Macro Final Exam

3 facts about Economic Fluctuations

1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantities fluctuate together 3. As output falls, unemployment rises

Three Theories of SARs

1. Sticky Wage Theory 2. Sticky Price Theory 3. Misperceptions Theory

Sticky Wage Theory

Nominal wages are sticky in the short run, they adjust sluggishly (due to labor contracts, social norms) Firms and workers set the nominal wage in advance based on Pe, the price level they expect to prevail. Higher P cause higher Y

Output equation for all three theories

Output = Natural rate of output in long run (Yn) + how much Y responds to unexpected changes in P (a) * (Actual price level (P) - Expected price level (Pe)) OR Y= Yn + a(P-Pe)

During periods of stagflation, what happens to output and prices in the economy?

Output falls and prices increase

What is the short-run cost of reducing inflation?

Output falls and unemployment rises

Exchange-Rate Effect

P rises (US interest rates rise. Foreign investors desire moer US bonds causing a higher demand for $ in foreign exchange market. US exchange rate appreciates. Imports are more than Exports) NX falls OR P decrease (interest rates and exchange rates to depreciate and Exports are more than Imports) NX increase

Interest-Rate Effect

P rises (buying g&s requires more dollars. To get these dollars, people sell bonds or other assets. This drives up interest rates) I falls OR P falls ( people buy bonds and other assets, lowering interest rates) I rises

Wealth Effect

P rises (dollars people hold buy fewer g&s so real wealth is lower) C falls OR P falls (dollars people hold buy more g&s so real wealth is higher) C rises

When the interest rate increases, the opportunity cost of holding money

increases, so the quantity of money demanded decreases

Regression comes at

irregular intervals. During recessions investment spending falls relatively ore than consumption spending

If the economy is initially at long-run equilibrium and aggregate demand declines, then in the long run the price level

is lower and output is the same as the original long-run equilibrium

An open-market purchase by the Federal Reserve creates an excess _____ of money. This causes interest rates to _____ and investment to _____. The change in investment causes aggregate demand to shift to the _____.

supply, fall rise, right

If the price level falls, the real value of a dollar

rises so people will want to buy more

The wealth effect, interest effect, and exchange-rate effect are all explanations for

the slop of the AD curve

How does the model of aggregate demand and aggregate supply explain economic fluctuations?

these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters

A decrease in the expected price level shifts

short-run, but not long-run aggregate supply curve

Aggregate supply shifts left, this causes

stagflation

If the Fed increase the money supply

the interest rate decreases, which tends to raise stock prices

Multiplier equation

1/1-MPC

If the MPC is 3/5 then the multiplier is

2.5, so a $100 increase in government spending increases aggregate demand by $250

How does the interest-rate effect help explain the slope of the aggregate-demand curve?

A fall in r increase money demand

The price level and quantity of output adjust to bring

AD and supply into balance

Why does the Aggregate-Demand curve slope downward?

An increase in Price reduces the quantity of g&s demanded because: the wealth effect, interest-rate effect, and the exchange rate

What shifts the AD curve?

Changes in C (stockmarket crash/boom), I (Investment Tax Credit or other tax incentives), G, or NX (Booms/ recessions in countries that buy our exports)

When the Fed sells government bonds, the reserves of the banking system

Decrease, so the money supply decreases

Sticky Price Theory

Due to menu costs, the cost of adjusting prices is sticky. Example: cost of printing out new menus for a restaurant. Firms with menu costs wait to raise prices while firms without menu costs can raise their prices immediately.

What shifts AS curve?

Everything that shifts LRAS shifts SRAS, too.

In what two ways does fiscal policy affect aggregate demand?

Expansionary fiscal policy Contractionary fiscal policy

What factors alter this relationship

Expected Inflation Supply Shock

Misperceptions Theory

Firms may confuse changes in P with changes in the relative price of the products they sell

How are inflation and unemployment related in the short run? In the long run

The Phillips curve describes the short run trade-off between inflation and unemployment. In the long run, there is not trade-off: inflation is determined by money growth, while unemployment equals its natural rate

Phillips Curve Equation

Unemployment rate= Natural rate of unemployment - a (Actual inflation- Expected inflation)

What is the AS curve in the short run?

Upward-sloping

What is the AS curve in the long run?

Vertical

Contractionary fiscal policy

a decrease in G and/or increase T, shifts AD left

The exchange-rate effect in based, in part, on the idea that

a decrease in the price level reduces the interest rate

A decrease in government spending initially and primarily shifts

aggregate demand to the left

Expansionary fiscal policy

an increase in G and/or decrease in T, shifts AD left

Automatic Stabilizers

are changes in taxes or government spending that increase aggregate demand without requiring policy makers to act when the economy goes into recession

The Federal Funds rate is the interest rate

banks change each other for short-term loans

Short-run economic fluctuations are often called

business cycles

In the short run, an increase in the money supply causes interest rates to

decrease, and aggregate demand to shift right

The interest-rate effect

depends on the idea that decreases in the interest rates increase the quantity of goods and services demanded

Permanent tax cuts shift the AD curve

father to the right then do temporary tax cuts

The misconceptions theory of the short-run aggregate supply curve says that if the price level is higher than people expected, then some firms believe that the relative prive of what they produce has

increased, so they increase production

When taxes decrease, consumption

increases as shown by a shift of the aggregate demand curve to the right

According to the liquidity preference theory, an increase in the overall price level is 10 percent

increases the equilibrium interest rate, which in turn decreases the quantity of goods and services demanded.

When the dollar depreciates, US net exports

raise,, which increases the aggregate quantity of goods and services demanded

How can the central bank use monetary policy to shift the AD curve?

the Fed's policy instrument is Money Supply(MS) To change the interest rate and shift the AD curve, the Fed conducts open market operations to change MS

Liquidity refers to

the ease with which an asset is converted into a medium of exchange

Using the liquidity-preference model, when the Federal Reserve decreases the money supply

the equilibrium interest rate increases

Other things the same, if the long-run aggregate supply curve says that the quantity of output firms supply will increase if

the price level is higher than expected making production more profitable

The sticky-wage theory of the short-run aggregate supply curve says that the quantity of output firms supply will increase if

the price level is higher than expected making production more profitable

The term crowding-out effect refers to

the reduction in aggregate demand that results when a fiscal expansion cause the interest rate to increase

Fiscal Policy

the setting of the level of govt spending and taxation by govt policymakers