Econ Final Definitions

Chapters 20 and 21

AD Curve is downward sloping because: (3)

1. Wealth effect

2. Interest rate effect

3. Exchange rate effect

Wealth effect

lower prices increase purchasing power → more consumption

Interest rate effect

lower prices → lower interest rates → more investment

Exchange rate effect

lower U.S. prices → weaker dollar → exports increase

LRAS is vertical or upward sloping?

vertical

SRAS is vertical or upward sloping?

upward sloping

Why SRAS slopes upward: (3)

1. sticky wage

2. sticky price

3. misperceptions

sticky wage

wages are fixed in short run → firms increase output when prices increase

sticky price

some prices don’t adjust quickly → higher prices lead to more output

misperceptions

firms mistake overall price increases as increases in relative prices of their goods

LRAS shifts include:

changes in labor, capital, natural resources, or technology

SRAS shifts include:

same as LRAS plus changes in expected prices

expansionary shift

AD shifts right; interest rates are lowered

contractionary shift

AD shifts left; interest rates are raised

Monetary Policy - controlled by the Fed

controls the money supply (MS) → affects interest rates; GOAL of lower interest rates during recessions to boost spending, raise them during booms to reduce inflation

Theory of Liquidity Preference

interest rates adjust to balance money supply and demand

• MS is fixed by the fed (vertical line)

• MD depends on interest rates

  • lower r → people want to hold more cash

  • higher r → people prefer interest-bearing assets

Interest Rate Effect of AD

if the price level (p) falls:

• people need less cash → lower money demand

• interest rate ® drops

• Investment (i) rises → AD increases

Fiscal Policy (congress and President)

• Government spending and taxes

• Expansionary

• Contractionary

The Multiplier Effect

Government spending boosts income → people spend more → AD increases more than the initial amount

Marginal Propensity to Consume (MPC)

fraction of income spent

• Multiplier = 1/(1-MPC)

The crowding-out effect

• fiscal stimulus may raise interest rates (more money demand)

• This could reduce private investment

• So, net effect on AD is smaller than the multiplier suggests

Zero Lower Bound and Liquidity Trap

when interest rates are near 0% monetary policy loses its power

• Fed alternatives:

  • Forward guidance

  • Quantitative easing

Forward guidance

promise to keep rates low

Quantitative easing

buying bonds/mortgages to inject money

Stagflation

high inflation, slow economic growth, high unemployment