CH 14 Practice Concept Check Quiz:ECON

According to Keynesian economists, prices tend to be ______________. As a result, Keynesian economists focus on _____________ changes and aggregate ____________.

sticky; short-run; demand FEEDBACK: Keynesian economists believe that prices are sticky because of contracts and money illusion. Because of price stickiness, when aggregate demand decreases, Keynesian economists believe that the economy does not self-adjust, contrary to the beliefs of classical economists. As a result, Keynesian economists focus on short-run changes that they believe shift aggregate demand back to equilibrium.

Which of the following led to the Great Depression?

a decline in AD Feedback The primary cause of the Great Depression was a significant decline in aggregate demand. This decline occurred mostly as a result of faulty macroeconomic policies.

Which of the following led to the Great Recession?

a decline in both AD and LRAS Feedback On one hand, the financial crisis led to a permanent breakdown in the loanable funds market, resulting in reduced funding opportunities for investment for the firms, which reduced the long-run aggregate supply. On the other hand, large declines in consumer wealth contributed to a significant decline in aggregate demand.

Identify whether the following statement is more likely to come from a classical economist or a Keynesian economist."The recent decline in consumer confidence will likely spell disaster for the economy."

classical FEEDBACK: The key here is the emphasis on price flexibility.

Classical economists believe that savings is ____________, while Keynesian economists believe that savings is ____________.

crucial to growth; a drain on demand Feedback Remember that classical economists focus on economic policies designed to promote long-run growth, in other words, a shift in the long-run aggregate supply. Hence, according to this viewpoint, savings is a very important positive factor in the economy, since savings is translated into investment and this increases capital and shifts out the long-run aggregate supply. On the other hand, savings in the Keynesian view is not helpful to the economy in the short run, which is a crucial time frame. Thus, Keynesian economists believe that savings reduces aggregate demand.

According to classical economics, a decrease in aggregate demand causes the price level to _____________ in the long run. On the other hand, an increase in aggregate demand causes the price level to _____________ in the long run. These changes occur because of _____________.

decrease; increase; price flexibility FEEDBACK: Classical economists believe that prices adjusted to long-run output equilibrium without the need for government intervention because of price flexibility. When aggregate demand decreases, prices decrease to restore the long-run equilibrium. When aggregate demand increases, prices increase to restore the long-run equilibrium.

Which of the following statements is consistent with what happened during the Great Recession?

Aggregate demand and long-run aggregate supply decreased, causing unemployment to rise to 10%. FEEDBACK: During the Great Recession, aggregate demand and long-run aggregate supply both decreased. These shifts eventually led to an unemployment rate of slightly more than 10%. Consumer sentiment did drop prior to and during the Great Recession, but this change affected aggregate demand, not aggregate supply.

Identify which of the following graphs will be drawn by classical and Keynesian economists, respectively, for an economy experiencing a decrease in wealth. Note that E1 and E2, respectively, are the initial and final equilibrium points before and after the wealth decrease.

Classical: Fig 4; Keynesian: Fig 1 Feedback First of all the question says that the economy experiences a decrease in wealth. This implies that the AD curve should shift left, irrespective of the classical or Keynesian point of view. Hence, we can exclude figures 2 and 3, since both these figures involve a rightward shift of the AD curve. According to classical economists, the economy is self-correcting and always ends up at full-employment output. So in classical economics, demand shifts only involve changes in the price level, with output being at the full-employment level. This is the case as shown in Figure 4. On the other hand, Keynesian economists hold the view that aggregate demand changes bring fluctuations to the economy and therefore demand shifts can result in equilibrium situations in which the real GDP drifts away from potential GDP. This is the case depicted in Figure 1.

Which economist would have been in favor of deregulating the banking system?

Friedrich von Hayek FEEDBACK: Hayek was the leader of the Classical School of Thought and was a strong advocate of less government intervention into markets.

Which of the following are supported by Keynesian economics? I. Markets always work. II. The economy is self-correcting. III. Demand side matters. IV. Government intervention can be necessary to restore full employment.

III and IV Feedback Classical economists believe that the economy is essentially self-correcting and therefore no matter what factors change in the economy, it automatically comes back to full employment in the long run. Thus, classical economists are essentially pro-market, because according to them, markets work in correcting themselves and there is no significant role for government policy. On the other hand, Keynesian economists believe that resource prices are sticky in the short run and they don't adjust quickly enough to restore the economy to full-employment equilibrium. The main focus of Keynesian economists is the demand side of the economy as a source of instability in the macroeconomy. Thus, their policy prescription is that the government should step in to aid the economy in restoring full employment when necessary.

Which of the following were common to the Great Depression and the Great Recession?

In both cases AD declined. Feedback During the Great Recession, the financial crisis led to a permanent breakdown in the loanable funds market, resulting in reduced funding opportunities for investment for the firms, which reduced the long-run aggregate supply. Simultaneously, large declines in consumer wealth contributed to a significant decline in aggregate demand. During the Great Depression, there was a significant decline in aggregate demand, which occurred mostly as a result of faulty macroeconomic policies. Thus, the common factor during the Great Depression and the Great Recession was a decline in aggregate demand.

Identify whether the following statement is more likely to come from a classical economist or a Keynesian economist."The recent decline in consumer confidence will likely spell disaster for the economy."

Keynesian FEEDBACK: The key here is that Keynesian economists emphasize the role of aggregate demand, which depends on consumer confidence.

During the 2008-9 Great Recession, the Obama administration proposed several stimulus packages with an aim to recover the economy from the economic crisis. Which school of thought will most likely support the administration's policy prescriptions?

Keynesian Feedback Contrary to the classical economists, Keynesian economists believe that during a recession it is unlikely for the economy to restore itself to full-employment equilibrium. Hence, it will be necessary for the government to step in to aid the economy in recovering from the recession. Thus, if individuals and firms are reluctant to spend—if AD is too low—the government might step in to fill the void by increasing GDP or prescribing polices aimed at stimulating the economy by increasing AD.

In which crisis do economists blame the government for causing further turmoil to the economy by decreasing the money supply and raising taxes?

The Great Depression Feedback During the Great Depression, the government let the money supply fall repeatedly, and raised income taxes and tariffs. During the Great Recession, the government actively sought to increase the money supply to aid the economy.

Which of the following statements is consistent with what happened during the Great Depression?

The unemployment rate was over 25% at the height of the Great Depression. This spike in unemployment was caused by the large decrease in aggregate demand. FEEDBACK: A large decrease in aggregate demand had tumultuous effects on the U.S. economy during the late 1920s and 1930s. By 1933, the unemployment rate was over 25%. This spike in unemployment was in large part due to faulty macroeconomic policies. It would take seven years after the start of the depression for potential GDP to return to pre-Depression levels. And it wouldn't be until the 1940s that the unemployment rate returned to single digits.

Classical economists focus on the ___________, while Keynesian economists focus on the ____________.

long run; short run Feedback Classical economists believe that the economy is essentially self-correcting, and therefore no matter what factors change in the economy, it automatically comes back to full employment in the long run. Thus, according to them, only the long run matters. On the other hand, Keynesian economists believe that resource prices are sticky in the short run and they don't adjust quickly enough to restore the economy to full-employment equilibrium. Thus, their policy prescription is that the government should step in to aid the economy in restoring it to full employment. Thus the key focus of Keynesian economists is the short run.