift SRAS shifts with it 3. if the economy is experiencing less than full economy the Keynesian model recommends that the government a. do nothing to stimulate economy b. Undertake expansionary fiscal policy to stimulate AD c. Undertake expansionary fiscal policy to stimulate AS d balance the budget to stimulate AD answer: B countercyclical policy, demand creates supply 4. If consumption increases to 750 when disposable income increases to 1,000 then the expenditure income is A. .75 B. 1.25 C. 1.33 D. 4 Answer: D 750/1000 .75 1/1.75 = 1/.25 4 5. According to the crowding out view of classical economists if a larger budget deficit leads to higher real interest rates, A: inflow of foreign capital, which will cause the dollar to appreciate, and NX to decline B: outflow of foreign capital, which will cause dollar to depreciate and NX to increase C: inflow of foreign capital, which will cause the dollar to depreciate, and NX to increase D: outflow of foreign capital, which will cause the dollar to appreciate, and NX to decrease Answer: A Higher interest rates capital inflows to increase and the dollar to appreciates which causes NX to decrease 6. new classical economists believe that an increase in deficit financing by the government will A: reduce government spending B: increase consumption C: reduce future taxes D: increase savings, but little else Answer: D
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