Intermediate Macroeconomics Test 2

IS Curve

(Investments-Savings) - Real goods sector of economy- production and consumption of goods and services; points on this curve have a given level of output (lower interest rate= higher output)... in equilibrium when investments=savings - shows the combination of r and Y that maintains S=I Classical- horizontal because of Say's Law; I=S can occur at any level of income; S(r) savings a function of interest rates Keynes- not all savings invested up front I(r) = S(y)... rather savings are a function of income and investments of interest rates (against Say's Law that AS creates AD)

How does wage rigidity lead to Keynesian view of involuntary unemployment?

Wage rigidity causes the wage level to be downwardly inflexible. In an economic downturn, when there is less demand for labor, the wages can't decrease which causes a further reduction in employment levels. This causes involuntary unemployment, as people who are willing to work at that wage level are laid off and the wages remain constant.

Fama's efficient market hypothesis

asset prices fully reflect all available information; there is no way to outperform the market in the SR; but in the LR, financially sound stocks can outperform the market

Phillips curve in Monetarism

believe that unemployment and inflation have an inverse relationship in the SR; vertical in LR

Schumpeter and Wicksell

changes in technology greatly affect change in business cycles

theory of rational expectations

individuals will take all available information about the future to use it to make decisions; means all curves shift simultaneously in response to monetary/fiscal policy

Phillips Curve

inflation and unemployment have a stable and inverse relationship, the lower an economy's rate of unemployment, the more rapidly wages paid to labor increase in that economy; in other words, high rates of growth in AD stimulate output which lowers the unemployment rate... this growth in AD also increase rate at which prices rise (hence higher inflation)... lower rates of unemployment can be achieved, but only at the cost of higher inflation rates - basic defect:

liquidity trap

injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective implications for potential effectiveness of monetary policy: (1) money instruments now paying interest (i.e. savings accounts), (2) there is an incentive to get out of these instruments and into bonds

wealth effect

when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more

What does the Fed do to avoid the crowding out effect?

when there is an increase in G, which increases nominal GDP, which increases r, the Fed will increase MS in order to keep r down... causes IS curve to shift to right (increased G), and LM curve to shift to the right (increase in MS)... results in higher nominal GDP with no change in r

equity

he value of an asset less the value of all liabilities on that asset

LM Curve

(Liquidity preference- Money Supply) Monetary sector of economy- all points are where money supply is willingly held... in equilibrium when when money supplied=money demanded; represents the corresponding interest rates and economic output/income needed in order for the MS to equal MD; upward sloping because when interest rates are high, a higher GDP is needed to increase MD Classical- vertical Liquidity trap- horizontal Otherwise- upward sloping

supply shocks

- An unexpected event that changes the supply of a product or commodity, resulting in a sudden change in its price. - can be negative (decreased S) or positive (increased S) - almost always negative, rarely positive Assuming aggregate demand is unchanged, a negative supply shock in a product or commodity will cause its price to spike upward, while a positive supply shock will exert downward pressure on its price. - how they lead to inflationary recessions: - correct policy response according to Keynes: to create demand, which would drive prices up and cause inflation - how to avoid inflationary recession: not creating demand, creating subsidies to create demand in private sector, so as to avoid inflation

Operation Twist

- Fed has responsibility of bringing high r down again after the government has brought them up - The name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds. "Operation Twist" describes a monetary process where the Fed buys and sells short-term and long-term bonds depending on their objective. For example, in September 2011, the Fed performed Operation Twist in an attempt to lower long-term interest rates. In this operation, the Fed sold short-term Treasury bonds and bought long-term Treasury bonds, which pressured the long-term bond yields downward.

Friedman's early restatement of the Quantity Theory of Money (weak form)

- MD is proportionate to P and real GDP; r, return on equities, and return on consumer durables (i.e. housing) -shortcomings: doesn't sufficiently establish that MS has to do with inflation, which affects nominal income

Factors causing LM curve to shift to the left

- a decrease in MS - change in liquidity preference to holding more cash (i.e. due to pessimistic expectations) - change in view on proper r level will shift speculative money demand

How changes in price levels affect IS and LM curves

- affect only LM curve because IS curve is determined by real factors - MD is determined by nominal GDP and thus an increase in P will cause an increase in D for money and would decrease real MS - In order to maintain equilibrium with an increase in prices, the LM curve must shift to the left because interest rates need to be higher to reduce the speculative demand for money to offset the smaller supply of real money and increased need of money for consumption.

Factors shifting LM curve to the right

- an expansion of MS (because higher nominal GDP would be needed for MD to equal the increased MS at a given r) - change in liquidity preference to holding less cash - change in view on proper r level will shift speculative money demand

Phillips curve in New Classical economics

- basically useless in this theory, because the use of rational expectations means that all curves shift simultaneously in response to monetary/fiscal policy... therefore, a shift in AD due to expected expansionary monetary policy would cause simultaneous shift to the right of labor demand, to the left of labor supply, and to the left of SRAS, thus returning the output to the same level with higher prices. - has little use because any expected changes in the price levels will be immediately factored into the decision/contracts and will have no effect on the level of employment - only use is for unexpected change in price levels, which are quickly taken into account (hours or days) and returns the employment level to the original value

2 limitations of monetary policy

- cannot peg interest rates beyond the short run - it cannot peg unemployment rate for more than short periods of time

Friedman's assertions on the quantity theory of money

- differs from classical: gives money intrinsic value, thus rejecting the neutrality of money, not as rigid, but can influence real income in the SR - differs from Keynesian: velocity is stable and the MS has considerable effect on real output in the SR, does not have 3 different kinds of demand, but focuses on MD being a function of the returns on various forms of wealth, which reduces need for Keynes's speculative D and keeps velocity stable (bonds, equities, durable goods, etc.)

Friedman's Restatement of the Quantity Theory of Money (strong form)

- explains effects on nominal income - MS is all that matters in changes of income

Factors during 1980s that led to relative demise of Monetarism

- it became known that the velocity of money was not always stable (broke the relationship between MS and nominal income)

3 criticisms that the Keynesian counter-critique has leveled against NC economists

- it costs a lot to acquire/ share all the information to form predictions - How do agents actually acquire knowledge of the correct model of the economy? - Each historical event is unique and non-repeatable; we cannot learn from the past because the past does not repeat itself

transmission mechanism

- money supply affects the economy through interest rates... an increase in the money supply leads to a decrease in interest rates which causes increase in investments - through monetary policy, the Fed is able to stimulate investments

Effects of slope of IS curve on effectiveness of monetary and fiscal policy

- more elastic (horizontal), greater the effectiveness of monetary policy and smaller the effectiveness of fiscal policy - less elastic (vertical), less the effectiveness of monetary policy and greater the effectiveness of fiscal policy

Factors causing IS curve to shift to the left

- negative future expectations - increase in taxes (because higher taxes decrease the proportion of disposable income to national income)

Keynesian assumptions the New Classical Model rejects

- notion of adaptive expectations (rather, people form rational expectations) - non-neutrality of money (returns to the classical view that money is neutral- does not have intrinsic value- and prices and wages are fully flexible, thus markets clear)

Classical assumptions the New Classical Model rejects

- perfect information (rather, people make rational expectations using the information they do have)

Factors causing IS curve to shift to the right

- positive future expectations (increase in investments) - increase in government spending

Factors determining slope of IS curve (usually downward sloping)

- r and Y - usually downward sloping because the lower the r, the higher the Y needed to create enough S to equal I - determined by marginal propensity to save and marginal efficiency of investments - flatter curve= higher multiplier (society spending more) - steeper curve= lower multiplier (thrifty society) - vertical= when interest elasticity of investment is 0

Factors determining slope of LM curve (usually upward sloping)

-normally upward sloping because when interest rates are high, a higher GDP is needed to increase L (money demand) - slope depends upon the interest rate elasticity of money demand - will be horizontal during liquidity trap or when expansion of MS only lowers r by a small amount (due to speculative D) - will be vertical under classical assumption that economy is always at full employment

4 basic monetarist propositions used to reassert central role of money within macroeconomics

1. MS is a dominant influence 2. LR, P change to reflect MS 3. SR, MS doesn't influence real variables 4. Private sector of economy is inherently stable

5 elements of Monetarism that have become included in mainstream macroeconomic theory

1. Notion of the NRU 2. Analysis of fluctuations as movements and trends (rather than deviation from potential) 3. Monetary policy is seen as a potent tool for stabilization 4. Controlling inflation is done through the MS and is the responsibility of the Fed 5. Limited benefits of active policy in stabilization (cannot achieve utopia)

6 policy implications of the New Classical Approach

1. Policy ineffectiveness proposition- anticipated fiscal/monetary policy will have no effect in changes in the level of employment/output 2. There is no output/employment cost of reducing inflation; the cause of inflation is growth in the Money Supply 3. Anticipated monetary policy will have no effect on real output due to the policy ineffectiveness proposition and superneutrality of money 4. Central bank independence- the more the central bank gives in to the whims of politicians, the more likely to be inflation 5. Government should focus on microeconomic policies or incentives for firms to be more productive and hire more workers 6. The Lucas critique of econometric models, which argues large-scale fixed econometric models have little to no predictive capabilities because rational actors will change their parameters based upon new information too quickly for the models

3 main differences Friedman makes, in contrast with Keynesian analysis, re-establishing role for quantity theory of money

1. Stability of demand for money (Friedman believes it to be stable, while Keynes argues it is unstable) 2. Friedman did not change his money demand into components (as Keynes did with his 3 demands- speculative, precautionary, and transaction) 3. Friedman believed money is a substitute for a broad range of real and financial assets; Keynes believed there is no asset that is a good substitute for money

4 basic tenets of the orthodox Keynesian school (early post-war years)

1. The economy is inherently unstable and subject to shocks (policy: need for government stabilization) 2. The economy takes a long time to return to full employment because prices and wages are downwardly flexible (argues "in the LR, we are all dead) (policy: need for government intervention to avoid downturn in the economy) 3. Output and employment are determined by AD (policy: AD should be stimulated to return to full employment... thus government spending is encouraged) 4. Fiscal (government) policy is more effective than monetary policy (policy: increase in government spending, rather than using the Fed/Money supply to assist economy in returning to full employment)

Keynes's 3 motives for holding money

1. Transactions motive: a function of income; money used for everyday expenditures, the greater the income, the greater the transactions (spending)... not as common today due to credit cards 2. Precautionary motive: a function of income; people hold money just in case they should need it... not as common today due to credit cards 3. Speculative motive (DIFFERENT from Classical Model because Keynes believed this to be a rational reason to hoard money not used to consumption, while classicists viewed hoarding money as irrational): a function of interest rates; money held instead of holding bonds, money held to play the market, we hold cash rather than other assets whose values are falling, money held to buy (or sell) bonds, depending on one's expectations of future interest rates

4 main features of New Classical Model

1. Walrasian general equilibrium framework- continuous market clearing and markets are competitive 2. All economic agents are rational- all seeking to maximize utility, profits, etc. 3. No systematic errors of prediction (in contrast to Keynesian view of animal spirits) 4. Agents don't suffer from money illusion

Keynes's sources of wage rigidity

1. Workers are interested in relative wages as well as real wages 2. Labor is unionized and wages set by contracts for several years 3. Even w/o labor contracts, there's an implicit contract not to lower wages b/c this hurts the image of the business and attitudes of workers

3 things monetary policy can do

1. prevent money itself from being a major source of economic disturbance 2. provide a stable background for the economy; producers and consumers perform most efficiently when there are stable prices 3. offset major disturbances in the economy caused by other sources (limited and should not be overused) (i.e. post-war,

How does Keynes get rid of the Classical notion of "neutrality of money"?

Money is not neutral because it serves a useful function as liquidity which people value, thus there are rational reasons for people to hoard money that they do not plan on using for consumption

Keynes's NAIRU vs. Friedman's NRU

The lowest rate of unemployment that an economy can sustain over the long run. Keynesians believe that a government can lower the rate of unemployment (i.e. employ more people) if it were willing to accept a higher level of inflation (the idea behind the Phillips Curve). However, critics of this say that the effect is temporary and that unemployment would bounce back up but inflation would stay high. Thus, the natural, or equilibrium, rate is the lowest level of unemployment at which inflation remains stable. Also known as the "non-accelerating inflation rate of unemployment" (NAIRU).

NAIRU

The specific level of unemployment that exists in an economy that does not cause inflation to increase. The non-accelerating rate of unemployment (NAIRU) often represents an equilibrium between the state of the economy and the labor market. NAIRU is also sometimes referred as a "long-run Phillips curve".

bond

a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.

policy ineffectiveness proposition

anticipated fiscal and monetary policy will have no effect in changes of employment and output even in the SR

policy ineffectiveness proposition

any expected fiscal or monetary policy will have no effect; only surprises have an effect and only in the very SR (within days or weeks)

Classical assumption of neutrality of money

changes in the aggregate money supply only affect nominal variables, rather than real variables; therefore, an increase in the money supply would increase all prices and wages proportionately, but have no effect on real factors such as GDP, unemployment levels, etc., thus changing the money supply will not change the aggregate supply and demand of goods, technology or services

Keynes's speculative demand for money

comes from speculative motive

liquidity preference

desire to hold cash vs. investing in bonds... determines interest rates. Keynes would argue that interest rate is what you get from parting with liquidity

Phillips curve in Keynesian economics

downward sloping in SR; vertical in LR

How is Fama's "Efficient Market Hypothesis" consistent with the NC Model?

it's consistent with rational expectations

IS-LM Model (aka Hicks-Hanson Model)

macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves. The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model). purpose: explains changes in national income when P is fixed in the SR, shows why AD curve shifts, used to analyze fluctuations in the economy and find stabilization policies

money illusion

many people have an illusory picture of their wealth and income based on nominal dollar terms, rather than real terms. Real prices and income take into account the level of inflation in an economy; workers are fooled... you don't know what price levels are supposed to be

interest rates

money charged to borrowers of a loan

superneutrality of money

money is neutral in the long run if changes in money growth will have no effect on real factors - how it negates the usefulness of monetary policy:

theory of adaptive expectations

people base their decisions on previous experiences

irrational exhuberance

people buy stock because everyone else is; consistent with the idea of animal spirits/herd instincts that people will buy/sell whatever other people are buying/selling which pushes prices away from the fundamental level that the efficient market hypothesis argues

income effect

the change in an individual's or economy's income and how that change will impact the quantity demanded of a good or service. The relationship between income and the quantity demanded is a positive one, as income increases, so does the quantity of goods and services demanded.

IRR

the interest rate needed for income to equal cost, the higher a project's internal rate of return, the more desirable it is to undertake the project

Friedman's Monetary Rule

the role of the Fed should be to increase MS at a standard and known rate

question of persistence of deviation from full employment

this persistence is not explained within the NC model (NC responds by arguing shocks in the economy can cause unemployment and these shocks can persist for a while)