Econ discussion section
Multiplier formula
1/(1-MPC)
What happens to consumer spending when the price level rises?
A rise in the price level reduces the real value of a dollar and makes consumers poorer, discouraging them from spending and therefore reducing the total quantity of goods and services demanded.
multiplier effect
An effect in economics in which an increase in spending produces an increase in national income and consumption greater than the initial amount spent.
Should monetary policy be made by rule or discretion? (NO)
Discretion should be used in making monetary policy to facilitate greater flexibility. In addition, it is difficult for economists to agree on what rules should be followed.
theory of liquidity preference
John Maynard Keynes' theory that the interest rate adjusts to bring money supply and money demand into balance. because in the short-run inflation is relatively stable, this theory applies to both the nominal and real interest rates.
When the government changes its spending, does aggregate demand change by the same amount?
No, the change in aggregate demand resulting from a change in government spending will be greater than the initial change in government spending because of the multiplier effect.
Should the government balance its budget? (NO)
While the government debt does represent a tax burden on younger generations, it is not large compared to the average person's lifetime income. In addition, future generations are often made better off by the public investments funded by an increase in government debt. Finally, population growth and technological progress cause the total income of the U.S. economy to grow over time, so as long as the government debt grows more slowly than the nation's income, there is nothing to prevent the government debt from growing forever.
How do you calculate real GDP?
Y = C + I + G + NX
short-run Phillips curve
a curve that shows the short-run trade-off between inflation and unemployment. it illustrates a negative relationship between the inflation rate and unemployment rate
Should tax laws be reformed to encourage saving? (YES)
a nation's saving rate is a key determinant of its long-run economic prosperity, and the US tax system discourages saving by taxing the return to saving quite heavily, taxing some forms of capital income twice, and means-testing some government benefits
What happens to cnet exports when the price level rises?
a rise in US price level drives up US interest rates, making US interest-bearing assets more attractive than foreign interest-bearing assets to US investors, reducing the supply of dollars in the foreign currency market. the dollar appreciates and causes a change in the real interest rate - each dollar buys more units of foreign currency and foreign prices are comparatively lower since a rise in US price level. foreign goods become cheaper than domestic goods so Americans export less and import more.
wealth effect
a rise in price reduces consumer spending
interest rate effect
a rise in price reduces investment spending
What happens to investment spending when the price level rises?
a rise in the price level means that households need to hold more money in order to buy the goods and services they want. Households will convert their interest-bearing assets into money. this reduces the demand of interest-bearing assets, drives up interest rates, and reduces the amount of investment.
aggregate demand and aggregate supply model
allows us to explain short-run fluctuations in economic activity around its long-run trend.
Crowding out definition
an offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
changes in investment and the aggregate demand curve
any event that changes how much firms want to invest at a given price level shifts the aggregate demand curve. i.e. an investment tax credit increases the quantity of investment goods that firms demand at any given interest rate and shifts aggregate demand rightward
changes in consumption and the aggregate demand curve
any event that changes how much people want to consume at a given price level shifts the aggregate demand curve. i.e. when government raises taxes, it discourages people from spending, shifting the aggregate demand curve leftward
changes in net exports and the aggregate demand curve
any event that changes net exports for a given price level shifts the aggregate demand curve. if foreign nations enter into a recession, they buy fewer goods from the US reducing net exports and shifting aggregate demand leftward.
Long Run Phillips Curve
any short-run equilibrium arrived at following a shift in aggregate demand will transition back into a long-run equilibrium at the natural level of output and natural rate of unemployment.
What causes shifts in the aggregate demand curve?
anything that affects its components (consumption, investment, government spending and net exports)
what causes shifts in the short-run aggregate supply curve?
anything that affects long-in aggregate supply (changes in labor, capital, natural resources or technology) as well as changes in the expected price level. a decrease in the expected price level shifts the short-run aggregate supply curve rightward.
exchange-rate effect
as price level rises, net exports decrease
policymakers authority over the Phillips curve
because aggregate demand can be altered with fiscal and monetary policy, policymakers can choose what point on the Phillips curve they want to be at.
why is the long-run aggregate-supply curve vertical?
because the natural level of output is determined by variables unrelated to price level. any change in the determinants of the natural level of output will shift the long-run aggregate supply curve.
misperceptions theory
changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output, confusing overall price changes with changes in the relative price of their good. suppliers respond by changing the amount the produce, thereby affecting the overall quantity of goods and services available.
MPC
defined as the fraction of each additional dollar that a household consumes.
the natural level of output depends on what?
depends on its supplies of labor, capital, natural resources and technology
how the aggregate supply of goods and services changes with changes in the aggregate price level depend on what?
depends on the time horizon we're concerned with.
how is money supply determined?
determined by the federal reserve and is therefore independent of the interest rate. however, money demand is decreasing in the interest rate.
in the short-run, discrepancies between actual and expected inflation cause what? long-run?
differences between the actual and natural rate of unemployment, but in the long run, expected inflation and actual inflation coincide, and the unemployment rate is the natural rate.
the sticky-price theory
emphasizes that the prices of some goods and services adjust slowly in response to menu prices. Failure to lower one's prices when the price level falls results in a fall in customers, motivating a decrease in production and hiring
Should the Fed aim for zero inflation? (NO)
estimates of the sacrifice ratio suggest that reducing inflation by 1 percentage point requires giving up about 5 percent of one year's output. In addition, this lost income is not distributed equally over the population and is concentrated on those workers who lose their jobs.
supply shocks
events that directly alter firms' costs and prices
when prices are lower than expected, what do firms do?
firms reduce production and employment
fiscal policy
fiscal policy refers to the setting of the level of government spending and taxation by policymakers.
sacrifice ratio
gives the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. rests on the idea that in the short run there will be a discrepancy between the actual price level and people's expectations of what the price level is.
Should the government balance its budget? (YES)
government debt places a burden on future generations of taxpayers, lowering their living standard. in addition, reduced national saving causes real interest rates to rise and investments to fall.
periods will low unemployment and high output are associated with what?
high aggregate demand, which puts upward pressure on wages and prices throughout the economy
When does money neutrality hold up?
holds only in the long run.
why does the aggregate demand curve slope downward?
in a market for one good, as the price of the good rises, consumers substitute away to other goods.
Should the government fight recessions with spending hikes or tax cuts? (tax cuts)
in addition to increasing aggregate demand by increasing households' disposable income, tax cuts also increase aggregate demand by altering incentives. Tax cuts can also increase aggregate supply by giving the unemployed a greater incentive to search for jobs and the employed a greater incentive to work longer hours.
Should the Fed aim for zero inflation? (YES)
inflation imposes many costs on the economy, and although there is a tradeoff between unemployment and inflation in the short run, reducing inflation is a policy with permanent benefits. if the Fed announces a credible commitment to zero inflation, it can directly influence expectations of inflation.
assuming that the economy was originally in long-run equilibrium, what will happen if a shift in the curves occur?
it may knock us out of long-run equilibrium into short-run equilibrium. depending on what kind of shift initiated the new equilibrium, further shifts will occur to bring us back to long-run equilibrium.
what happens when the government alters its purchases of goods and services?
it shifts the aggregate demand curve directly
in practice, what does the theory of rational expectations mean?
means that if the government or federal reserve can credible commit and advertise their intent to engage in contractionary monetary policy, then people's expectations of the price level will immediately adjust, and there will be no trade-off between inflation and unemployment
quantity of output supplied formula
natural level of output + a (actual level - expected price level) a measures how responsive quantity of output supplied is to discrepancies between actual and expected prices.
unemployment rate
natural rate of unemployment - a(actual inflation - expected inflation)
Should tax laws be reformed to encourage saving? (NO)
policymakers should be sure to distribute the tax burden fairly, and proposals to increase the incentive to save increase the tax burden on those who can least afford it. High-income households save a greater fraction of their income than low-income houses, so any change in tax policy that favors those who fair will also favor people with high incomes. National saving could also be increased by reducing the budget deficit instead.
Should monetary and fiscal policymakers try to stabilize the economy? (NO)
policymakers should not try to stabilize the economy. Monetary and fiscal policy do not affect the economy immediately but instead work with a long lag, and economic conditions can easily change between the time a policy action begins and the time it takes effect.
what will money have an influence on in the short run?
real and nominal variables
the theory of rational expectations
says that while people optimally use all information they have, including information about government policies, when forecasting the fate.
classical dichotomy
separation of nominal and real variables
why is long-run macroeconomic equilibrium stable but not short-run?
short-run equilibria are always transitioning into long-run ones.
the short-run Phillips curve will shift in response to what?
supply shocks, establishing a new equilibrium inflation rate.
the spending multiplier
tells us how many times bigger the change in GDP will be given some change in aggregate expenditure
what does the logic of the multiplier tell us?
that an increase in government causes an increase income and an increase in money demand
natural rate hypothesis
the claim that unemployment eventually returns to its normal, or natural, rate regardless of the rate of inflation.
menu prices
the costs to firms of changing prices
when money supply shifts rightward, what happens?
the equilibrium interest rate falls, causing investment spending and borrowing by consumers to increase and aggregate demand to also shift rightward
money neutrality
the idea that changes in the money supply do not affect real variables
the equilibrium interest rate
the interest rate at which money supply equals money demand
changes in government spending and the aggregate demand curve
the most direct way of shifting the aggregate demand curve. if government spending rises, then the quantity of goods and services demanded at any price level is higher and the aggregate demand curve shifts rightward.
natural level of output
the production of goods and series that an economy achieves in the long run when unemployment is at its normal (natural) rate.
how will the short-run Phillips curve shift when expected prices come to coincide with actual prices again?
the short-run aggregate supply curve will shift leftward, causing a rightward shift in short-run aggregate supply and a leftward shift in the short-run Phillips curve, establishing a new long-run equilibrium at a lower inflation rate. However, in the short-run, output will be below the natural rate.
what does the aggregate demand curve show us?
the total quantity of goods and services demanded at each price level.
why does the short-run aggregate supply curve slope upward?
there are three theories: the sticky-wage theory, the sticky-price theory, and the misperceptions theory
what can the federal reserve do to reduce inflation
they can engage in contractionary monetary policy, reducing the money supply and shifting aggregate demand leftward.
what do the stick-wage, sticky-price and misperceptions theory all have in common?
they maintain that changes in output are causes by discrepancies between actual and expected prices
how many times bigger will the change in aggregate demand be than the initial change in government spending?
this depends on the marginal propensity to consumer (MPC) of the population.
the sticky-wage theory
this theory argues that the short-run aggregate supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. 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
Should the government fight recessions with spending hikes or tax cuts? (with spending hikes)
traditional Keynesian analysis indicates that increases in government purchases are a more potent tool than decreases in taxes. when government gives a dollar in tax cuts to a household, part of that dollar may be saved rather than spent.
what happens when expected prices are adjusted to correspond to actual prices?
using sticky-wage theory as an example, nominal wages are adjusted and production and employment are restored to their long-run levels. in the same way, the short-run Phillips curve slopes downward because of the discrepancy between expected and actual inflation
real variables
variables measured in quantities or relative prices
nominal variables
variables measured in terms of money
when prices are higher than expected, what do firms do?
when prices are higher than expected, firms have an incentive to increase production and employment
when is the economy in long-run macroeconomic equilibrium?
when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.
when is the economy in short-run macroeconomic equilibrium?
when the quantity of aggregate output is equal to the quantity demanded
interest rate and money demand curve
while money is the most liquid asset, it earns no interest; the interest rate is therefore the opportunity cost of holding cash, and the higher the interest rate, the less cash you'll want to hold. the money demand curve is therefore downward sloping in the interest rate.
the rightward shift of the money demand curve will result in what?
will increase the interest rate, reducing investment spending and offsetting the increase in aggregate demand.
an increase in money demanded will lead to what?
will shift the money demand curve rightward, resulting in a higher equilibrium interest rate. this is in accordance with the remainder of the argument of the interest rate effect.
Should monetary policy be made by rule or discretion? (YES)
yes, in order to limit incompetence and abuse of power as well as more inflation than is desirable. discretion results in more inflation when policymakers renege on their commitments to keep inflation low once the public forms expectations of inflation in order to achieve lower unemployment.
Should monetary and fiscal policymakers try to stabilize the economy? (YES)
yes, policymakers should try to stabilize the economy. Monetary and fiscal policy can stabilize aggregate demand and, by extension, production and employment, reducing the severity of economic fluctuations