ECON 202 TEST 3 humpries chap 11

Keynes' law

"demand creates its own supply"

Say's law

"supply creates its own demand"

Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?

A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite.

What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?

A smaller labor force would be reflected in a leftward shift in AS, leading to a lower equilibrium level of GDP and higher price level.

Schism

A split or division between strongly opposed sections or parties

How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?

An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level.

If the economy is operating in the Keynesian zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?

Because the SRAS curve is horizontal in the Keynesian zone, a decrease in AD should depress real economic activity but have no effect on prices.

In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?

Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason.

Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation?

Expansionary monetary policy shifts AD to the right. A continuing expansionary policy would cause larger and larger shifts (given the parameters of this problem). The result would be an increase in GDP and employment (a decrease in unemployment) and higher prices until potential output was reached. After that point, the expansionary policy would simply cause inflation.

Suppose concerns about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?

Given the assumptions made here, the cuts in R&D funding should reduce productivity growth. The model would show this as a leftward shift in the SRAS curve, leading to a lower equilibrium GDP and a higher price level.

Suppose, after five years of sluggish growth, the economy of the European Union picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment?

Higher EU growth would increase demand for U.S. exports, reducing our trade deficit. The increased demand for exports would show up as a rightward shift in AD, causing GDP to rise (and the price level to rise as well). Higher GDP would require more jobs to fulfill, so U.S. employment would also rise.

The short run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?

Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve.

Suppose the U.S. Congress passes significant immigration reform that makes it easier for foreigners to come to the United States to work. Use the AD/AS model to explain how this would affect the equilibrium level of GDP and the price level.

Immigration reform as described should increase the labor supply, shifting SRAS to the right, leading to a higher equilibrium GDP and a lower price level.

Describe the mechanism by which supply creates its own demand.

In order to supply goods, suppliers must employ workers, whose incomes increase as a result of their labor. They use this additional income to demand goods of an equivalent value to those they supply.

Aggregate demand (AD):

Refers to the amount of total spending on domestic goods and services in an economy

aggreget supply

Reflects decisions by businesses that make decisions about what quantity to supply based on expected profits Profits are determined by the price of output firms sell and by the price of inputs, like labor or raw materials, firms buy

Aggregate supply (AS) curve

Shows the total quantity of output (real GDP) that firms produce and sell at each aggregate price level

Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.

Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level.

If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?

Since the SRAS curve is vertical in the neoclassical zone, unless the economy is bordering the intermediate zone, a decrease in AS will cause a decrease in the price level, but no effect on real economic activity (for example, real GDP or employment).

A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?

Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession (and GDP was less than potential), the tax cuts would increase GDP and "lead the economy out of recession."

GDP Gap

The difference between actual GDP (Y) and potential GDP (Y*) at any aggregate price level

Describe the mechanism by which demand creates its own supply.

When consumers demand more goods than are available on the market, prices are driven higher and the additional opportunities for profit induce more suppliers to enter the market, producing an equivalent amount to that which is demanded.

aggregate demand/aggregate supply model

a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level

stagflation

an economy experiences stagnant growth and high inflation at the same time

full-employment GDP

another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment

Intuition

each time a good or service is produced and sold, it generates income earned by someone

neoclassical economists

economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run

neoclassical zone

portion of the SRAS curve where GDP is at or near potential output where the SRAS curve is steep

intermediate zone

portion of the SRAS curve where GDP is below potential but not so far below as in the Keynesian zone; the SRAS curve is upward-sloping, but not vertical in the intermediate zone

Keynesian zone

portion of the SRAS curve where GDP is far below potential and the SRAS curve is flat

short run aggregate supply (SRAS) curve

positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed

aggregate demand (AD

the amount of total spending on domestic goods and services in an economy

potential GDP

the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions

aggregate supply (AS)

the total quantity of output (i.e. real GDP) firms will produce and sell

aggregate supply (AS) curve

the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level

aggregate demand (AD) curve

the total spending on domestic goods and services at each price level

Aggregate supply (AS):

total quantity of output (real GDP) firms produce and sell

long run aggregate supply (LRAS) curve

vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run

Aggregate Demand

• Spending by households, firms, government and the rest of the world • AD is what economists call total planned expenditure •Determined by a number of factors, one of them is the aggregate price level - an index number such as the GDP deflator that measures the average price of the things we buy