Macroeconomics Exam 3: Chapters 11 & 13

Chapter 11: Classical Keynesian Macro Analyses --- Chapter 13: Fiscal Policy

aggregate demand (AD)

total demand for goods and services in an economy: C + I + G + (X - M)

short-run aggregate supply (SRAS)

upward-sloping curve showing output when input prices are sticky

long-run aggregate supply (LRAS)

vertical curve showing full-employment output determined by resources and technology

equilibrium (short run)

intersection point of AD and SRAS → determines the price level and real GDP

recessionary gap

when real GDP is less than full-employment GDP (or potential GDP at full employment)

signifies inefficient resource use, higher unemployment, reduced consumer spending, and downward pressure on the price level

usually addressed using expansionary fiscal policy

inflationary gap

when real GDP is greater than full-employment GDP (or potential GDP at full employment)

signifies an overheating economy during expansion, leading to upward pressure on prices (inflation)

usually combated through contractionary policies

demand shock

an event that shifts aggregate demand

• taxes

• government spending

• exports

• investment

supply shock

an event that shifts aggregate supply

• input prices

  • natural disasters

demand-pull inflation

inflation caused by an increase in aggregate demand (AD > SRAS)

“too much money chasing too few goods”

cost-push inflation

inflation caused by a decrease in aggregate supply (higher costs)

stagflation

the combination of rising prices and falling output (SRAS shifts left)

• stagnant growth

• high unemployment

• high inflation (rising prices)

results from supply-side shocks (i.e., energy shortages) and poor policy, leading to higher production costs and slower growth

classical economics

theory that the economy is self-correcting with fully flexible prices, wages, and interest rates

• LRAS is vertical

• real GDP = full-employment output

  • dependent on labor, capital, and technology

Say’s Law

the idea that supply creates its own demand

money illusion

when people confuse nominal changes with real changes in purchasing power

keynesian economics

theory that prices are “sticky” and government intervention may be needed (markets are not always self-correcting)

• inflationary + recessionary gaps

sticky prices

prices that adjust slowly to changes in supply and demand

discretionary fiscal policy

government use of spending and taxes to influence the economy

expansionary fiscal policy

policy used to fight recessions

• government spending ↑

• taxes ↓

• AD shifts right

contractionary fiscal policy

policy used to fight inflation

• government spending ↓

• taxes ↑

• AD shifts left

government spending (G)

spending by the government on goods and services

taxes (T)

government charges that affect disposable income and consumption

multiplier effect

initial spending leads to additional rounds of spending, amplifying impact on AD

crowding-out effect

government borrowing raises interest rates and reduces private investment

ricardian equivalence

theory that tax cuts may not increase AD because people save for future taxes

interest rate (r)

the cost of borrowing money

interest rate effect

higher interest rates reduce investment and consumption, lowering AD

investment (I)

spending by firms on capital goods

consumption (C)

household spending on goods and services

exports (X)

goods and services sold to other countries

imports (M)

goods and services bought from other countries

aggregate demand shift right

caused by:

• ↑ government spending

• ↓ taxes

• ↑ investments

• ↑ exports

→ increases GDP and price level

aggregate demand shift left

caused by:

• ↓ government spending

• ↑ taxes

• ↓ investments

• ↓ exports

→ decreases GDP and price level

short-run aggregate supply shift left

caused by higher input costs → increased prices, decreases GDP

short-run aggregate supply shift right

caused by lower input costs → decreased prices, increases GDP

long-run aggregate supply shift right

caused by increases in labor, capital, or technology

time lags (fiscal policy)

delays in recognizing, implementing, and seeing effects of policy