Chapter 20 Macro

What are economic fluctuations?

Long run - Real GDP grows 3% per year short run - GDP fluctuates around its trend (recessions and depressions) short run fluctuations are also called business cycles.

The Interest-Rate Effect (P and I )

Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell bonds or other assets. This drives up interest rates. Result: I falls.(Recall, I depends negatively on interest rates.)

The Wealth Effect (P and C )

Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer. Result: C falls.

The Exchange-Rate Effect (P and NX )

Suppose P rises. U.S. interest rates rise (the interest-rate effect). Foreign investors desire more U.S. bonds. Higher demand for $ in foreign exchange market. U.S. exchange rate appreciates. U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Result: NX falls.

Why the AD Curve Might Shift

Any event that changes C, I, G, or NX—except a change in P—will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right

Changes in L or natural rate of unemployment

Immigration Baby-boomers retire Govt policies reduce natural u-rate

3. The Misperceptions Theory

Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

Depressions-

Severe recessions (very rare)

Changes in C examples

Stock market boom/crash Preferences re: consumption/saving tradeoff Tax hikes/cuts

Most economists believe that money neutrality holds a. in the short run but not the long run. b. in the long run but not the short run. c. in both the short run and the long run. d. in neither the short run nor the long run.

b. in the long run but not the short run.

Which of the following typically rises during a recession? a. consumption b. unemployment c. corporate profits d. automobile sales

b. unemployment

The natural rate of output (YN)

is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output  or full-employment output.

Recessions

period of falling real income and rising unemployment

The AD curve (Aggregate Demand)

shows the quantity of all g&s demanded in the economy at any given price level.

An increase in P reduces the quantity of g&s demanded because:

the wealth effect (C falls) the interest-rate effect (I falls) the exchange-rate effect (NX falls)

Economic Fluctuations

Caused by events that shift the AD and/or AS curves.

three facts about economic fluctuations

1- economic fluctuations are irregular and unpredictable 2- most macroeconomic qualities fluctuate together 3- as output falls, unemployment rises

Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eq'm to new LR eq'm.

Changes in NX examples

Booms/recessions in countries that buy our exports Appreciation/depreciation resulting from international speculation in foreign exchange market

Changes in G examples

Federal spending, e.g., defense State & local spending, e.g., roads, schools

Changes in I examples

Firms buy new computers, equipment, factories Expectations, optimism/pessimism Interest rates, monetary policy Investment Tax Credit or other tax incentives

2. The Sticky-Price Theory

Imperfection: Many prices are sticky in the short run. Due to menu costs, the costs of adjusting prices. Examples: cost of printing new menus, the time required to change price tags Firms set sticky prices in advance based on PE. Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively low, which increases demand for their products,so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

1. The Sticky-Wage Theory

Imperfection: Nominal wages are sticky in the short run,they adjust sluggishly. Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. .

What the 3 SRAS Theories Have in Common.

In all 3 theories, Y deviates from YN when P deviates from PE. Y = Yn + a(P-Pe)

Changes in K or H

Investment in factories, equipment More people get college degrees Factories destroyed by a hurricane

Which of the following decreases in response to the interest-rate effect from an increase in the price level? a. both investment and consumption b. consumption but not investment c. investment but not consumption d. neither investment nor consumption

a. both investment and consumption

17. Wages tend to be sticky a. because of contracts, social norms, and notions of fairness. b. because of contracts, but not social norms or notions of fairness. c. because of social norms and notions of fairness, but not contracts. d. None of the above are correct.

a. because of contracts, social norms, and notions of fairness.

14. Other things the same, if the price level falls, people a. increase foreign bond purchases, so the supply of dollars in the market for foreign-currency exchange increases. b. increase foreign bond purchases, so the supply of dollars in the market for foreign-currency exchange decreases. c. decrease foreign bond purchases, so the supply of dollars in market for foreign-currency exchange increases. d. decrease foreign bond purchases, so the supply of dollars in the market for foreign-currency exchange decreases.

a. increase foreign bond purchases, so the supply of dollars in the market for foreign-currency exchange increases. As the price level falls, the interest rates decrease. Foreign interest rates are relatively higher, so to buy them supply of dollars has to increase.

20. According to the misperceptions theory of aggregate supply, if a firm thought that inflation was going to be 5 percent and actual inflation was 6 percent, then the firm would believe that the relative price of what it produce had a. increased, so it would increase production. b. increased, so it would decrease production. c. decreased, so it would increase production. d. decreased, so it would decrease production.

a. increased, so it would increase production. P<PE, then the firm would believe that the relative price increased, so it would increase production.

10. If the price level falls, the real value of a dollar a. rises, so people will want to buy more. This response helps explain the slope of the aggregate demand curve. b. rises, so people will want to buy more. This response shifts aggregate demand to the right. c. falls, so people will want to buy less. This response helps explain the slope of the aggregate demand curve. d. falls, so people will want to buy less. This response shifts aggregate demand to the left.

a. rises, so people will want to buy more. This response helps explain the slope of the aggregate demand curve. If P falls, the real value of a dollar, 1/P, rises. Purchasing power of consumers increases. So, consumers demand more.

Suppose a stock market crash makes people feel poorer. This decrease in wealth would induce people to a. decrease consumption, which shifts aggregate supply left. b. decrease consumption, which shifts aggregate demand left. c. increase consumption, which shifts aggregate supply right. d. increase consumption, which shifts aggregate demand right.

b. decrease consumption, which shifts aggregate demand left.

19. Other things the same, if the money supply rises by 2% and people were expecting it to rise by 5%, then some firms have a. higher than desired prices which increases their sales. b. higher than desired prices which depresses their sales. c. lower than desired prices which increases their sales. d. lower than desired prices which depresses their sales.

b. higher than desired prices which depresses their sales. If the money supply rises by 2% and people were expecting it to rise by 5%, it means actual prices are lower than expected prices, P<PE. So output should decrease, Y<YN.

18. The sticky-wage theory of the short-run aggregate supply curve says that when the price level is lower than expected, a. relative to prices wages are higher and employment rise. b. relative to prices wages are higher and employment falls. c. relative to prices wages are lower and employment rises. d. relative to prices wages are lower and employment falls.

b. relative to prices wages are higher and employment falls. When P<PE, actual output is below the potential output, Y<YN. So employment falls.

Which of the following would both shift aggregate demand right? a. the price level decreases and government expenditures increase b. the price level decreases and the government repeals an investment tax credit c. government expenditures increase and the money supply increases d. None of the above are correct.

c. government expenditures increase and the money supply increases

Which of the following shifts both the short-run and long-run aggregate supply right? a. an increase in the actual price level b. an increase in the expected price level c. an increase in the capital stock d. None of the above is correct.

c. an increase in the capital stock

According to the aggregate demand and aggregate supply model, in the long run an increase in the money supply leads to a. increases in both the price level and real GDP. b. an increase in real GDP but does not change the price level. c. an increase in the price level but does not change real GDP. d. no change in either the price level or real GDP.

c. an increase in the price level but does not change real GDP.

13. When the price level falls a. people want to hold more money. b. the interest rate rises. c. investment spending rises. d. All of the above are correct.

c. investment spending rises. According to the interest rate effect, decrease in prices decreases the interest rates. Investment spending increases.

12. As the price level falls a. people will want to buy more bonds, so the interest rate rises. b. people will want to buy fewer bonds, so the interest rate falls. c. people will want to buy more bonds, so the interest rate falls. d. people will want to buy fewer bonds, so the interest rate rises.

c. people will want to buy more bonds, so the interest rate falls. As the price level falls, real wealth increases. Increase in real wealth will increase the demand for bonds, increase bond prices. That will decrease the interest rates.

5. According to classical macroeconomic theory, changes in the money supply affect a. real GDP and the price level. b. real GDP but not the price level. c. the price level, but not real GDP. d. neither the price level nor real GDP.

c. the price level, but not real GDP. Remember, M*V=P*Y, an example of classical dichotomy. Change in the money supply affect price level but not real GDP

The aggregate demand curve shifts right if either a. speculators gain confidence in U.S. assets or foreign countries enter into recession. b. speculators gain confidence in U.S. assets or recessions in foreign countries end. c. speculators lose confidence in U.S. assets or foreign countries enter into recession. d. speculators lose confidence in U.S. assets or recessions in foreign countries end.

d- .speculators lose confidence in U.S. assets or recessions in foreign countries end.

Which of the following effects helps to explain the slope of the aggregate-demand curve? a. the exchange-rate effect b. the wealth effect c. the interest-rate effect d. All of the above are correct.

d. All of the above are correct.

Other things the same, an increase in the price level makes the dollars people hold worth a. more, so they can buy more. b. more, so they can buy less. c. less, so they can buy more. d. less, so they can buy less.

d. less, so they can buy less.

As the price level rises, the exchange rate a. falls, so exports rise and imports fall. b. falls, so exports fall and imports rise. c. rises, so exports rise and imports fall. d. rises, so exports fall and imports rise.

d. rises, so exports fall and imports rise.

8. Which of the following is included in the aggregate demand for goods and services? a. consumption demand b. investment demand c. net exports d. All of the above are correct.

d. All of the above are correct.

The long-run aggregate supply curve shifts right if a. immigration from abroad increases. b. the capital stock increases. c. technology advances. d. All of the above are correct.

d. All of the above are correct.

9. Which of the following effects helps to explain the slope of the aggregate-demand curve? a. the exchange-rate effect b. the wealth effect c. the interest-rate effect d. All of the above are correct.

d. All of the above are correct. 3 effects, the wealth effect, the interest-rate effect, and the exchange-rate effect explain the slope of the aggregate-demand curve

2. Which of the following is correct? a. Economic fluctuations are easily predicted by competent economists. b. Recessions have never occurred very close together. c. Spending, income, and production do not fluctuate closely with real GDP. d. None of the above is correct.

d. None of the above is correct. Economic fluctuations are almost impossible to predict. Recessions have occurred very close together in 70's and 80's. Spending, income, and production fluctuate closely with real GDP

1. Which of the following is correct? a. Short run fluctuations in economic activity happen only in developing countries. b. During economic contractions most firms experience rising sales. c. Recessions come at regular intervals and are easy to predict. d. When real GDP falls, the rate of unemployment rises.

d. When real GDP falls, the rate of unemployment rises. Fact #3 about cycles, when GDP falls, unemployment rises.

Financial Crisis Suppose that banks are less able to raise funds and so lend less. Consequently, because people and households are less able to borrow, they spend less at any given price level than they would otherwise. The crisis is persistent so lending should remain depressed for some time. Refer to Financial Crisis. What happens to the price level and real GDP in the short run? a. both the price level and real GDP rise b. the the price level level rises and real GDP falls c. the the price level level falls and real GDP rises d. both the price level and real GDP fall

d. both the price level and real GDP fall

According to the misperceptions theory of the short-run aggregate supply curve, if a firm thought that inflation was going to be 4 percent and actual inflation was 2 percent, then the firm would believe that the relative price of what it produces had a. increased, so it would increase production. b. increased, so it would decrease production. c. decreased, so it would increase production. d. decreased, so it would decrease production.

d. decreased, so it would decrease production.

6. Most economists believe that classical macroeconomic theory is a good description of the economy a. in neither the short nor long run. b. in the short run and in the long run. c. in the short run, but not in the long run. d. in the long run, but not in the short run.

d. in the long run, but not in the short run. Keynesian economy describes short-run economy well, but classical economy works in the long-run.

16. When taxes decrease, consumption a. decreases as shown by a movement to the left along a given aggregate-demand curve. b. decreases as shown by a shift of the aggregate demand curve to the left. c. increases as shown by a movement to the right along a given aggregate-demand curve. d. increases as shown by a shift of the aggregate demand curve to the right.

d. increases as shown by a shift of the aggregate demand curve to the right. Decrease in taxes, increases the real income. So Aggregate demand increases, demand curve shifts right.

3. Recession come at a. regular intervals. During recessions consumption spending falls relatively more than investment spending. b. regular intervals. During recessions investment spending falls relatively more than consumption spending. c. irregular intervals. During recessions consumption spending falls relatively more than investment spending. d. irregular intervals. During recessions investment spending falls relatively more than consumption spending.

d. irregular intervals. During recessions investment spending falls relatively more than consumption spending. Recessions are irregular and investment spending is the most volatile component of the GDP.

The sticky-wage theory of the short-run aggregate supply curve says that when the price level is lower than expected, a. production is more profitable and employment rises. b. production is more profitable and employment falls. c. production is less profitable and employment rises. d. production is less profitable and employment falls.

d. production is less profitable and employment falls.

4. The classical dichotomy refers to the separation of a. variables that move with the business cycle and variables that do not. b. changes in money and changes in government expenditures. c. decisions made by the public and decisions made by the government. d. real and nominal variables.

d. real and nominal variables. Classical dichotomy says that change in monetary variables affect nominal variables but not real variables. So it separates real and nominal variables.

11. The aggregate quantity of goods and services demanded changes as the price level falls because a. real wealth falls, interest rates rise, and the dollar appreciates. b. real wealth falls, interest rates rise, and the dollar depreciates. c. real wealth rises, interest rates fall, and the dollar appreciates. d. real wealth rises, interest rates fall, and the dollar depreciates.

d. real wealth rises, interest rates fall, and the dollar depreciates. When P falls, real wealth rises. When P falls, interest rates fall, remember the fisher equation, nominal interest rates= real interest rates + inflation When interest rates fall, domestic assets become less attractive, so demand for dollar falls and the dollar depreciates.

15. As the price level rises, the exchange rate a. falls, so exports rise and imports fall. b. falls, so exports fall and imports rise. c. rises, so exports rise and imports fall. d. rises, so exports fall and imports rise.

d. rises, so exports fall and imports rise. According to the interest-rate effect, increase in prices increase the interest rates, foreigners increase their demand for U.S. assets, so dollar will gain value (appreciates). Exports will become more expensive (exports fall) and imports will become cheaper (imports rise).

7. Aggregate demand includes a. only the quantity of goods and services households want to buy. b. only the quantity of goods and services households and firms want to buy. c. only the quantity of goods and services households, firms, and the government want to buy. d. the quantity of goods and services households, firms, the government, and customer abroad want to buy.

d. the quantity of goods and services households, firms, the government, and customer abroad want to buy. Aggregate Demand=Y=C+I+G+NX, so it includes the quantity of goods and services households, firms, the government, and customer abroad want to buy.