macro 3

What does the Long-Run Phillips Curve show? Why does it have a different slope than the Short-Run Phillips Curve, and what is the implications of that?

Shows the Natural Rate of Unemployment inflation is stable only when unemployment is equal to the natural rate of unemployment. If unemployment is below its natural rate, inflation will accelerate

What does Aggregate Demand (AD) show?

Shows the negative relationship between Aggregate output (income) and the price level.

What does the Short-Run Phillips Curve show?

Shows therelationship between the inflation rate and the unemployment rate

Why does it make sense to make Planned Investment a downward sloping function of real interest rates?

The HIGHER the interest rate the LOWER the level of planned investment. As interest rate falls, more projects become profitable. (Allows for more planned investment).

real wealth effect

The change in consumption brought about by a change in real wealth that results from a change in the price level.

Why is AD downward sloping?

The higher the Interest rate, the less planned investment.

What is Potential GDP?

The level of Aggregate Output that can be sustained in the long run without inflation.

What is represented on the vertical axis and horizontal axis of a Phillips Curve graph?

Vertical axis = Inflation rate Horizontal axis = Unemployment rate

in the long run

WAGES will RISE to catch up with the increase in the overall price level.

Inflationary Expectations

What causes the Phillips curve to shift?

What is "crowding in"?

When planned investment rises as a result of Contractionary Fiscal Policy (lower interest rates)

ar full capacity

all labor and capital are utlized

How does Contractionary Monetary Policy decrease output?

by decreasing the money supply.

a permanent INCREASE in government purchases is

completely crowded out by a DECREASE in consumption and investment IN THE LONG RUN, OUTPUT ALWAYS RETURNS TO GDP

at AD 3 on SRAS

economy is full to capacity government spending increases because SRAS is very steep partial crowding out of much larger **low opportunity cost**

if gov spending increases and taxes decrease

expansionary fiscal policy

What is the result of accommodating the cost shock?

increasing the Ms, which will shift AD to the right, counteracting the cost shock. inflation caused by an increase in costs -> inflation caused by SRAS shifting left (causing price to go up in the short run)

why does AD slope down?

interest rate effect real wealth effect

liquidity trap

interest rates can't fall below zero monetary policy can no longer increase output expansionary policy is completely ineffective

when overall price level rises

interest rates will INCREASE causing investments to DECREASE. aggregate expenditures will DECREASE, thus DECREASING the quantity demanded.

how does Cost-Push Inflation shift the Short-Run Phillips Curve?

led to high unemployment and high inflation (stagflation), which shifted the Phillips curve upwards and to the right.

LM

liquidity of money curve the federal reserve sets real interest rates so the LM curve is vertical

with excess capacity

many resources are underutilized

real interest rates rise

money supply DECREASES planned investment DECREASES

when firms begin to produce more output, prices begin to rise EXCEPT

nominal wages are sticky

when government accomodates to the cost shock

output returns to potential but with an even HIGHER inflation rate

What is stagflation, and what causes it?

persistent high inflation combined with high unemployment and stagnant demand in a country's economy Occurs when output is falling at the same time that prices are rising. Or when the economy is facing both Contraction and Inflation at the same time.

Structural Unemployment

portion of unemployment that is due to changes in the structure of the economy, results in a loss of jobs in certain industries

frictional unemployment

portion of unemployment that is due to the normal turnover in the labor market; short-run job/ skill matching problems

increasing inflation

price level increases

if wages are sticky or slow to respond

real wages FALL when price level INCREASES firms have a profit incentive to INCREASE output

How does the Fed fight inflation?

reduce money supply; causes short term interest rates to grow

WAGES will RISE to catch up with the increase in the overall price level.

shifting the short run philips curve UP

expansionary fiscal policy

shifts AD curve to the right

aggregate demand

shows equilibrium output at each price level

when the economic output expands

the price level of most goods and inputs RISE

If output prices rise, and wages remain unchanged, what happens to firms' profit maximizing output?

their profit maximizing output rises because wages are sticky -sticky wages cause the AS curve to be upward sloping and to the right

when AD decreases, causing output to fall

there is a downward pressure on prices in the long run, nominal wages and other sticky prices will fall SRAS shifts back to the right until output rises back to potential

The Fed can also purchase T-bills

this increases demand, and then causes prices to rise. increases inflation decreases unemployment rate

in the long run, a tax cut causes the overall price level

to increase with no change in aggregate output (income) under AD-AS Keynesian model **example of demand pull inflation**

in the long run,

wages will adjust to the higher price level shifting SRAS to the LEFT until output returns to potential GDP

On the AD/AS graph, what does the P represent on the vertical axis? What does Y represent on the horizontal axis?

(P) = Price Level (Y) = Aggregate output (Income)

real wage=

(nominal wages/ price level increase)

How does Expansionary Monetary Policy increase output?

-by increasing the money supply.

How does the Keynesian Model adjust from the short-run to the long-run? Be able to how the SRAS shifts when wages adjust to the long-run equilibrium.

-expansionary fiscal policy and expansionary monetary policy only expand output in the short run -in the long run, both expansionary policies are inflationary

How does Monetary Policy affect the AD/AS graph?

. The decrease in the money supply will lead to a decrease in consumer spending The increase in the money supply will lead to an increase in consumer spending

Why are wages 'sticky'? Review the 4 reasons I listed in class that wages are slow to respond to changes in prices in the short-run.

1. explicit contracts (including union contracts) >have to be renegotiated in order for wages to adjust 2. social or implicit contracts not to lower wages 3. imperfect information= firms don't have perfect information on profit-maximizing prices and market wages 4. minimum wage

AD slopes DOWNARD

1. higher price levels ^ interest rates (interest rate effect) 2. value of some asset falls households decrease consumption (real wealth effect)

how to stimulate growth in the long run

1. spend more on R & D ^ TECHNOLOGY 2. spend more on investment ^ CAPITAL 3. Increase labor supply ^ LAND

cost push inflation

1. there is a sudden INCREASE in price of key resource (cost shock) 2. cost shock shifts SRAS to the left - output falls and higher prices (stagflation) 3. In the long run, because we have idle resources -price level and nominal wages fall shifting SRAS to the right

What factors shift the SRAS curve?

1.Change in costs of key inputs (wages,oil). 2.Changes in our ability to produce (A,K,L)

1991

1st GULF WAR

What is the Natural Rate of Unemployment?

4.8%

What causes AD to shift, and in which direction?

A change in consumption, investment, govt. spending, and net exports.

aggregate production function

A x F (K,L) OUTPUT is the level of technology MULTIPLIED by a function of capitial and land

Why is the Long-Run Aggregate Supply Curve (LRAS) vertical?

Always vertical because wages fully adjust to prices in the long run.

What is "crowding out"?

An INCREASE in Govt. spending or INCREASE in interest rates that causes DECREASE in private investment spending

How does Expansionary Fiscal Policy increase output?

An Increase in Govt. spending or a reduction in Net taxes.

What is the link from the Money Market to the Macro Goods and Services market? (Hint: Planned Investment)

An Increase in Interest Rate (r) decreases output (Y) (r) lowers planned investment.

How does Monetary Policy and/or Fiscal Policy shift the AD curve?

An increase in Money supply⇒ Increase in Output. An Increase in Govt. Spending or Decrease in Taxes will

in an open economy

As interest rates are INCREASED, consumers tend to have less money to spend. With less spending, the economy *slows* and *inflation* DECREASES

Why does the Short-Run Aggregate Supply (SRAS) curve slope upward?

As prices of final goods and services RISE, price of inputs such as the wages of workers, rise more slowly

What does it mean for the Fed to accommodate a cost shock?

By increasing the Money Supply and shifting AD to the Right. counteracting the cost shock.

How does the economy move from one point on the Phillips Curve to another?

Curve moves as price levels and unemployment shift.

How does Contractionary Fiscal Policy decrease output?

Decreases Govt. spending or increases Net taxes.

How does Fiscal Policy affect the AD/AS graph?

Expansionary policy involves an increase in government spending, a reduction in taxes Contractionary policy involves a decrease in government spending, an increase in taxes

What are the 2 components of the Natural Rate of Unemployment?

Frictional and Structural People with disabilities and people who are retired

If the real wage FALLS,

INCREASE profits, so the firm will INCREASE the amount of labor it employs firms will substitute the less expensive labour for capital and their costs will be lower so they can produce and sell more output

shifts to the LEFT

If the Fed successfully LOWERS expected inflation, how does the Short-Run Phillips Curve respond?

how does Demand Pull Inflation work?

If there is an INREASE in aggregate demand, there will be an UPWARD MOVEMENT along the Phillips curve.

How is the Macro Goods and Services market connected to the Money Market? (Hint: Money Demand)

Income increases (Y), this shifts Money demand to the right, which increases the interest rate, slowering inflation

Explain how Cost-Push Inflation works, in the short-run through the Long-Run.

Inflation Caused by an increase in costs. Shifts AS curve to the left.

Explain how Demand Pull Inflation works, in the short-run through the Long-Run.

Inflation Caused by an increase in demand or Money supply. Ultimately causes inflation in the long run.

the federal reserve purchases t bills in order to

LOWER interest rates, causing the economy to move to the LEFT in the short run philips curve

Why is the SRAS curve flat on the left side and steep on the right side?

Low levels of Aggregate output cause the curve to flatten. As the Economy approaches Capacity the curve steepens.

2000

NASDAQ bubble popped