Econ Exam 4

classical dichotomy in the short run

during the time horizon over which prices are sticky, the classical dichotomy no longer holds - nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the classical model.

The business cycle

economy-wide fluctuations in output, incomes, and employment.

Marginal Propensity to Consume (MPC)

-The increase in consumption resulting from a one-dollar increase in disposable income -The Slope for Planned expenditure is positive because holding all else constant, higher income leads to higher consumption and thus higher planned expenditure and vice versa and it is equal to the MPC because it shows how much consumption and therefore planned expenditure increase when income increases by $1

Shocks

-Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels.

putting together the IS-LM model

-The IS−LM model combines the elements of the Keynesian cross and the elements of the theory of liquidity preference. The IS curve shows the points that satisfy equilibrium in the goods market, and the LM curve shows the points that satisfy equilibrium in the money market -The intersection of the ISand LMcurves shows the interest rate and income that satisfy equilibrium in both markets for a given price level.

Putting it all together Keynesian Cross

-The Keynesian cross assumes the economy is in equilibrium when actual expenditure equals planned expenditure. -Focusing on investment, planned investment is fixed and exogenous, and it equals actual investment ONLY at the equilibrium level of income, output in the Keynesian cross. -at points other than equilibrium, firms are selling more or less than anticipated and are consequently running down or building up their inventories, so the difference between actual expenditure and planned expenditure is unplanned inventory investment -When that difference is positive (Y>PE), actual investment is greater than planned investment because firms are selling less than anticipated and are facing unplanned inventory accumulation. Which leads firms to decrease production and fire workers -When that difference is negative (Y <PE), actual investment is less than planned investment because firms are selling more than anticipated and are facing unplanned inventory depletion. Which leads firms to increase production and hire workers

boost from tax multiplier vs government multiplier

the tax multiplier is smaller in absolute value than the government-purchases multiplier because when given a tax cut, consumers save 1-MPC of the increase in disposable income, so the initial boost in spending is smaller than that from an increase in government purchases

Common features of the business cycle

when GDP growth declines, consumption growth falls (typically by a smaller amount), investment growth falls (typically by a larger amount), and unemployment rises.

The classical dichotomy

The theoretical separation of real and nominal variables in the classical model, which implies that nominal variables do not influence real variables. -According to the classical model, the money supply affects nominal variables but not real variables. -the theoretical separation of real and nominal variables is called the classical dichotomy, and the irrelevance of the money supply for the determination of real variables is called monetary neutrality. -Most economists believe this is true in the long run

IS-LM Models

-A model of aggregate demand that shows what determines aggregate income for a given price level by analyzing the interaction between the goods market and the money market. -two components: the IS curve, where IS stands for investment and saving, which represents equilibrium in the goods market and the LM curve, where LM stands for liquidity and money, which represents equilibrium in the money market -both are linked by the interest rate as it affects both investment and money demand -shows that the interaction between the goods market and the money market determines the position and slope of the aggregate demand curve and, therefore, the level of national income in the short run. -is based on an analysis of equilibrium in the goods market and equilibrium in the money market, supposing that the price level is fixed -can be interpreted in two ways: as a theory of income determination that shows what causes income to change in the short run, when the price level is fixed and as a theory of aggregate demand that shows what causes the aggregate demand curve to shift

actual expenditure

-Actual expenditure is the amount households, firms, and the government SPEND on goods and services: -- actual expenditure= C+actual investment+G -Drawing on the graph, actual expenditure occurs along a 45 ° line with output, income on the x-axis and actual expenditure on the y-axis.

Supply shocks

-Adverse supply shocks put upward pressure on firms' production costs and therefore the prices they charge for their products, while favorable supply shocks do the opposite. Therefore they are sometimes called price shocks

Demand Shocks

-As we saw earlier, when prices are sticky, exogenous shocks to aggregate demand cause output and employment fluctuations, which are considered costly and undesirable -Rather than waiting for prices to adjust and return the economy to a long-run equilibrium, the Fed could keep output and employment closer to their natural levels by changing the money supply to offset shocks to aggregate demand. -Specifically, the Fed could offset a decrease in aggregate demand by increasing the money supply and the Fed could offset an increase in aggregate demand by decreasing the money supply

Long Run Aggregate Supply

-In the long run, the aggregate supply curve is vertical because output is determined by the amounts of capital and labor and by the available technology but not by the level of prices. Therefore, shifts in aggregate demand affect the price level but not output or employment. -Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon. -The classical model describes how the economy behaves in the long run, so we derive the long-run aggregate supply curve from the classical model. -According to the classical model, output does not depend on the price level , so the long-run aggregate supply curve is vertical -shifts in the aggregate demand curve- including shifts caused by a change in monetary policy-affect the price level but not the level of output or the unemployment rate

short-run aggregate supply curve

-In the short run, the aggregate supply curve is horizontal because wages and prices are sticky at predetermined levels. Therefore, shifts in aggregate demand affect output and employment. -At these prices firms: are willing to sell as much as their customers are willing to buy and hire exactly the amount of labor necessary to produce the quantity demanded -the intersection of the aggregate demand curve and the short-run aggregate supply curve determines the level of output -shifts in the aggregate demand curve-including shifts caused by a change in monetary policy-affect the level of output and therefore the unemployment rate but not the price level -Over time, prices gradually become "unstuck," and the adjustment of prices moves the economy back to a long-run equilibrium at which the aggregate demand curve intersects both the long-run aggregate supply curve and the short-run aggregate supply curve .

The breakdown of the IS Curve

-The negative relationship between the interest rate and the level of income that arises in the market for goods and services. -The combination of the Keynesian cross and the investment function is called the IS curve, which is a graph of all combinations of the interest rate and income that result in equilibrium in the market for goods and services -shows, for any given interest rate, the level of income that brings the goods market into equilibrium, holding the fiscal policy variables G and T constant. -The IScurve shows the combinations of the interest rate and income that are consistent with equilibrium in the market for goods and services. The IScurve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the curve to the right. Changes in fiscal policy that reduce the demand for goods and services shift the IScurve to the left.

The breakdown of the LM Curve

-The positive relationship between the interest rate and the level of income (while holding the price level fixed) that arises in the market for real money balances. -The combination of the theory of liquidity preference and the money demand function is called the curve, which is a graph of all combinations of the interest rate and income that result in equilibrium in the market for real money balances. -shows, for any given level of income, the interest rate that brings the money market into equilibrium, holding the monetary policy variable M constant -The LM curve shows the combinations of the interest rate and income that are consistent with equilibrium in the market for real money balances. The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve upward. Increases in the supply of real money balances shift the curve downward.

Effect of monetary policy on interest rates

-The theory of liquidity preference is supported by the data in the SHORT RUN: a decrease in the money supply decreases the supply of real money balances and increases nominal interest rates when the price level is fixed (and vice versa) -The Fisher effect is supported by the data in the LONG RUN: a decrease in the money supply eventually - as prices become unstuck - decreases expected inflation and, therefore, nominal interest rates (and vice versa) -Once we allow the demand for real money balances to depend on national income, the theory of liquidity preference yields a relationship between income and the interest rate. -A higher income raises the demand for real money balances, and this in turn raises the interest rate. The upward-sloping ! curve summarizes this positive relationship between income and the interest rate. -, the theory of liquidity preference and the money demand function tell us that the interest rate increases when income increases, and vice versa.

Keynsian cross

-a basic model of income determination. It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that changes in fiscal policy have a multiplied impact on income - in the short run, an economy's total income is determined mostly by the spending plans of households, firms, and the government -the more goods and services firms can sell, the more output they produce and the more workers they hire and the more output firms produce and the more workers they hire, the higher the economy's total income

theory of liquidity preference

-a basic model of the determination of the interest rate. It takes the money supply and the price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances. -in the short run, an economy's interest rate adjusts to balance the supply and demand for the economy's most liquid asset: money. -The demand for real money balances is downward-sloping because, holding all else constant, as the interest rate increases, people want to hold less of their wealth in the form of money, and vice versa. -Together, the supply and demand for real money balances determine the equilibrium interest rate. - If interest rate is greater than equilibrium interest rate, quantity of real money balances supplied < quantity of real money balances demanded • individuals try to obtain money by selling bonds or making bank withdrawals • to attract now-scarcer funds, banks and bond issuers raise the interest rates they offer • this process continues until the equilibrium interest rate is reached -If interest rate is less than equilibrium interest rate, quantity of real money balances supplied > quantity of real money balances demanded • individuals holding the excess supply of money try to convert it into interest-bearing assets • this gives banks and bond issuers the ability to lower the interest rates they offer • this process continues until the equilibrium interest rate is reached

The AD/AS model

-is the model most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy -shows how the price level and aggregate output are determined -shows how the economy's behavior is different in the short run and in the long run

Aggregate Demand Curve

-slopes downward. It tells us that the lower the price level, the greater the aggregate quantity of goods and services demanded. Negative relationship between price level and output -holding all else constant, an increase in the price level causes a decrease in the quantity of goods and services demanded , and vice versa. - the possible combinations of price level and output for a given value of the money supply . If the central bank changes the money supply, then the possible combinations of output and price levelchange, so the aggregate demand curve shifts. -

Keynesian Cross and interest rates

-the Keynesian cross yields a relationship between the interest rate and national income. -A higher interest rate lowers planned investment, and this in turn lowers national income. The downward-sloping & curve summarizes this negative relationship between the interest rate and income. -Together, the Keynesian cross and the investment function tell us that income increases when the real interest rate ' decreases, and vice versa.

planned expenditure

-the amount households, firms, and the government PLANNED TO SPEND on goods and services - PE= C(Y-T)+ planned investment+ G -

Okun's Law

The negative relationship between unemployment and real GDP, according to which a decrease in unemployment of 1 percentage point is associated with additional growth in real GDP of approximately 2 percent.

Neutrality of money

Neutrality of money: The property that a change in the money supply does not influence real variables.

nominal variables vs real variables

Nominal: Variables measured in current dollars; variables not adjusted for inflation. Real: Variables measured in constant dollars; variables adjusted for inflation.

long run vs the short run

The crucial difference between how the economy works in the long run and how it works in the short run is that prices are flexible in the long run but sticky in the short run.

flexible vs sticky prices

flexible: Prices that adjust quickly to equilibrate supply and demand. Happens in the long run sticky: Prices that adjust sluggishly and, therefore, do not always equilibrate supply and demand. Happens in the short run