MACRO Test 3

shocks

exogenous changes in agg. supply or demand

In the long run, the output is determined by

factor supplies and technology Ybar= F(Kbar,Lbar)

determine if the following statement is true or false, and explain why if money demand does not depend on the interest-rate, the IS curve is horizontal

false. Money demand affects the money market, and that's the LM curve, not the IS-curve.

When prices are sticky... demand is affected by

fiscal policy (G andT ) monetary policy (M ) other factors, like exogenous changes in C or I

states with larger housing price crashes tended to have higher

foreclosure rates

Ybar is equal to

full-employment or natural level of output, at which the economy's resources are fully employed

Okun's law

he negative relationship between GDP and unemployment.

The LM curve slopes upward because ______ income increases the ______ of money and thereby the interest rate

higher, demand

The IS curve sloped downward because a _____ interest rate reduces _____ and thereby income

higher, planned investment

If a computer glitch at credit card companies makes stores start accepting only cash payments, the demand for money will ______. If the money supply is held constant, the aggregate demand curve will shift to the _______

increase, left

Determine if the following statement is true or false and explain why: if investment does not depend on the interest-rate, the LM curve is horizontal.

False. Investment is per of planned expenditure, so changes in investment affect the IS curve, not the LM curve.

Quantity Theory of Money

Let M be the money supply in the economy Let V be the number of times that a dollar bill changes hands (also known as velocity) Then the number of dollars exchanged in a year must equal MV

Quantity Theory of Money Equation

M x V = P x T IF its sales of a final good we should replace T with Y

short run

Many prices are "sticky" at a predetermined level.

If the Fed responds to an adverse supply shock by expanding the money supply, it will

keep the economy closer to its natural levels of output and employment.

In the short-run equilibrium, if ___________ then over time, P will...

Y> Y bar P will rise Y< Y bar P will fall Y= Y bar P will remain constant

a decrease in real money balances (M/P) causes

a decrease in the demand for goods& services.

In the IS-LM model, which of the following causes income to decline and the interest rate to rise?

a decrease in the money supply

as a result of contraction in aggregate demand, the ____ declines but over time it returns to its former level as the expected price level _____

a level of output, falls

Stagflation - lower output and higher prices - is caused by

an adverse shock to aggregate supply

An increase in the price level causes a fall in real

money balances (M/P)

"Full employment" means that unemployment equals its

natural rate (not zero).

GDP is made up of

consumer spending, investments, government spending, and exports minus imports

Consumption and investment fluctuate with GDP, but _____ is less volatile

consumption

Favorable supply shocks lower

costs and prices

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. Output ______ in the short run and the price level _____ in the long run.

declines by 5%, declines by 5%

In the short run a decrease in SRAD decreases

output and employment

The sticky price model of aggregate supply explains why

output declines when prices fall below expected prices

The severity of the Great Depression may be partly explained by an increase in expected

deflation, which raised real interest rates above nominal interest rates.

When prices are sticky... output and employment also depend on

demand

The adjustment of _________ is what moves the economy to its long-run equilibrium.

prices

A supply shock alters

production costs, affect the prices that firms charge. (also called price shocks)

A central bank can reduce inflation at the smallest cost if people's expectations of inflation

quickly respond to new policy regimes

An expansion in aggregate demand increases _____ in the short run. in the long run, however, it increases only the _____

real GDP; the price level

in the sticky price model: If all firms have sticky prices this implies ______

that the price level is equal to the expected price level and aggregate supply is horizontal in the short run

a rightward shift in aggregate _____ moves the economy along the short - run Phillips curve to a point with ____ inflation

demand, higher

long-run aggregate supply curve

does not depend on P, so LRAS is vertical.

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment when the central bank increases the money supply? A graph may be helpful for your answer.

the LM curve shifts downward. Income, consumption, and investment all rise. The interest rate falls.

At the intersection of the IS and LM curves,

the goods market and money market are both in equilibrium

model of aggregate demand and supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

An increase in the expected price level shifts

the short-run aggregate supply curve to the left

Which of the following would contribute to a decline in the index of leading indicators, suggesting that a recession is more likely?

• a decline in the slope of the yield curve

IS-LM model

A model of aggregate demand that shows what determines aggregate income for a given price level by analyzing the interaction between the goods market and the money market

A best selling book titled Retire Rich convinces the public to increase the percentage of their income devoted to saving. Use the IS-LM model to predict the short-run effects on income, the interest rate, consumption, and investment. Explain what the Fed should do to keep income at its initial level. A graph may be helpful for your answer.

Consumers now wish to save more and consume less, causing the IS curve to shift inward. Income, the interest rate, and consumption all fall while investment rises. if the Fed wants to keep income at its initial level, we must increase the money supply and ship the LM curve downward

In a typical recession, consumption ____________. Investment moves in the same direction but proportionally___________.

Falls, more

Suppose the sudden death of a popular president reduces consumer confidence, inducing people to save more. To stabilize aggregate demand, the Fed should

increase the money supply to lower interest rate

Suppose an economy in long run equilibrium experiences an increase in taxes. Use the IS-LM diagram to describe both the short-run effects and the long-run effects on national income, the interest rate, the price level, consumption, investment, and real money balances.

In the short run, higher taxes reduce consumer's disposable income, shifting the IS curve left. Output, consumption, and the interest rate decline and investment increases. In the long run, prices decline since output is below long-run equilibrium. The LM curve then shifts right as real money balances increase, causing output to return to the previous long-run level. Prices and the interest rate are now permanently lower, and lower consumption is offset by higher investment.

Suppose an economy in long run equilibrium experiences an increase in government purchases. Use the IS-LM diagram to describe both the short-run effects and the long-run effects on national income, the interest rate, the price level, consumption, investment, and real money balances.

In the short run, increased government purchases shift the IS curve to the right. Output, consumption, and interest rates increase while investment falls. In the long run, prices begin to rise which reduces real money balances. This shifts the LM curve to the left until output falls back to the long-run equilibrium. Prices and interest rates are permanently higher at the new long-run equilibrium, while levels of investment are permanently lower.

Suppose an economy in long run equilibrium experiences an increase in the money supply. Use the IS-LM diagram to describe both the short-run effects and the long-run effects on national income, the interest rate, the price level, consumption, investment, and real money balances.

In the short run, the LM curve shifts to the right as a result of the money supply increase. The interest rate falls while output, investment, and income all increase. Since this level of output is above the long-run level, prices begin to rise. Rising prices lower real money balances, which raises the interest rate. This causes the LM curve to shift back until it reaches the original equilibrium level. Thus, in the long run, there is no impact on real variables from this increase in the money supply.

If the Fed holds the interest rate constant in response to an increase in government purchases the money supply will ____ and the impact on the income will be ____ than if the money supply were held constant

Increase, larger

An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. How does this change affect the demand for money?

Interest-bearing checking accounts make holding money as checkable deposits more attractive. This increases the demand for money.

An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. Using your answers to previous questions, If the Fed keeps the money supply constant, what will happen to output and prices in the short run and in the long run?

Keeping the money supply constant, the decrease in velocity shifts aggregate demand down. Output falls in the short run. Prices fall in the long run, while output remains unchanged from the initial long run equilibrium.

Why are prices sticky?

Menu costs. Broad interpretation = loss of customer goodwill when prices change regularly, or disruption to internal financial planning!

The Fed is considering two alternative monetary policies: 1. Holding the money supply constant and letting the interest rate adjust 2. Adjusting the money supply to hold the interest rate constant Using the IS-LM model, which policy will better stablize output if all shocks to the economy arise from exogenous changes in the demand for goods and services.

Policy 1) will be more effective in stabilizing output in this scenario. If all shocks arise from exogenous changes in the demand for goods and services, then all shocks shift the IS curve. With a constant money supply, the change in the interest rate partially offsets the change in output. With a constant interest rate, however, this offsetting effect is absent, so output fluctuates more.

The Fed is considering two alternative monetary policies: 1. Holding the money supply constant and letting the interest rate adjust 2. Adjusting the money supply to hold the interest rate constant Using the IS-LM model, which policy will better stablize output if all shocks to the economy arise from exogenous changes in the demand for money

Policy 2) will be more effective in stabilizing output in this scenario. If all shocks in the economy arise from exogenous changes in the demand for money, then all shocks shift the LM curve. With the interest rate held constant, the LM curve does not shift in response to money demand shocks because the Fed immediately adjusts the money supply to satisfy demand. Therefore, there is no fluctuation in output under this strategy.

In the long run, an increase in M raises the _________ but output _______

Price level, stays the same

Long run

Prices are flexible, and respond to changes in supply or demand.

Changes in demand for goods & services (C ,I ,G ) only affect

Prices not Quantities

An increase in the money supply shifts the AD curve to the

Right

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. In what direction does the real interest rate move in the short run and in the long run? (Hint: Use the model of the real interest rate in Chapter 3 to see what happens when output changes.)

Savings will decline causing real interest rates to rise in the short run. In the long run, real interest rates are unaffected.

An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. What happens to the velocity of money?

Since money demand increases, velocity falls.

quantity theory of money

Suppose that T transactions (exchanges of goods for money) take place in a year suppose that P is the price in a typical transaction. the number of dollars exchanged in a year, by the definition of these two variables, equals PT.

Suppose the Fed only cares about keeping the price level stable. How should it respond to an exogenous decrease in the velocity of money?

The Fed should increase aggregate demand by increasing the money supply. This keeps prices and output at their original equilibrium.

Now suppose the Fed only cares about keeping output and employment at their natural levels. How should it respond to an exogenous decrease in the velocity of money?

The Fed should increase the money supply, boosting aggregate demand and returning output to natural levels.

Now suppose the Fed only cares about keeping output and employment at their natural levels. How should it respond to an exogenous increase in the price of oil?

The Fed should increase the money supply, boosting aggregate demand and returning output to natural levels.

An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. Using your answers to previous questions, If the goal of the Fed is to stabilize output, what should the Fed do?

The Fed should increase the money supply, shifting aggregate demand out to offset the previous shift.

An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. Using your answers to previous questions, If the goal of the Fed is to stabilize the price level, what should the Fed do?

The Fed should increase the money supply, shifting aggregate demand out to offset the previous shift.

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment when the government increases taxes? A graph may be helpful for your answer.

The IS curve shifts to the left by an amount equal to (-MPC/(1-MPC)) deltaT. Investment rises while income, interest rates, and consumption all fall.

According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment when the government increases government purchases? A graph may be helpful for your answer.

The IS curve shifts to the right by (1/(1-MPC)) deltaG. Income, interest rates, and consumption all rise. Investment falls.

• According to the IS-LM model, what happens in the short run to the interest rate, income, consumption, and investment when the government increases government purchases and taxes by equal amounts? A graph may be helpful for your answer.

The IS curve shifts to the right by deltaG. Output and the interest rate increase while consumption and investment fall.

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. What happens to the aggregate demand curve?

The aggregate demand curve shifts down

A wave of credit card fraud increases the frequency with which people make transactions in cash. Use the IS-LM model to predict the short-run effects on income, the interest rate, consumption, and investment. Explain what the Fed should do to keep income at its initial level. A graph may be helpful for your answer.

The increased demand for cash shifts the LM curve upward. The interest rate rises while income, consumption, and investment all fall. If the Fed wants to keep income at its initial level, it must increase the money supply to counteract the initial leftward shift of the LM curve.

After the invention of a new high-speed computer chip, many firms decide to upgrade their computer systems. Use the IS-LM model to predict the short-run effects on income, the interest rate, consumption, and investment. Explain what the Fed should do to keep income at its initial level. A graph may be helpful for your answer.

The invention of the new chip increases investment demand, shifting DIS curve outward. Income, consumption, investment, and interest rate. All increases. if the Fed wants to keep income at its initial level, then it must decrease the money supply shifting the LM curve leftward

real money balances

The quantity of money expressed in terms of the quantity of goods and services it can buy; the quantity of money divided by the price level (M/P).

Suppose the Fed only cares about keeping the price level stable. How should it respond to an exogenous increase in the price of oil?

There is no policy that can stabilize prices in the short run. In the long run, prices will return to their initial level without intervention.

Determine if the following statement is true: If money demand does not depend on income, the LM curve is horizontal

True. The LM curve represents the combinations of income and the interest rate which are in equilibrium in the money market. If money demand is independent of income, there is only one interest rate for which the money market will be in equilibrium, meaning the LM curve must be horizontal.

Determine if the following statement is true or false and explain why: If money demand is extremely sensitive to the interest rate, the LM curve is nearly horizontal.

True. Consider a case where income increases by $1. If money demand is extremely sensitive to the interest rate, then it takes only a small increase in the interest rate to reduce money demand and restore equilibrium. Therefore, the LM curve is nearly horizontal.

determine if the following statement is true or false and explain why: If investment does not depend on the interest rate the IS curve is vertical

True. The IS curve represents the relationship between the interest rate and the level of income. Investment spending partially determines that level of income. If investment does not depend on the interest rate, this implies that output is independent of the interest rate, and the IS curve must be vertical.

Determine if the following statement is true or false: If money demand does not depend on the interest rate the LM curve is vertical

True. The LM curve represents the combinations of income and the interest rate which are in equilibrium in the money market. If money demand is independent of the interest rate, there is only one level of income for which the money market will be in equilibrium.

Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. Using your answer to the previous question, what happens to unemployment in the short and long run according to Okun's law?

Unemployment rises by 4% in the short run, and is unaffected in the long run.

The appointment of a new dovish fed chair, increases, expected inflation Use the I SLM model to predict the short, run effects of income, the interest rate, consumption, and investment. Explain with the feds should do to keep income at its initial level. a graph may be helpful for your answer.

an increase in expected inflation reduces the demand for money shifting the LM curve downward, the interest-rate falls, while investment, income, and consumption all rise. If the Fed wants to keep income at its initial level, I must decrease the money supply in counteract the initial shift of the LM curve.

In the IS-LM model, which of the following causes both the interest rate and income to decline?

an increase in taxes

the short-run aggregate supply (SRAS) curve is

horizontal

in the sticky price model: the aggregate supply curve in the case the desired price does not depend on aggregate output (a=0) How does this compare to the short-run aggregate supply curve in chapter 10?

if the desired price does not depend on aggregate output. this implies that the price level is equal to the expected price level. this implies that aggregate supply is horizontal in the short run as assumed in chapter 10

Long-run effects of an increase in M An increase in M shifts AD curve to the _____

right

Short-run effects of an increase in M an increase in aggregate demand. causes output to _____ (remember that SRAS is horizontal and they provide as much as demanded)

rise

If output is above its natural level, over time the price level will ______, shifting the ______ curve and moving the economy toward its long-run equilibrium.

rise, LM

In the short run... The price level is fixed at a predetermined level, and firms

sell as much as buyers demand.

Aggregate demand

shows the relationship between the price level and the quantity of output demanded

a rightward shift in aggregate ______ shifts the short-run Phillips curve so the economy experiences_____ inflation for any level of unemployment

supply, lower

according to the theory of liquidity preferences the central bank can increase the ____ of the money and ____ the interest rate

supply, lower