CH. 9

Why is the LAS curve vertical?

Because output is independent of the price level.

What are five factors that cause the AD curve to shift?

1) Changes in foreign income 2) changes in expectations 3) changes in exchange rates 4) changes in the distribution of income 5) changes in governmental aggregate demand policy.

According to Keynesians how could the economy's output deviate from its potential?

1) When aggregate demand falls, firms lower production and lay off workers. People's income to fall, lowering consumption expenditures further and causing firms to lower production. Leads to equilibrium where output is lower than potential output. 2) When aggregate demand is high, firms increase production and hire workers. Peoples' income increase, increasing consumption expenditures further and causing firms to increase production. Leads to an equilibrium where output is greater than potential output.

Why does the paradox of thrift suggest that government needs to intervene in a recession?

Increasing savings will lower aggregate income and set in motion a cycle of declining expenditures and production. This will reduce income so saving and investment will be in equilibrium, but then the econ will be in an almost permanent recession, with ongoing unemployment. Keynesians believe that in this case the economy will need government's help to prop up aggregate expenditures.

Why is knowing the level of potential output important to designing appropriate fiscal policy?

Knowing where the economy is relative to potential output tells you whether to implement expansionary or contractionary policy.

Why might deflation be a problem for an economy?

When prices fall, profits decline, making entrepreneurs hesitant to start businesses, slowing the growth of the economy. Asset values also decline, reducing the value of collateral used to support consumer and producer loans & therefore spending --> undermine business and consumer confidence.

Why, in principle, would one expect the AD curve to be vertical?

When the price level rises, all prices rise together. Since wages have risen as much as prices for consumer goods, no relative prices have changed and therefore people's decisions to consume should not change either.