EC102 Ch.19-21 HW

CH. 20 1. Notice that real GDP trends upward over time but experiences ups and downs in the short run. These short-run fluctuations in real GDP are often referred to as the:

- business cycle

Notice that real GDP trends upward over time but experiences ups and downs in the short run. A period of declining real GDP, such as the blue-shaded period in 1948, is known asa recession .

A recession

Suppose the Fed doubles the growth rate of the quantity of money in the economy. In the long run, the increase in money growth will change which of the following? Check all that apply. A. The price level B. The inflation rate C. The level of technological knowledge D. The size of the labor force

A, B

Which of the following probably occurred as the U.S. economy experienced increasing real GDP in 1950? Check all that apply. A. Home sales declined. B. Industrial production declined. C. Retail sales increased. D. The unemployment rate declined. E. Consumer spending increased.

C, D, E

Trade surplus if NX = Trade Deficit if NX = Trade balance if

Trade surplus if NX = + Trade Deficit if NX = - Trade balance if exports = imports From the market for loanable funds, you know that the equilibrium real interest rate is 4%. At this rate, the level of net capital outflow is equal to $5 billion. Because net capital outflow must be equal to net exports, this means that net exports must equal $5 billion as well. Therefore, the economy is experiencing a trade surplus.

True or False: Short-term fluctuations in real GDP are irregular and unpredictable.

True

Velocity of $ Equation

V=PY/M = Price level * GDP / Money Supply - The quantity equation: M x V = P x Y

Quantity Theory of $ / The classical dichotomy - Velocity (is fixed/changes) - Change in M (does/does not affect) Y - Change in M (does/does not lead to) a proportional change in P

CD: theoretical separation of nominal + real variables! (1) Velocity of $ doesn't change; it's fixed (2) Change in M doesn't affect Y - Implies that a change in M leads to a proportional change in P - V=PY/M *M does NOT affect Y *M AFFECTS P proportionally

Monetary Neutrality:

the notion that an increase in the quantity of money will impact the price level but not the output level.

- What happens to AS or AD curves to show the short-run impact of the increase in government spending. - In the short run, the increase in government spending on infrastructure causes the price level to (rise above/fall below) the price level people expected and the quantity of output to (rise above/fall below) the natural level of output. The increase in government spending will cause the unemployment rate to (rise above/fall below) the natural rate of unemployment in the short run. - During the transition from the short run to the long run, price-level expectations will (adjust upward/downward/remain the same) and the curve will shift to the (AD/SRAS) curve will shift to the (left/right). - In the long run, as a result of the increase in government spending, the price level (inc/dec/remains the same) , the quantity of output (rises above, returns to, falls below) the natural level of output, and the unemployment rate (rises above, returns to, falls below) the natural rate of unemployment.

- AD shifts RIGHT - rise above - rise above - fall below - adjust UPWARD - SRAS - shifts LEFT - LR: price level increases, Q of output RETURNS TO natural level of output + U-Rate RETURNS TO the natural rate of unemployment.

- What happens to AS or AD curves to show the short-run impact of the sharp increase in saving. - In the short run, the increase in government spending on infrastructure causes the price level to (rise above/fall below) the price level people expected and the quantity of output to (rise above/fall below) the natural level of output. The increase in government spending will cause the unemployment rate to (rise above/fall below) the natural rate of unemployment in the short run. - During the transition from the short run to the long run, price-level expectations will (adjust upward/downward/remain the same) and the curve will shift to the (AD/SRAS) curve will shift to the (left/right). - In the long run, as a result of the increase in government spending, the price level (inc/dec/remains the same) , the quantity of output (rises above, returns to, falls below) the natural level of output, and the unemployment rate (rises above, returns to, falls below) the natural rate of unemployment.

- AD shifts left (bc C falls) - price level FALLS below expected - Q expected output FALLS below - Unemployment rat RISES above natural UR - SR transition: P expectations ADJUST DOWN - SRAS - shifts RIGHT - LR: P decreases, Y returns to natural level of output + UR returns to natural UR

- The classical dichotomy: - Monetary Neutrality: - Quantity theory:

- Classical Dichotomy: The distinction between real variables + nominal variables. - Money Neutrality: the notion that an increase in the quantity of money will impact the price level but not the output level. - Velocity Equation *Quantity theory of money is based on money neutrality!

Suppose you've just inherited $10,000 from a relative. You're trying to decide whether to put the $10,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond. The opportunity cost of holding the inheritance as money depends on the interest rate on the bond. Compute the opportunity cost of holding the $10,000 as money for Interest rate on govt bond of 6% and 3%. What does the previous analysis suggest about the market for money? A. The quantity of money demanded decreases as the interest rate falls. B. The quantity of money demanded increases as the interest rate falls. C. The supply of money is independent of the interest rate.

Opportunity cost (dollars per year): 10000(.06) = 600 10000(.03) = 300 B. The quantity of money demanded increases as the interest rate falls. *Reminder: interest rate = cost of borrowing = opp cost of holding money The demand for money arises largely from its usefulness in making daily transactions. Since the opportunity cost of holding money falls as the interest rate falls, people will hold a larger fraction of their assets as money when the interest rate is low—in other words, they demand more money at lower interest rates.

Quantity of Output Supplied =

Natural Level of Output + α × (Price Level Actual − Price Level Expected)

Change due to a quota: - Demand for LF's: Inc/dec/no change - Real interest rate: Inc/dec/no change - NCO: Inc/dec/no change - NX: Inc/dec/no change

- Demand for LF's: no change - Real interest rate: no change - NCO: no change - NX: no change - Quota imposes no change on LF's demand (domestic investment and net capital outflow), or supply (national saving), + r. - Although the demand for dollars increases b/c NX rise for any given r, the rise in the real exchange rate also dampens net exports, counteracting the initial effect of the quota. *The end result is no change in net exports, so the lobbyists were incorrect in their original assessment.

4. Suppose the U.S. automobile industry is concerned about foreign car producers exporting their goods to the United States, a practice that hurts domestic producers. Lobbyists claim that implementing a quota on imports would shrink the size of the trade deficit. - What happens to the curve(s) in foreign-currency exchange market? - The dollar (appreciates/depreciates)

- Demand increases - Dollar appreciates When the U.S. government imposes a quota, NX will rise for any given real exchange rate (bc imports decrease). This change translates in this model into an increase in the demand for dollars, which leads to an increase in the real exchange rate. Therefore, the dollar has appreciated. Recall that the supply curve in this model of the foreign-currency exchange market is derived from NCO, which is affected only by the real interest rate, not the real exchange rate. Hence, the supply curve does not shift in this scenario.

6. Suppose the French suddenly develop a strong taste for California wines. - What happens in U.S. dollars in the market for foreign-currency exchange as a result of this change in tastes? - This causes the value of dollars in the market for foreign-currency exchange to (rise/fall/remain unchanged) , and the equilibrium quantity of net exports to remain unchanged .

- Demand shifts right (When the French develop a strong taste for California wines, the demand for dollars in the foreign-currency market increases at any given real exchange rate.) - Value of dollars RISES - Q of NX = unchanged The result of the increased demand for dollars is a rise in the real exchange rate. However, because nothing happens to national saving or domestic investment in the loanable funds market, the real interest rate remains the same, and thus, net capital outflow also remains unchanged. Additionally, since net capital outflow equals net exports in equilibrium, the quantity of net exports remains the same.

Change Needed to Decrease AS: - Inflation Expectations: (higher/lower) - Tax rates: (inc/dec) - Burdensome regulations: (inc/dec)

- Inflation expectations: HIGHER - Tax rates: INC - Burdensome regulations: INC If workers, landlords, and firms expect higher rates of inflation in the future, they will negotiate existing wage and rent contracts in order to compensate for rising prices. The increase in wages and rents represents an increase in input costs for firms, reducing the quantity of aggregate output supplied at each price level. Higher inflation expectations shift the AS curve to the left. Rising tax rates can discourage people from working (since they keep a smaller fraction of before-tax earnings) and reduce firm incentives to produce output (since they keep a smaller share of before-tax profits). If firms respond to tax cuts by decreasing the quantity of aggregate output supplied at each level, then an increase in tax rates will shift the AS curve to the left. Burdensome regulations increase the cost of producing output. Adding burdensome regulations will therefore increase firm input costs as firms take on additional costs to comply with the regulations. The higher input costs reduce short-run aggregate supply and shift the AS curve to the left.

Change Needed to INC AS: - Input prices: (higher/lower) - Human capital: (improves/declines) - Technology: (improves/declines)

- Input prices: DEC - Human capital: Improves - Technology: Improves Lower input costs decrease the cost of production, enabling firms to supply a higher quantity of aggregate output at each price level. A decrease in input prices shifts the AS curve to the right. Human capital, the knowledge and skills embodied in the workforce, is an important determinant of productivity. Improvements in human capital enhance productivity (output per hour of labor), causing firms to supply a higher quantity of aggregate output at each price level. Rising levels of human capital shift the AS curve to the right. Improvements in technology boost productivity, causing firms to supply a higher quantity of aggregate output at each price level. Technological improvements shift the AS curve to the right.

The following graph shows the money market in a hypothetical economy. The central bank in this economy is called the Fed. Assume that the Fed fixes the quantity of money supplied. Suppose the price level increases from 90 to 105. After the increase in the price level, the quantity of money demanded at the initial interest rate of 9% will be than the quantity of money supplied by the Fed at this interest rate. People will try to their money holdings. In order to do so, people will bonds and other interest-bearing assets, and bond issuers will find that they interest rates until the money market reaches its new equilibrium at an interest rate of.

- MD INC/shifts RIGHT (Since Y, r, + P affect MD)

AS/AD graph: Expected price level is equal to the actual price level, + the economy is in long-run equilibrium at its natural level of output, $100 billion. Suppose a bout of severe weather drives up agricultural costs, increases the costs of transporting goods and services, and increases the costs of producing goods and services in this economy. - what happens? - The short-run economic outcome resulting from the increase in production costs is known as ____ - Now suppose that the government immediately pursues an accommodative policy by increasing government purchases in response to the short-run economic impact of the severe weather. - In the long run, when the government pursues accommodative policy, the output in the economy will be (higher/lower/same) and the price level will be (higher/lower/same) as before.

- SRAS shifts LEFT - Stagflation b/c P rises (inflation) + since Y decreases, UR rises! - output will be the same - Price level will be higher

5. Suppose that Mexico experiences a sudden bout of political turmoil, which causes world financial markets to become uneasy. Because people now view Mexico as unstable, they decide to pull some of their assets out of Mexico and put them into more stable economies. This unexpected shock to the demand for assets in Mexico is known as capital flight. - what happens in the market for foreign exchange? - Real Interest Rate: Inc/dec/no change - Real Exchange Rate: Inc/dec/no change - NCO: Inc/dec/no change

- Supply (NCO) shifts right - Real Interest Rate: INC - Real Exchange Rate: DEC - NCO: INC - If people decide to move their capital to safer havens, net capital outflow in Mexico increases for any given real interest rate. This results in a rightward shift of the NCO curve. - The demand for LF's is composed of NCO + domestic investment, which causes the demand for LF's to increase in Mexico, and in turn causes the real interest rate to rise.

What changes need to occur (inc/dec) to Increase AD (shift right). For example, from output of $300 at price level of 140 to output now at $400 (same price level) - Wealth - Taxes - Expected rate of return on investment - Incomes in other countries

- Wealth: INC - Taxes: DEC - Expected rate of return on investment: INC - Incomes in other countries: INC The level of consumer spending depends, in part, on household wealth. As household wealth rises, consumer spending rises at each price level. An increase in consumer spending leads to an increase in aggregate demand. A decrease in taxes increases households' disposable income. Households will spend more, causing aggregate demand to increase at each price level. The rate of return that businesses expect on capital projects is a key determinant of investment. Suppose a technological breakthrough causes an increase in the expected return on investment. Investment spending will rise, and aggregate demand will increase at each price level. When the incomes of foreigners increase, foreigners will purchase more domestic products, causing exports to rise. Because net exports are one component of aggregate demand, this increase in net exports (exports minus imports) leads to an increase in aggregate demand at each price level.

3. As the price level rises, the cost of borrowing money will (rise/fall) , causing the quantity of output demanded to (rise/fall) . This phenomenon is known as the _________ effect.

- cost of borrowing will RISE - QD of output will FALL - interest rate effect If the price level rises, people will need more money to carry out day-to-day transactions. As people demand more money, the cost of borrowing money—the interest rate—will rise (assuming that the quantity of money in the economy is fixed). As a result, business investment slows, leading to a decreased demand for domestic output. This is known as the interest rate effect of a change in the price level. Note that a higher interest rate decreases not only investment spending, but also consumer spending, as people will want to save more. So, at a higher interest rate, business investment decreases and household saving increases, leading to a decreased demand for domestic output.

Now, suppose the government is experiencing a budget deficit. This means that national saving will (inc/decrease) , which leads to a (inc/decrease) in the supply of loanable funds.

- national savings will DECREASE - DECREASE in the supply of loanable funds When the government is experiencing a budget deficit, national saving decreases. This leads to a decrease in the supply of loanable funds, which increases the real interest rate. The foreign-currency exchange market is derived from the relationship between NCO, NX, + real exchange rate. Net capital outflow represents the quantity of domestic currency supplied for the purpose of buying foreign assets. The level of net capital outflow is determined by the real interest rate, not the real exchange rate. Therefore, the supply curve in the foreign-currency exchange market is vertical at the level of net capital outflow that occurs at the equilibrium real interest rate. A budget deficit causes real interest rate to increase, lowering NCO.

- The vertical axis of the aggregate demand and aggregate supply model measures the overall (price level, quantity of output, demand, or supply). - The aggregate (demand/supply) curve shows the quantity of output that households, firms, the government, and foreign customers want to buy at each price level.

- price level - Demand

Economists use the model of aggregate demand and aggregate supply to examine the economy's short-run fluctuations around the long-run output level. - The horizontal axis of the aggregate demand and aggregate supply model measures the overall (price level, quantity of output, demand, or supply) - The aggregate (demand/supply) curve shows the quantity of goods and services that firms produce and sell at each price level.

- quantity of output - supply - The price level, a nominal variable, is on the vertical axis, + the quantity of output, a real variable, is on the horizontal axis. - The downward-sloping AD curve shows the quantity of output that governments, consumers, business firms, + foreign customers wish to buy at each price level. - The upward-sloping AS curve shows the quantity of output that firms produce and sell at each price level.

- Effects of a Budget Deficit: - Real Interest Rate: Inc/Dec - Real Exchange Rate: Inc/Dec - Trade Balance: Surplus/Deficit/Balance

- r INCREASES - E INCREASES - Trade BALANCE - In a govt budget deficit, national saving decreases. This leads to a decrease in the supply of LF's + an increase in r. - A higher real interest rate decreases NCO, shifting the supply curve in the foreign-currency exchange market to the left. This causes the real exchange rate to increase + NX to decrease. - Overall, the budget deficit leads to a trade deficit as well. This is commonly known as the twin deficit problem.

Additionally, as the price level falls, the impact on the domestic interest rate will cause the real value of the dollar to (rise/fall), in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore (rise/fall) , and the number of foreign products purchased by domestic consumers and firms (imports) will (rise/fall) . Net exports will therefore (rise/fall) , , causing the quantity of domestic output demanded to (rise/fall) . This phenomenon is known as the ____ rate effect.

- real value of dollar FALL - EX RISE - Im FALL - NX RISE - QD of domestic output RISE - Exchange rate effect When an economy's price level falls, consumers require less money to purchase a given basket of goods and services, so that money demand falls, causing the domestic interest rate to fall. Investors respond to lower domestic interest rates by seeking higher returns abroad. As domestic investors attempt to convert dollars into foreign currency to buy foreign assets, the supply of dollars increases in the market for foreign-currency exchange, and the real value of the dollar falls. When each dollar buys fewer units of foreign currencies, foreign goods become more expensive than domestic goods. Because of dollar depreciation, foreigners find domestic goods to be relatively inexpensive. Exports of domestic goods to foreigners therefore rise, while domestic imports of foreign goods fall. Net exports (exports minus imports) therefore rise, leading to a rise in the quantity of domestic output demanded. The tendency for a fall in the price level to decrease the real exchange rate and increase net exports is known as the exchange rate effect

As the price level rises, the impact on the domestic interest rate will cause the real value of the dollar to (rise/fall) in foreign exchange markets. The number of domestic products purchased by foreigners (exports) will therefore (rise/fall) , and the number of foreign products purchased by domestic consumers and firms (imports) will (rise/fall) . Net exports will therefore (rise/fall), causing the quantity of domestic output demanded to (rise/fall). This phenomenon is known as the ____ effect.

- real value of dollar RISE - number of domestic products purchased by foreigners (exports) FALL (relatively cheaper) - number of foreign products purchased by domestic consumers and firms (imports) will RISE - NX FALL - QD output FALLS - Exchange Rate Effect When an economy's price level rises, consumers require more money to purchase a given basket of goods and services, so that money demand rises, causing the domestic interest rate to rise. Foreign investors respond to higher domestic interest rates by seeking higher returns in the domestic economy. As foreign investors attempt to convert foreign currency into dollars to buy domestic assets, the demand for dollars increases in the market for foreign-currency exchange, and the real value of the dollar rises. When each dollar buys more units of foreign currencies, foreign goods become less expensive than domestic goods. Because of dollar appreciation, foreigners find domestic goods to be relatively more expensive. Exports of domestic goods to foreigners therefore fall, while domestic imports of foreign goods rise. Net exports (exports minus imports) therefore fall, leading to a fall in the quantity of domestic output demanded.

As the price level falls, the purchasing power of households' real wealth will (rise/fall) , causing the quantity of output demanded to (rise/fall) . This phenomenon is known as the ______ effect.

- rise, rise, wealth - Households often hold some of their wealth in the form of savings accounts or cash. As the price level falls, the purchasing power of this wealth rises because the money will purchase more of the (now lower-priced) goods. According to the wealth effect, decreases in the price level increase the quantity of output demanded.

For example, the sticky-price theory asserts that the output prices of some goods and services adjust slowly to changes in the price level. Suppose firms announce the prices for their products in advance, based on an expected price level of 100 for the coming year. Many of the firms sell their goods through catalogs and face high costs of reprinting if they change prices. The actual price level turns out to be 90. Faced with high menu costs, the firms that rely on catalog sales choose not to adjust their prices. Sales from catalogs will (rise, fall remain the same), and firms that rely on catalogs will respond by (reducing/increasing) the quantity of output they supply. If enough firms face high costs of adjusting prices, the unexpected decrease in the price level causes the quantity of output supplied to (rise above/fall below) the natural level of output in the short run.

- sales will fall - firms reduce supply - quantity output supplied will fall BELOW natural rate of output in short run According to the sticky-price theory, the short-run aggregate supply curve slopes upward because the prices of some products adjust slowly to economic conditions. Some firms set prices for prolonged periods of time because they face high menu costs when prices are adjusted frequently. If the price level turns out to be lower than people expected, the prices of products of firms with more flexible pricing options will be low compared to the prices of products of firms that face high menu costs. Firms with rigid prices will see their sales decline and will cut back on production. An unexpectedly high price level has the opposite effect. Flexible firms will adjust their prices upward, while prices at sticky-price firms will lag behind. Sticky-price firms will see their sales increase because of their relatively low prices, causing them to increase production.

2. For example, an increase in the money supply, a 1.(real/nominal) variable, will cause the price level, a 2.(real/nominal) variable, to increase but will have no long-run effect on the quantity of goods and services the economy can produce, a 3.(real/nominal) variable. The distinction between real variables and nominal variables is known as 4. (price neutrality, the classical dichotomy, quantity theory)

1. MS = Nominal 2. Price level = Nominal 3. output = real 4. the classical dichotomy Real variables measure quantities of goods and services, such as the quantity of a particular good or service produced in an economy or the number of units of one good a unit of another good can buy. Nominal variables, such as the quantity of money or the price level, are measured in terms of dollars. The classical dichotomy is the separation of economic variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money).

Direction of LRAS Curve Shift (Left, No shift, Right) 1. The government allows more immigration of working-age adults who find work. 2. A scientific breakthrough significantly increases food production per acre of farmland. 3. A government-sponsored training program increases the skill level of the workforce

1. Right 2. Right 3. Right

Every dollar saved can go toward either 1._____________ or 2. _____________. This equation 3. ____________ represents the two sides of the market for loanable funds, with the supply of loanable funds coming from 4.____________ and the demand for loanable funds coming from 5.____________. Note that all the components of the demand and supply of loanable funds depend on the 6. ____________ in the domestic economy.

1. increasing domestic capita 2. purchasing a foreign asset 3. S = I + NCO 4. National saving 5. investment and net foreign investment 6. the real interest rate

Which of the following probably occurred as the U.S. economy experienced declining real GDP in 1957? Check all that apply. A. Total real income declined. B. Consumer spending increased. C. The unemployment rate increased. D. Corporate profits declined.

A, C, D

1. In a large open economy, what is the source of the domestic supply of loanable funds? A. Investment B. Net foreign investment C. National saving D. National saving and investment

C. National saving - Let S = saving, I = investment, and NCO = net foreign investment (NCO). - MLF's in an open economy can be described by: S = I+NCO Every dollar saved can go toward either increasing domestic capital or purchasing a foreign asset. This equation represents the two sides of the market for loanable funds, with the supply of loanable funds coming from national saving and the demand for loanable funds coming from investment and net foreign investment. Note that all the components of the demand and supply of loanable funds depend on the real interest rate in the domestic economy.

2. In an open economy, why is the demand curve for dollars in the foreign-currency exchange market downward sloping? A. A depreciation of the dollar reduces the quantity of dollars demanded in the market for foreign-currency exchange. B. A depreciation in the domestic currency causes exports to fall and imports to rise and, therefore, net exports to fall. C. When the value of the domestic currency depreciates, domestic goods become less expensive relative to foreign goods, making domestic goods more attractive to domestic and foreign consumers. D. Net capital outflow equals net exports

C. When the value of the domestic currency depreciates, domestic goods become less expensive relative to foreign goods, making domestic goods more attractive to domestic and foreign consumers. By letting NX stand for net exports and NCO stand for net capital outflow, the market for foreign-currency exchange in an open economy can be described by the following equation: NX = NCO The difference between imports and exports of goods and services must equal the difference between the purchase and sale of capital assets abroad. This equation illustrates that net capital outflow represents the quantity of domestic currency supplied for the purpose of buying foreign assets, whereas net exports represent the quantity of dollars demanded for the purpose of buying domestic net exports of goods and services. On the demand side, when the domestic currency depreciates, domestic goods become less expensive relative to foreign goods. This makes domestic goods more attractive to both domestic and foreign consumers. Therefore, exports from the domestic country will increase, imports into the country will decrease, and net exports will rise. Hence, a depreciation of the dollar increases the quantity of dollars demanded.

Suppose the government passes a law that reduces unemployment benefits in a way that causes unemployed workers to seek out new jobs more quickly. The policy will cause the natural rate of unemployment to (rise/fall), which will: A. Not affect the long-run aggregate supply curve B. Shift the long-run aggregate supply curve to the right C. Shift the long-run aggregate supply curve to the left

FALL, B

For example, the sticky-wage theory asserts that output prices adjust more quickly to changes in the price level than wages, in part because of long-term wage contracts. Suppose a firm signs a contract agreeing to pay its workers $15 per hour for the next year, based on an expected price level of 100. If the actual price level turns out to be 110, the firm's output prices will _______ , and the wages the firm pays its workers will remain fixed at the contracted level. The firm will respond to the unexpected increase in the price level by _______ the quantity of output it supplies. If many firms face similarly rigid wage contracts, the unexpected increase in the price level causes the quantity of output supplied to _____ Correct the natural level of output in the short run. - The short-run quantity of output supplied by firms will rise above the natural level of output when the actual price level (rises above/falls below) the price level that people expected.

Rise, Increase, Rise above, rise above