Macroeconomics Test III
American Recovery and Reinvestment Act of 2009
$700 billion bailout package to create new jobs, save existing ones, spur economic activity, and invest in long—term infrastructure development, somewould be spent directly by the federal government and other funds were supplied to state governments
example: Government spends $20 billion on Boeing airplanes
- Boeing's revenue rises by $20 billion - Boeing can use revenue to give out wages, stock dividends, etc. - Consumers receiving wages/dividends/etc can spend new income on other goods and services - leads to right shift in aggregate demand calculation: - govt purchases are $20 billion -MPC is 0.8 = $80/$100 -spending multiplier = 1/1-0.8 = 1/0.2= 5 - 5 times 20 = $100 billion shift in aggregate demand rightwards
shifts along Philips curve
- Fed monetary policy
Policy response to Great Recession
- Federal Reserve reduces federal funds rate to near zero - Fed purchases mortgages and other private loans to expand money supply - Treasury injects capital into banking system to increase bank liquidity and stop credit crunches - Government increases spending and reduces taxes
changes in labour
- Immigration (increase in labour --> increase in Yn) - large scale retirements (baby boomers retiring) - government policies reducing/increase natural rate of unemployment
Impact on money market: Credit card availability increases, which reduces cash on hand
- MD shifts left, r falls
example: An economy requires $200 billion increase in AD to end a recession
- MPC = 0.8 - spending multiplier is therefore equal to 5 200/5 = 40 billion - $40 billion would need to be spent by the government to shift the AD curve by $200 billion in this economy
Impact on money market: Fed buys/purchases bonds in open-market operations
- MS shifts right, r falls
Impact on money market: Fed reduces reserve requirement
- MS shifts right, r falls
If the Fed increases the money supply unexpectedly,
- P will rise in the long run - in short run, firms with menu costs will wait to raise prices (low prices will increase demand along with output and employment) - higher P is associated with higher Y since SRAS is upward sloping
If the interest rate < equilibrium,
- Qdemand is greater than Qsupply so it causes a shortage of money - lower interest rates lead to higher money holdings -leads to new equilibrium with - shifts ALONG aggregate demand curve, causing fall
If the interest rate > equilibrium,
- Qdemanded is lower than Qsupply, leading to a shortage of money - people holding surplus money will buy interest-bearing assets which lowers the interest rate - This causes people to hold more money and create a new equilibrium
Canadian stock boom, effect on US
- affects net exports and aggregate demand - shifts AD curve right - short run Y and P rise - in LR, Y returns to Yn but P rises
example: Recession reduces demand for net exports by $10 billion
- aggregate demand falls initially by $10 billion - MPC = 0.8 - spending multiplier is therefore equal to 5 -5 times 10 equals 50 - there will be a $50 billion dollar decrease in aggregate demand (shifts leftward)
stock market crash
- aggregate demand problem (affects consumer wealth) - shifts AD to the left - Y and P both fall, based on the graph -in LR, Y shifts back to equilibrium but P falls
COVID-19 pandemic
- aggregate demand problem (people are cutting expenditures) - AD shifts left - in SR, Y and P both fall - in LR, Y returns to normal, but P falls
changes in technological progress
- better technology/efficiency - most important to us, shifts LRAS to the right a ton
example of crowding-out effect
- change in Y due to government purchases will increase money demand, which increases r (since MS stays the same) - since r rises, there will be less overall investment spending and consumption, so it shifts the curve slightly leftward
What shifts the long-run aggregate supply curve?
- changes in technological progress - changes in physical/human capital -changes in natural resources - changes in labour
Fed response to a stock boom
- decrease MS and increase r (purpose is to stabilize output and price level)
tax hikes
- decrease household wealth - decreases AD by reducing consumption - size of AD shift depends on multiplier and crowding out effects - there shouldn't be much crowding out effect since this is contractionary fiscal policy
How to analyze economic fluctuations?
- determine whether aggregate supply or aggregate demand shifts - identify direction of the shift - notice shift effects on short run Y and P - use AS and AD diagram to move short-run equilibrium back to long-run equilibrium
People respond to incentives
- example would be a tax cut - incentive to work increases Qg+s supplied, shifting the AS curve right
Suppose the Fed convinces everyone it is committed to reducing inflation
- expected inflation falls, Philips curve shifts downwards -disinflations can cause less unemployment that predicted by sacrifice ratio
Examples of Changes in G
- federal, state, or local spending
Employment Act of 1946
- government policy to promote maximum employment, production, and purchasing power - government should avoid being cause fluctuations - government should respond to changes in AD in private economy
Policymakers can either
- have a low unemployment rate with high inflation OR - have a low inflation rate with higher unemployment
Accommodating supply shocks
- if government does not intervene, supply shock will cause wages to fall but prices will return to to normal level at LRAS - if government intervenes through fiscal and monetary policy, SRAS will return to Yn but the P will rise
Fed response to stock market crash
- increase MS and decrease r (purpose is to stabilize output and price level)
tax cuts
- increase household wealth - increases AD by increasing consumption - size of AD shift depends on multiplier and crowding out effects - HOUSEHOLD PERCEPTION IS IMPORTANT FACTOR TOO-
Oil Prices Rise
- increase in costs, which affects aggregate supply - shifts SRAS left leading to a period of stagflation - in short run, Y decreases but P increases - in LR, Y returns to Y1, but at higher P
changes in human and physical capital
- investment in factories or equipment - more/less college degrees - natural disasters destroy factories
Raising the interest rate
- makes it less attractive to own stocks since bonds now earn higher return - reduces demand for gods and services - stock prices go down
Case against stabilization policy
- monetary policy affects economy with a lag - Firms make plans in advance so investment takes time to respond to interest rate - Fiscal policy also operates with a lag - legislative process takes time and compromises - this could lead to counterintuitive policies if the
1960s inflation
- policymakers opt for reduced unemployment at expense of inflation - fiscal policy funding Vietnam War - Fed enacted expansionary fiscal policy - leads to strong aggregate demand growth
If P > Pexpected
- revenue is higher, but labor cost is not - more profitable production increases output and employment
If P < Pexpected
- revenue is lower, but labour cost is not - less profitable production reduces output and employment
Example: stock market boom increases household wealth
- short run effect: increases AD and Y - Fed responds by increasing r and lowering MS
Example: Congress balances the budget by reducing government spending
- short run effect: reduces AD and Y - Fed responds by increasing MS and lowering r
Example: A war in the Middle East increases the price of oil
- short run: reduces AD and Y - Fed responds by increasing MS and lowering r
Examples of Change in C
- stock booms or crashes - tax hikes or cuts
shifts of Philips curve
- supply shocks - expectations - anything that changes natural rate of unemployment
Examples of Change in I
- technological progress for firms - expectations (optimism or pessimism) - interest rate - monetary policy changes - Investment Tax Credit/tax incentives
Example: Fed reduces money supply
- this raises interest rate by shifting MS curve left - increase in r decrease Qdemanded for goods and services -shifts AD curve left
Examples of Changes in NX
-Booms/recessions in countries that buy our exports -Appreciation/depreciation resulting from international speculation in foreign exchange market
changes in natural resources
-discovery of new mineral deposits -reduction in supply of imported oil -changing weather patterns that affect agricultural production
Why does the Fed watch the stock market?
-fluctuations in the stock prices are signs of broader economic development - stock prices are a forward-looking variable (predictor) ex. Economic Boom of 1990s - rapid GDP growth and falling u-rate - indicated by rising stock prices ex. Great Recession of 2008 - indicated by falling stock prices (lost 1/2 of value)
Great Recession of 2008
-housing market had low interest rates, easier access to credit, and government encouragement leads to riskier mortgage-backed securities - rising home prices lead to defaults and foreclosures across the country, and the newly foreclosed homes bring down prices - contraction in the aggregate demand - multiple industries hurt significantly like construction - Y falls significantly, and u-rate increases
Three facts about economic fluctuations
1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantities fluctuate together 3. As output falls, unemployment rises
spending multiplier
1/(1-MPC)
estimate sacrifice ratio
5%
contractionary fiscal policy
A decrease in government spending or an increase in taxes - shifts AD to left
inflation
A general and progressive increase in prices
stagflation
A period of falling output and rising prices
Disinflation
A reduction in the rate of inflation. Economy still facing inflation but at a declining rate. - requires enduring high unemployment and low output
business cycle
Alternating periods of economic expansion and economic recession; fluctuations in the economy
supply-side economics
An economic philosophy that holds the sharply cutting taxes will increase the incentive people have to work, save, and invest. Greater investments will lead to more jobs, a more productive economy, and more tax revenues for the government.
expansionary fiscal policy
An increase in government spending or a reduction in taxes - shifts AD to right
supply shock
An unexpected event that causes the short-run aggregate supply curve to shift
What are the determinants of aggregate demand?
Consumer spending, investment spending, government spending, net export spending
Greenspan Era
Fed Chairman Alan Greenspan in 1987 - favorable supply shock for OPEC in 86' - falling inflation, unemployment, and no more stagflation - Gulf War causes inflation to rise, but unemployment to fall; unemployment rises right after war and supply shock - 1990s are period of economic prosperity (low inflation and low unemployment) - 2001 Tech Bubble Burst depresses aggregate demand, increases unemployment, and leads to expansionary fiscal and monetary policy - 2003-2006 experiences low unemployment due to expansionary fiscal policy
Ben Bernanke
Fed Chairman Ben Bernanke, 2006 2007 Recession - Booming housing market since 1990s collapses with prices falling by 1/3 - declines n household wealth and aggregate demand - Financial institutions suffer due to presence of mortgage-backed securities - steep increase in unemployment 2007-2010 - rising unemployment, low inflation 2010-2015 - steep economic recovery -unemployment returns to near normal, though some people become discouraged workers
Volcker Disinflation
Fed Chairman Paul Volcker - Appointed in late 1979 under high inflation & unemployment - Changed Fed policy to disinflation - Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce inflation. Success: Inflation fell from 10% to 4%, but at the cost of high unemployment - illustrates high costs of disinflation in short run, but beneficial in long run
misperceptions theory
Firms may confuse changes in P with changes in the relative price of the products they sell - if P > Pe, a firm sees its price rise before realizing all prices are rising - the firm may believe its relative prices are rising and may increase output and employment as a result
federal funds rate
Interest rate banks charge each other for short term loans
Keynesian presidents
JFK - advocated for tax cuts, investment tax credits, Obama - American Recovery and Reinvestment Act
theory of liquidity preference
Keynes's theory that the interest rate adjusts to bring money supply and money demand into balance
wealth effect
The tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls. - if P declines, this increases the value of money which means higher consumption and quantity demanded of goods and services
philips curve equation
Urate = Unatural - a (actual inflation - expected inflation)
GDP equation
Y = C + I + G + NX
output equation
Y = Yn + a (P - Pexpected)
Productivity function
Y =A f(K, H, N, L)
Variables that influence money demand
Y, r, and P
Can government spending affect the aggregate supply curve as well?
Yes -infrastructure (better roads can lead to more productivity) - however, these policies are more long term
aggregate supply curve
a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level
Aggregate Demand Curve
a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level
long-run aggregate supply curve
a curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied
short-run aggregate supply curve
a curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms
Philips Curve
a curve that shows the short-run trade-off between inflation and unemployment
crowding out
a decrease in investment that results from government borrowing
The money demand curve is
a downward sloping curve that shows the relationship between the quantity of money demanded and the interest rate
exchange rate effect
a lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports
expected inflation
a measure of how much people expect the price level to change
Recession
a period of declining real incomes and rising unemployment (supply exceeds demand)
depression
a severe recession
liquidity trap
a situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound - Fed uses other measures to stimulate economy -AD, production, and employment trapped at low levels
The money supply curve is
a vertical line that shows the relationship between the quantity of money supplied and the interest rate
supply shocks affect the
aggregate supply curve and short-run Philips curve
The MD curve slopes downwards because
as the interest rate falls, the demand for money rises because there is no reason to invest money in bonds at low interest rates so people prefer to hold more in currency; high interest rates means that people will want to accrue interest on bonds so less people want liquid money
Marginal Propensity to Consume (MPC)
change in consumption/change in income
automatic stabilizers
changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action - tax systems, government spending programs,
What can shift the AD curve?
changes in the C, I, or NX of an economy EXCEPT CHANGES IN P
To reduce AD, the Fed must pursue
contractionary monetary policy
selling government bonds
contractionary monetary policy
An increase in r will
decrease money demand
The sacrifice ratio can be spread out over time
example: to reduce inflation by 6%, 30% of the GDP must be sacrificed - either do 30% reduction over one year OR - 10% reduction for three years
buying government bonds
expansionary monetary policy
Budget deficits lead to
higher interest rates; decreased aggregate supply
interest rate effect
if price levels fall, buying goods and services requires less money, which increases spending on assets and bonds, investment goods, all of which shifts the quantity demanded for goods and services
current economic climate
in 2018, u-rate was 4% and inflation rate was near 2.4% - flat Philips curve due to inflation expectations 2020 coronavirus pandemic will increase unemployment and reduce aggregate demand and aggregate supply, decreases output
To decrease aggregate demand using monetary policy
increase interest rates and lower money supply
An increase in P will
increase money demand
An increase in Y will
increase money demand
A stock market boom
increases AD - household wealth increases, leading to higher consumption - firms seek to sell more shares of stock to stimulate investment
in the short run, the Fed can reduce the unemployment rate by
increasing the actual inflation rate (beyond the expected rate)
Misery Index =
inflation rate + unemployment rate
If the event changes price level, then
it moved along aggregate demand curve
If the event does not change price level, then
it shifts the aggregate demand curve
If a tax cut is permanent,
it will have a larger effect on AD shift
If a tax cut is temporary,
it will have a smaller effect on AD shift
Classical dichotomy assumptions only apply in the
long run
To increase aggregate demand using monetary policy
lower interest rates and increase money supply
Budget surpluses lead to
lower interest rates; increased aggregate supply
The interest rate effect has the
most important effect on the US economy
sticky wage theory
nominal wages are slow to adjust to changing economic conditions - sluggish changes are due to labour contracts and social norms - firms and workers set nominal wages in advance based on price level they expect to prevail (use CPI for this)
crowding-out effect
occurs when expansionary fiscal policy raises the interest rate - reduces investment spending - reduces net increase in aggregate demand - curve shift becomes smaller than initial shift
credit crunch
occurs when there is a lack of funds available in the credit market, making it difficult for borrowers to obtain financing, and leads to a rise in the cost of borrowing
sacrifice ratio
percentage points of annual output lost per 1 percentage point reduction in inflation change in Y (%)/ change in inflation by 1%
quantitative easing
purchase of a large variety of financial assets and instruments to stimulate economy (mortgages, corporate debt, long-term government bonds)
forward guidance
raise inflation expectations by committing to keep interest rates low
A stock market crash
reduces AD - household wealth decreases, leading to less consumption - firms sell fewer shares of stock
Wages are related to the
short run aggregate supply curve
Automatic stabilizers include all of the following except: a. unemployment insurance b. social security c. welfare d. pay-as-you-go tax system
social security
As MPC increases,
spending multiplier increases
change in output =
spending multiplier times government purchases (can also be net exports, etc.)
investment tax credit (ITC)
tax breaks to firms that invest in new capital
multiplier effect
the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
Aggregate Demand
the amount of goods and services in the economy that will be purchased at all possible price levels
natural rate of output (Yn)
the amount of output the economy produces when unemployment is at its natural rate (also known as potential output or full-employment output)
money demand
the amount that households and firms want to hold in currency and deposits - preference for liquidity - assumes only two assets in household wealth: currency and bonds
natural rate hypothesis
the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation (proposed by Friedman and Phelps)
money market
the equilibrium of the market is found when MS = MD, which also has an equilibrium interest rate
Short-Run Phillips Curve (SRPC)
the negative short-run relationship between the unemployment rate and the inflation rate
sticky price theory
the prices of some goods and services also adjust sluggishly in response to changing economic conditions - due to menu costs - firms set sticky prices in advance based on Pexpected
money supply
the quantity of money available in the economy
fiscal policy
the setting of the level of government spending and taxation by government policymakers
Aggregate Supply
the total amount of goods and services in the economy available at all possible price levels
stabilization policy
the use of government policy to reduce the severity of recessions and rein in excessively strong expansions - Keynes argues that fluctuations would become destabilizing if not handled by policy - caused by booms/busts abroad, stock market booms/crashes, rising/falling prices
rational expectations theory
theory in which people optimally use all the information they have - includes information on government policy when forecasting the future - implied disinflation could be much less costly - believes true sacrifice ratio is smaller than estimate
Long Run Philips Curve (LRPC)
there is no relationship between inflation and unemployment in the long run, making the LRPC a straight line
in the short run, there is a
tradeoff between unemployment and inflation
In the long run, unemployment and inflation are
unrelated
Fed policies
uses monetary policy to shift AD curve using money supply, specifically federal funds rate
Disinflationary Monetary Policy
• Contractionary monetary policy moves economy from A to B. • Over time, expected inflation falls, PC shifts downward. • In the long run, point C: the natural rate of unemployment, lower inflation.