Exam 3

Idea of says law vs keynes law

says: supply creates its own demand

keynes: demand creates its own supply

when do says law and keynes law apply best

says: long run

keynes: short run

constraints of says law and keynes law

keynes: In the short run, recessions happen when firms face a lack of demand

says: If only demand mattered, the government could grow the economy just by spending or cutting taxes. Economies have real limits on production.

aggregate supply? when does it slope up?

total amount of GDP firms produce and sell at each price level

when price of output increases, firms produce more to make more profit

vertical line at point: potential GDP (long run)

aggregate demand? why may it slope down?

total spending on domestic goods C+I+G+(X-M)

a higher price level

1. lowered purchasing power (c falls)

2. Raises demand for credit and interest rates (I falls)

3. makes exports pricier than imports (X-M) falls

two things that can cause shifts in aggregate supply

1. productivity growth

2. changes in input prices

things that can cause shifts in aggregate demand

changes in C, I, G, (X-M)

• if any one increases or decreases, theres a shift

explain shifts in aggregate supply and demand in relation to each other

the slopes meet at equilibrium. if one changes, its dragged along the other

unemployment and AD/AS diagram

low when output is closer to potential GDP

high when output is farther from potential GDP

inflation and AD/AS diagram

inflation tends to increase during or just after booms, and decrease during recessions

• a right-shifting AD curve when the economy is near potential GDP can cause inflationary stress

• so can shifting SRAS to the left (lowers output and raises prices

basically when AD shifts right when AS is static and when AS shifts left when AD is static

keynesian zone

a point far left on the AD/AS curve, where its more flat

intermediate zone

a point far somewhat at the middle of the AD/AS curve, where its getting steeper

neoclassical zone

a point far right on the AD/AS curve, where its very steep

what did keynes advocate for and why

counter cyclical spending: economy is down, gov spending goes up

start spending to stimulate demand

keynesian perspective

firms only produce output if it’s expected to sell

aggregate demand is not stable and can fluctuate

whats keynesian perspective on recession based on

1. aggregate demand is not always high enough to force firms to hire workers and reach full employment

2. economy may only slowly shift in AD because of sticky wages/prices

sticky wages/prices

when wages/prices do not fall in response to a decrease in demand or rise in response to an increase in demand

why are wages sticky

coordination argument: people care about how much others are being paid, so they dont wanna be paid less

2 sets of costs that come with changing prices

• uses company resources

• customers may be angry

what causes recession and unemployment

1. sticky wages and prices

2. drop in demand (excess of labor)

look at expenditure multiplier

phillips curve - how does it relate to AD/AS

illustrates tradeoff between unemployment and inflation

• neoclassical has low unemployment and high prices

• keynesian has high unemployment and low prices

what does keynesian economics say is the solution to a recession

expansionary fiscal policy

• tax cuts/increase in gov spending to stimulate aggregate demand

what does keynesian economics say is the solution to a high neoclassical (high inflation risk)

contractionary fiscal policy

• decrease tax cuts and gov spending

neoclassical perspective

• the government shouldnt interfere with recessions

• the economy would fix itself in the long run

neoclassical vs keynesian

1. What determines the economy’s size?

2. Wages and prices

1. neoclassical

   1. potential gdp

   2. flexible, so it adjusts

2. Keynesian

   1. AD can affect size in the short run

   2. sticky in the short run

full employment and how to grow potential GDP

• zero cyclical employment

1. increase in physical capital

2. increase in human capital

3. increase in technology

how to read neoclassical model

AS curve is a vertical line at potential GDP, and output is determined by supply no matter where the AD is drawn

• LRAS shifts right over time as productivity rises

explain how the economy is flexible even when AD shifts right or when AS shifts left

AD shifts right (AS shifts left)

1. the two are at equilibrium

2. ad shifts right - unemployment is too low, so employers raise wages to attract

3. as shifts left

4. the two are at equilibrium again but at a different price level

5. both equilibriums are on the vertical line

AS shifts right (AD shifts left)

1. as too high, shifts right, high unemployment

2. ad shifts left

3. same original level of output, but lower price

adaptive vs rational expectation

adaptive: people look at past experience and gradually adapt to changes

rational: people form the most accurate expectation using available info to make quick adjustments

expected inflation

future rate of inflation that consumers and firms consider when decision making

keynesian vs neoclassical perspective

keynesian: gov should adjust AD to help economy

neoclassical: government may be slow to make changes, which may make things worse

describe the long run phillips curve

• AD along LRAS changes price level but not output, so unemployment is at a natural rate

• at a natural rate, the phillips curve is vertical no matter the price level or inflation

how do neoclassical economists want to fight unemployment or inflation

• focus on how the gov can change public policy, not AD, to reduce natural rate of unemployment

• AD has not long term effect on unemployment

• would want AD to change only as AS shifts to the right

  • keeps price level the same and inflation low

whats the primary concern of neoclassical economists and what does it depend on

how to grow potential GDP, which depends on long-term productivity growth

3 categories of federal reserve regulation

1. capital

2. reserve

3. types of investments

a minimum net worth as % of assets to protect depositors and creditors

why is it hard to regulate the banks

require assessments of loans

deposit insurance vs lender of last resort — WHat, WHO, and WHY

deposit insurance - makes sure depositors dont lose money even if the bank fails, paid by the FDIC to protect depositors

lender of last resort - the fed provides short-term emergency loansto banks to keep them afloat

what is monetary policy and describe the two types

managing interest rates and credit conditions

Expansionary: increases the supply of money and the quantity of loans, or reduces interest rates

contractionary: reduces the supply of money and the quantity of loans and increases interest rates

the feds primary responsibility

methods of conducting monetary policy

1. open market operations - creating/destroying money

   1. the FED buying/selling bonds from banks

      1. Buying: gives money to banks to put towards loans

      2. Selling: takes away from bank money that can go towards loans

2. changing reserve requirements

   1. causes there to be more or less money to be lended

3. changing the discount rate

   1. alter the interest rate charged by the banks on loans

monetary policy should be ________

countercyclical: moving opposite of the business cycle

• at lows, expansionary

• at highs, contractionary

federal funds rate

the interest rate at which one bank lends funds to another overnight

How does a central bank “raise” interest rates

• they pay interest to banks based on what the banks have in reserve

• encourages banks to keep their money so that they can accumulate more interest

HOW do expansionary and contractionary monetary policy effect the AD curve and WHY

• Contractionary: discourages borrowing, leading to less consumption and investment, so AD shifts left

• Expansionary: interest is lowered, so banks lend more to make money back from that interest, leading to more consumption and investment, so AD shifts right

inflation targeting

the rule that a central bank should focus on keeping inflation low

• the fed does not have an inflation targeting rule; its supposed to monitor both unemployment and inflation

zero lower bound

banks cant make nominal interest rates negative

• even if interest is lowered to zero, real interest can still be positive, which discourages investment and consumption

real = nominal - inflation