5 - Short-Run Economic Fluctuations

MPS + MPC = ?

1

How is the spending (expenditure) multiplier calculated?

1 / ( 1 - MPC) MPC - Marginal propensity to consume

What causes the aggregate demand curve to shift?

1) Changes in consumption. (Rightward shift - tax cut or stock market boom. Leftward shift - tax increase or stock market decline) 2) Changes in investment. (Rightward shift - optimism about the future, a fall in interest rates due to an increase in the money supply. Leftward shift - pessimism about the future, a rise in interest rates) 3). Changes in government purchases (Rightward shift - increased spending on infrastructure, greater spending on defense. Leftward shift - Budget cuts, decreased spending). 4) Changes in net exports (Rightward shift - overseas boom, speculation that causes exchange-rate depreciation. Leftward shift - overseas recession, speculation that causes an exchange-rate appreciation).

Why might the short-run aggregate supply curve shift?

1) Changes in labor (Rightward shift - increase in quantity of labor available. Leftward shift - decrease in quantity of labor available). 2) Changes in capital - (Rightward shift - increase in physical or human capital. Leftward shift- decease in physical or human capital). 3) Changes in natural resources (Rightward shift - increase in availability. Leftward shift - decrease in availability.) 4) Changes in Technology (Rightward shift - advancement in technology. Leftward shift - decrease in available technology, possibly due to government regulation). 5) Changes in expected price level (Rightward shift - decrease in expected price level. Leftward shift - increase in expected price level).

Why might the long run aggregate supply curve shift?

1) Changes in labor - Increase in immigration or exodus of citizens going overseas, change in minimum wage laws (increase - leftward shift, decrease - rightward shift). 2) Changes in capital - Increase in capital stock shifts the curve right, decrease shifts left. 3) Changes in natural resources - A new mineral deposit shifts rightward. Sustained poor weather shifts leftward. 4) Changes in technological knowledge - Includes opening up an economy to allow for specialization (like a high-technology industry) or even government regulation restricting production methods (say for pollution concerns)

Discuss the four types of lag that may occur.

1) Data Lag - The time it takes to get macroeconomic data such as real GDP or the unemployment rate. 2) Recognition Lag - The delay in fiscal policy caused by the time that it takes to realize that there is a problem to be corrected. 3) Decision Lag - The delay in fiscal policy caused by the time that it takes to decide on a course of action. 4) Implementation lag - The time it takes to put action into practice.

If the FED wants to engage in expansionary monetary policy, what are its options?

1) Open market treasury security purchases 2) Lowering the discount rate 3) Lowering the federal funds target rate 4) Changing the reserve requirement

If the FED wants to engage in contractionary monetary policy, what are its options?

1) Open market treasury security selling 2) Raising the discount rate 3) Raising the federal funds target rate 4) Changing the reserve requirement

List the three reasons why the short-run aggregate supply curve shifts upward.

1) Sticky-wage theory 2) Sticky-price theory 3) The misperceptions theory

List several automatic stabilizers

1) Tax system (progressive income tax, payroll tax reductions due to lower earnings, corporate income tax reductions because of lower profits) 2) Unemployment insurance 3) Welfare 4) Other various social assistance programs (SNAP)

List the three reasons why the aggregate demand curve slopes downward.

1) The Wealth effect 2) The interest effect 3) The exchange rate effect

What two assumption leads the basic aggregate demand and aggregate supply model to experience some difficulty and may lead us to some misleading results?

1) The economy does not experience continuing inflation. 2) The economy does not experience long-run growth. This leads to the concept of the dynamic aggregate demand and aggregate supply model.

In recent years, the FED has conducted policy by setting a target for the federal funds rate. List several reasons why the FED has decided to use the federal funds rate as its target.

1) The money supply is hard to measure with sufficient precision. 2) Money demand fluctuates over time, which leads to fluctuations in interest rates, aggregate demand, and output. 3) Easier to accommodate the day-to-day shifts in money demand (by adjusting the money supply accordingly)

Discuss the wealth effect and its impact on the aggregate demand curve.

A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

Use the theory of liquidity preference to explain how a decrease in the price level affects the aggregate-demand and money market.

A decrease in the price level reduces money demand, shifting the demand curve downward in the money market. Interest rates decrease as a result, increasing investment and the quantity of goods and services demanded.

When a supply shock occurs, what would a contractionary or expansionary fiscal / monetary policy lead to?

An expansionary policy would expand aggregate demand in an effort to decreases unemployment, but inflation will raise further. A contractionary policy would try to fight inflation by reducing it, but at the cost of higher unemployment.

Use the theory of liquidity preference to explain how an increase in the price level affects the aggregate-demand and money market.

An increase in the price level raises money demand, shifting the demand curve upward in the money market. Interest rates increase as a result, reducing investment and the quantity of goods and services demanded.

Discuss the sticky price theory and its impact on the short-run aggregate supply curve.

An unexpectedly low price level leaves some firms with higher-than desired prices, which depressed their sales and leads them to cut back production. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs.

How does the interest rate relate to the quantity of money demanded?

As the interest rate increases, the opportunity cost of holding money increases and reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded of money.

Discuss the interest effect and its impact on the aggregate demand curve.

As the price level falls, households require less money to buy goods and services. Households reduce holdings and increase lending. The increase in lending drives down interest rates. This encourages spending on investment goods and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

Discuss the misperceptions theory and its impact on the short-run aggregate supply curve.

Changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. Some suppliers may think their relative prices have fallen, which induces a fall in production.

If a country wants to reduce inflation, what must occur?

Contractionary monetary policy and a period of high unemployment and low output. After expectations of lower inflation start to affect behavior, the short-run Phillips curve will shift downward leading to an equilibrium point between the new short-run Phillips curve and the long-run Phillips curve that has a lower point of inflation at the natural rate of unemployment.

Contractionary monetary or fiscal policy has what effect on the Phillips curve?

Decreases in the money supply, cuts in government spending, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment (downward movement).

When the economy goes into a recession, real GDP ________, and unemployment ________.

Falls, rises

Briefly describe the ideology behind supply-side economics.

Fiscal policy actions that are intended to have long-run effects by expanding the productive capability of the economy and increasing the rate of growth. This usually involves changing taxes to increase the incentives to work, save, invest, and start a business.

In addition to the multiplier and crowding-out effect, what is another important determinant of the size of the shift in aggregate demand that results from a tax change?

Households' perception about whether the tax change is permanent or temporary. If the tax cut is perceived as temporary, households might only increase spending by a little since they view the reduction as only slightly adding to their financial resources.

How does expectation inflation influence the Phillips curve?

If over time people get used to higher rates of inflation (say when the FED pursues expansionary policy leading to a temporary trade-off between low unemployment and a higher price level), they raise their expectations of inflation and start taking this into account when setting wage and prices. The short-run Phillips curve shifts to the right (upward) leading to a higher levels of inflation at the natural rate of unemployment (long-run Phillips curve equilibrium point).

Describe how the interest rate adjusts to bring the quantity of money supplied and quantity of money demanded into balance according to the theory of liquidity preference.

If the interest rate is above the equilibrium level, the quantity of money people want to hold is less than the quantity the FED has created, and this surplus of money puts downward pressure on the interest rate causing bond issuers and banks to lower interest rates.. If the interest rate is below the equilibrium level, the quantity of money people want to hold is greater than the quantity the FED has created, and this shortage of money puts upward pressure on the interest rate causing bond issuers and banks to increase interest rates.

Why is the long-run aggregate supply curve vertical?

In the long run, an economy's production of goods and services (real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. The quantity of output (a real variable) does not depend on the level of prices (a nominal variable).

An increase in the aggregate demand for goods and services has a larger impact on output ________ and a larger impact on the price level ________.

In the short run, in the long run

Expansionary monetary or fiscal policy has what effect on the Phillips curve?

Increases in the money supply, increases in government spending, or cuts in taxes will expand aggregate demand and move the economy to a point on the Phillips curve with lower unemployment and higher inflation (upward movement).

What is the opportunity cost of holding money?

Interest rate

If aggregate expenditure is MORE than GDP, what happens to inventories, GDP, and employment?

Inventories will fall. GDP and employment both increase.

If aggregate expenditure is LESS than GDP, what happens to inventories, GDP, and employment?

Inventories will rise. GDP and employment both decrease.

What are the possible effects of cutting corporate income taxes on aggregate supply (supply-side economics)?

Investment spending is encouraged resulting in expansion of capital (and therefore long-run aggregate supply). Potential increase in the pace of technological change.

How is the tax multiplier calculated?

MPC / MPS OR (1 / ( 1 - MPC)) * MPC OR -MPC / ( 1 - MPC ) MPC - Marginal propensity to consumer MPS - Marginal propensity to save

change in consumption/change in disposable income = ?

Marginal propensity to consume

Change in equilibrium real GDP / Change in autonomous expenditure = ?

Multiplier 1 / ( 1 - MPC)

Discuss the sticky wage theory and its impact on the short-run aggregate supply curve.

Nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected. NOTE: This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.

For all points above the 45 degree line, what is occurring?

Planned aggregate expenditure is greater than GDP and there is an unplanned decrease in inventories. Production and employment will increase.

For all points below the 45 degree line, what is occurring?

Planned aggregate expenditure is less than GDP and there is an unplanned increase in inventories. Production and employment will decrease.

List one reason for active stabilization policy and one reason against

Pro: Production and employment stabilization reducing the impact of a recession / negative output gap period. Con: Monetary and fiscal (especially fiscal) policy often has a long lag and may be implemented after the recession has ended and the economy is entering an expansionary phase.

What are the possible effects of cutting individual income taxes on aggregate supply (supply-side economics)?

Reducing marginal tax rates increase the incentive to work thereby increasing the quantity supplied of labor. Cutting taxes also raises the return to SOME forms of entrepreneurship, like a sole proprietorship. Return to saving is also increased.

How does a negative supply shock affect the Phillip curve?

Rightward shift leading to higher inflation and higher level of unemployment.

Explain how the following affects the short-run aggregate supply curve: Increase in the expected price of an important natural resource.

Shift the SRAS curve leftward, decreasing SRAS Cost of producing output rises.

Explain how the following affects the short-run aggregate supply curve: Increase in workers and firms adjusting to having previously underestimated the price level

Shift the SRAS curve leftward, decreasing SRAS Workers and firms increase wages and prices.

Explain how the following affects the short-run aggregate supply curve: Increase in the expected future price level.

Shift the SRAS curve leftward, decreasing SRAS. Workers and firms increase wages and prices.

Explain how the following affects the short-run aggregate supply curve: Increase in productivity

Shift the SRAS curve rightward, increasing SRAS Costs of producing output fall.

Explain how the following affects the short-run aggregate supply curve: Increase in the labor force or the capital stock.

Shift the SRAS curve rightward, increasing SRAS. More output can be produced at every price level.

Explain how the following affects the aggregate demand curve: Increase in the exchange rate (the value of the dollar) relative to foreign currencies.

Shift the aggregate demand curve leftward, decreasing AD Imports will rise and exports will fall, reducing net exports.

Explain how the following affects the aggregate demand curve: Increase in personal income or business taxes.

Shift the aggregate demand curve leftward, decreasing AD. Consumption spending falls when personal taxes rise and investment falls when business taxes rise.

Explain how the following affects the aggregate demand curve: Increase in interest rates

Shift the aggregate demand curve leftward, decreasing AD. Higher interest rates raise the costs to households and firms for borrowing, reducing consumption and investment spending.

Explain how the following affects the aggregate demand curve: Increase in the growth rate of domestic GDP relative to the growth rate of foreign GDP.

Shift the aggregate demand curve leftward, decreasing AD. Imports will increase faster than exports, reducing net exports.

Explain how the following affects the aggregate demand curve: Increase in households' expectations of their future incomes

Shift the aggregate demand curve rightward, increasing AD. Consumption spending rises.

Explain how the following affects the aggregate demand curve: Increase in firms' expectations of the future profitability of investment spending.

Shift the aggregate demand curve rightward, increasing AD. Investment spending increases.

Explain how the following affects the aggregate demand curve: Increase in government purchases

Shift the aggregated demand curve rightward, increasing AD.

When aggregate demand shifts rightward, what happens in the short-run? Without intervention, what occurs in the long-run?

Short-run: Increase in price level and output (real GDP) Long-run: Change in expectations shifts the SRAS leftward leading to a return to natural level of output but with a higher price level.

When aggregate demand shifts leftward, what happens in the short-run? Without intervention, what occurs in the long-run?

Short-run: Pricing and output (real GDP) fall. Long-run: Change in expectations leads to SRAS shift to the right. Output returns to natural level. Price level is lower overall.

When short-run aggregate supply shifts leftward, what happens in the short-run? Without intervention, what occurs in the long-run?

Short-run: Stagflation. Increase in price level with a decrease in output (real GDP) Long-run: Changes in expectations shifts the SRAS back to its original position returning the price level and output back to their original levels.

What are some of the reasons why the short-run Phillips curve would shift?

Supply shock or changes in expected inflation.

What are the two most important forces in practice that influence the economy in the long-run?

Technology and monetary policy

Describe the relationship between the Phillip's curve and the aggregate demand curve.

The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate supply curve.

if actual inflation is less than expected inflation, what can be said about actual real wages and what will happen with the unemployment rate?

The actual real wage is greater than the expected real wage. The unemployment rate rises.

if actual inflation is greater than expected inflation, what can be said about actual real wages and what will happen with the unemployment rate?

The actual real wage is less than the expected real wage. The unemployment rate falls.

A sudden crash in the stock market shifts which curve on the AG-AS model?

The aggregate demand curve (leftward)

Fluctuations in the economy are often called what?

The business cycle.

Among the three reasons why aggregate demand slopes downward, which is the most important for the US economy?

The interest rate effect

The 45 degree line diagram in macroeconomics show what?

The relationship between planned expenditure and GDP.

A change in the expected price level shifts which curve on the AG-AS model?

The short-run aggregate supply curve.

What are the possible effects of cutting dividend and capital gains taxes on aggregate supply (supply-side economics)?

The supply of loanable funds are increased which increases savings and investments while also lowering the equilibrium interest rate.

Why is the long-run Phillips curve vertical?

There is no trade-off between inflation and unemployment in the long run. Growth in the money supply determines the inflation rate. In the long run, expected inflation adjusts to changes in actual inflation and the short-run Phillips curve shirts. The long-run Phillips curve is vertical at the point of the natural rate of unemployment.

Discuss the exchange rate effect and its impact on the aggregate demand curve.

When a fall in the US price level cause US interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates US net exports and thereby increase the quantity of goods and services demanded. Conversely, when the US price level rises and causes US interest rates to rise, the real value of the dollar increases, and this appreciation reduces US net exports and the quantity of goods and services demanded.

Use the theory of liquidity preference to explain how a decrease in the money supply affects the aggregate-demand curve.

When the FED contracts the money supply, shifting the MS curve to the left, it raises interest rates and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate demand curve to the left.

Use the theory of liquidity preference to explain how an increase in the money supply affects the aggregate-demand curve.

When the FED increases the money supply, shifting the MS curve to the right, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate demand curve to the right.

How could crowding-out effect a tax reduction?

When the government cuts taxes and stimulates consumer spending, earnings and profits rise, which further stimulate consumer spending. At the same time, higher income leads to higher money demand, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. Because of this crowding-out effect, the shift in aggregate demand could be larger or smaller than the tax change that causes it.

What is the investment accelerator?

When the multiplier affect from increased government expenditure or consumer expenditure spurs higher demand for investment goods and increased investment. (EX: Higher demand for cars lead to Ford building another plant in the US).

If the government wants to contract aggregate demand, it can ________ government purchases or ________ taxes.

decrease, increase

When the Federal Reserve increases the money supply, it ______ aggregate demand and moves the economy along the Phillips curve to a point with ______ inflation and ______ unemployment.

expands, higher, lower

If the central bank wants to expand aggregate demand, it can ________ the money supply, which would ________ the interest rate.

increase, decrease

If the Federal Reserve increases the rate of money growth and maintains it at the new higher rate, eventually expected inflation will ______ and the short-run Phillips curve will shift _______.

increase, upward

If aggregate expenditure is equal to GDP, then inventories are _______ and the economy is in _______ ________.

unchanged, macroeconomic equilibrium