INF Economics Module 5: The Great Depression

Circular flow of income

economic model that pictures income as flowing continuously between businesses and consumers

Procyclical variable

An economic variable that moves in the same direction as real GDP— increasing during expansions and decreasing during recessions.

Countercyclical Variable

An economic variable that moves in the opposite direction as real GDP—decreasing during expansions and increasing during recessions.

Correlation

A measure of the extent to which two factors vary together, and thus of how well either factor predicts the other.

Potential output

the amount of real GDP the economy produces when the labor market is in equilibrium and capital goods are not lying idle

Growth rate of technology

Technology growth rate = Output growth rate - a

National income identity

Production = Consumption + Investment + Gov. Purchase + Net Exports

Y = C + I + G + NX

Consumption

total consumption spending by households on final goods

and services divided in to 3 categories: services, non-durable goods, durable goods

Investment

is the purchase of new goods that increase the capital stock, allowing us to produce more output in the future. Divided into business fixed investment, new residential construction, and inventory investment.

Government purchases

all purchases of goods and services by the government

Accounting relationship within a firm

Production = Sales + Changes in inventory

Unplanned inventory investment

an increase in inventories that comes about because a firm sells less than it anticipated

Planned spending

all expenditure in the economy except for unplanned inventory investment: GDP = Planned spending + unplanned inventory investment

Consumption smoothing

the idea that households like to keep their flow of consumption relatively steady over time. When income is unusually high, the household saves (or pays off existing loans) and when income is unusually low, the household borrows (or draws down existing savings).

Aggregate spending

the total amount of spending by households, firms

and the government on the goods and services that go into real GDP

Flexible vs sticky wages

If prices and wages are flexible, they adjust immediately to shifts in supply and demand curves. The price is always at the point where supply equals demand. If prices and wages are sticky, they do not adjust immediately to shifts in supply and demand curves. Instead, the adjustment to equilibrium can take some time.

Autonomous spending

the intercept of the planned spending line. It is the amount of spending that there would be in the economy if income was zero. It is positive, for two reasons. First, a household with no income still wants to consume something, and so it will either draw upon its existing savings or it will borrow against future income. Second, the government consumes even if income was zero.

Marginal propensity to spend

the slope of the planned spending line. It tells us how much planned spending increases if there is a one dollar increase in income. The marginal propensity to spend is positive: Increases in income lead to

increased spending by households and firms. The marginal propensity to spend is less than one, largely because of consumption smoothing by households. If household income goes up by one dollar, households typically consume only a fraction of the increase, saving the remainder to finance future consumption.

Aggregate expenditure model

takes as its starting point the fact that GDP measures both total spending and total production. The model focuses on the relationships between output and spending which we write as:

GDP = Planned spending

Planned spending = Autonomous spending + Marginal propensity to spend × GDP

The model finds the value of output for a given value of the price level. It is then combined with a model of price adjustment to give a complete picture of the economy.

Wealth effect

the effect on consumption of a change in wealth

Multiplier

Multiplier = 1/(1 - Marginal propensity to spend)

Liquidity

the ease with which an asset can be converted into cash

Bank run

occurs when a significant fraction of a bank's depositors all try to withdraw their funds at the same time. If the bank is unable to meet its depositors' demands, it may be forced out of business. This is known as a bank failure.

Coordination game

a strategic situation where there are multiple equilibria

Currency-deposit ratio

the total amount of currency (that is, either banknotes or coins) divided by the total amount of deposits in banks

Loan-deposit ratio

equals the total amount of loans made by banks divided by the total

amount of deposits in banks

Price-adjustment equation

The difference between potential and actual output is called the output gap: Output gap = Potential real GDP − Actual real GDP.

If the economy is in recession, the output gap is positive. If the economy is in a boom, then the output gap is negative. The inflation rate when the economy is at potential output (that is, when the output gap is zero) is called autonomous inflation. The overall inflation rate depends upon both autonomous inflation and

the output gap, as shown in the price-adjustment equation: Inflation rate = Autonomous inflation − Inflation sensitivity × Output gap.

Monetary policy

changes in interest rates and other tools that are under the control of the monetary authority of a country (the Central Bank).

Fiscal policy

refers to changes in taxation and the level of government purchases; such policies are typically under the control of a country's lawmakers.

Stabilization policy

refers to the use of monetary and fiscal policies to prevent large fluctuations in real GDP.