Macro test 3 study guide

Aggregate Demand Curve

The aggregate demand (AD) curve illustrates the relationship

between the price level P and the economy’s demand for final

goods and services Y .

The relationship is inversed

Why, then, does the aggregate demand curve slope

downward and to the right? 3 reasons

1 Real-balances (or wealth) effect

2 Interest rate effect

3 Foreign purchases (or international trade) effect

real-balances effect

says that as the price level

rises, fixed wages have reduced purchasing power. With

lower purchasing power, households may reduce their

purchases, resulting in falling consumption spending.

interest rate effect

says that as the price level rises,

the demand for money rises, resulting in higher interest

rates. Higher interest rates curtail consumption and

investment spending

Foreign purchases effect

says that as the domestic

price level rises relative to foreign price levels (and

exchange rates remain temporarily unchanged), domestic

citizens will buy more foreign goods and fewer domestic

goods, resulting in less demand for domestically produced

goods.

Each of these three effects individually suggests a negative

relationship between the price level P and the economy’s

demand for final goods and services. Taken together, and

barring any other effects, it is clear that the AD curve

should slope downward with respect to Y

Aggregate supply

def: The aggregate supply (AS) curve illustrates the relationship between the economy’s price level P and its production of final goods and services Y .

short run: positive effect (sticky prices & sticky wages) wages are stickier they are an output price. (more on the slides so update)

Long run: price level has no effect because all input and output prices are flexible.

as the price level increases, input prices rise to match higher

output prices. As a result, firm profits are left unchanged

and they desire to produce no more or less.

the natural level of output

is the economy’s output level under normal

circumstances.

The Classical Dichotomy

The notion that real and nominal variables can be evaluated

separately. That is, real variables only affect real variables and

nominal variables only affect nominal variables.

Nominal Variables: Measured in direct monetary units without any adjustment for inflation or changes in the value of money (price level)

Real Variables: Measured in physical units or relative purchasing power in terms of other goods and services ()

the classical dichotomy is rebutted with sticky prices theory.

The factors that shift the AS curves left or right are called?

determinants of aggregate supply

Determinants of aggregate demand

1. Land (+) (any natural resource) (both)

2. Labor (+) (both)

3. Capital Goods (+) (Both)

4. Entrepreneurial ability (+) (both)

5. Technology (+) (both)

6. Input prices (-) (Short run only)

7. Expected price level (-) (Short run only because it’s a nominal variable)

aggregate supply-aggregate demand model, or AS − AD model, for short

is determined by the intersection of the AD and ASSR curves. The economy’s long run equilibrium is found where AD and ASLR intersect. Each equilibrium is characterized by an equilibrium output level Y ∗ and an equilibrium price level P∗.

Rise in price is called what?

inflation

The Illusion of Government Wealth

The economic fallacy of focusing entirely on visible government projects (like bridges or roads) while completely ignoring the private projects and goods that taxpayers would have created if their money hadn't been taken.

The Risk-to-Reward Distortion

The reduction of entrepreneurial incentive caused by high taxes, where the business creator takes 100% of the risk but is forced to give up a massive percentage of the reward to the state.

Impact on Business Expansion

The drain on private capital that prevents corporations from reinvesting in new machinery, developing new products, or hiring more workers.

Impact on Consumer Demand

The direct reduction of consumer purchasing power, leaving individuals with less money to spend on private-sector goods and services.

The Cost of Bureaucracy

The economic drain represented by the salaries of tax collectors and administrators, which diverts human energy away from wealth production and into wealth redistribution.

The Illusion of Government Credit

The economic fallacy of focusing entirely on the visible farms or businesses saved by state loans while ignoring the invisible, efficient private enterprises that were starved of that same capital.

The Risk-Sharing Distortion

The practice where the state risks the taxpayers' money on high-risk borrowers who cannot secure private financing, forcing the public to bear the losses while the borrower reaps any potential gain.

Private vs. Government Lending Standards

Private lenders risk their own capital and select borrowers based on efficiency and productivity, whereas government lenders use public funds and often prioritize political visibility or social sentimentality.

Impact on Production Efficiency

The economic drag caused by keeping failing or inefficient businesses artificially alive, which traps resources that would otherwise flow to highly productive elements of the economy.

The True Nature of Capital

Hazlitt's reminder that wealth and capital consist of real tangible goods (like a tractor or a factory) rather than tokens of exchange (like paper money or credit lines), which cannot be multiplied simply by issuing a loan.

demand pull inflation

As the economy moves from the original equilibrium to

the new one, the price level increases. This temporary

increase in the price level due to an increase in aggregate

demand is called

A decrease in AD would have the opposite effect and

would result in temporary deflation as the economy moves

from the old equilibrium to the new one

cost-push inflation

When inflation occurs as a result of a decrease in

aggregate supply

Fiscal policy

is the use of government spending and

taxation to influence macroeconomic conditions like real

GDP, unemployment, and inflation.

two basic types of fiscal policy

discretionary and non-discretionary policy.

Non-discretionary policy

occurs without Congressional

action. These policies are passive or automatic. For this

reason, non-discretionary policy is sometimes called an

“automatic stabilizer”.

Programs like unemployment benefits, food stamps, and

Medicaid are considered non-discretionary fiscal policies.

also considered automatic stabilizers because

they prevent large drops in spending as a result of

economic downturns or large increases in spending as a

result of expansions.

Discretionary policy

is changes in government taxing

and spending that occur at the option of the federal

government. Discretionary policy requires a literal act of

Congress with each intervention.

Discretionary fiscal policy is typically promoted by the

U.S. President, often based on the advice of the

President’s Council of Economic Advisers (CEA).

The CEA is comprised of three economists appointed by

the President to advise on economic issues.

Since discretionary policy is more of a one-time use policy,

it can be used to smooth business cycles.

countercyclical fiscal policy.

Many economists argue that fiscal policy should be used

to stimulate the economy when it is doing poorly and to

slow down the economy if there is evidence it is expanding

too rapidly.

expansionary fiscal policy is being used

when government raises spending G and/or cuts taxes T

to combat recession or high unemployment.

Recall that in the AE model, both increases in G and

decreases in T will cause equilibrium output to rise.

As a result, these changes cause the AD curve to shift

right in the AS − AD model.

Because of the spending multiplier, a given change in G

or T will typically have a disproportionately large effect on

equilibrium output.

primary goal of fiscal policy

counter the cyclical business cyclical.

counter cyclical

Short run; real GDP the smoothing of the business cycle

budget deficit.

When the government spends in excess of its tax revenue,

i.e. G > T ,

EX: 2001

budget surplus.

When the government spends less than it collects in tax

revenue, i.e. G < T ,

balanced budget

When the government spends exactly what it collects in tax revenue, i.e. G = T ,

national debt

is the total amount of money the U.S. government owes

Rachet effect (for dept)

recognition lag

is the length of time it takes to realize

real GDP is falling or that intervention is warranted.

min 3 month most 6 months

administrative lag

is the length of time, once

recognized, it takes to implement the appropriate policy

intervention.

weeks-months-never

operational lag

is the length of time required for a

policy’s effects to become evident.

these three lag effects can combine to

sometimes take

12 - 18 months, or possibly longer

Fiscal Policy

the use of government spending and taxation by elected officials to influence a country's macroeconomic conditions, such as aggregate demand, employment, inflation, and economic growth. [1, 2]

Main Types of Fiscal Policy

• Expansionary Policy: Involves increasing government spending, lowering taxes, or boosting transfer payments to stimulate demand and fight recessions. This typically leads to or increases a budget deficit. [1, 2, 3]

• Contractionary Policy: Involves decreasing government spending or raising taxes to cool down an overheating economy and rein in inflation. This can result in a budget surplus. [1, 2, 3]

• Neutral Policy: Maintains a balanced approach where spending roughly equals tax revenue, used when the economy is in a steady state

money is anything that satisfies

three important criteria

Medium of exchange

Store of value

Unit of account

Because money has these properties, it is useful for trade.

It helps overcome the transactions costs of barter and

solves the so-called “double coincidence of wants

Other important characteristics of a good money might

include

Portability

Divisibility

Securability

Durability

Cheap to produce

Difficult to counterfeit

Money can either take the form of

currency or

electronic/digital money.

Currency

is physical money, i.e.

coins and paper money.

Electronic/digital money

is

money that is stored digitally using some kind of

computer system.

fiat money

Because there is no physical commodity like gold or silver

backing the U.S. Dollar, it is sometimes called a

The U.S. permanently ended the gold standard

whereby Federal Reserve Notes were redeemable for gold, in 1973.

token money.

Because the material value of the U.S. Dollar is less than

the face value, it is sometimes called a

money supply

is the overall amount of

money in an economy.

In the U.S. there are three primary measures of the money

supply.

M0

M1

M2

M0

The M0 is the narrowest measure. It is sometimes called

the monetary base and includes currency in circulation

and central bank reserves.

M1

is the standard “narrow” measure of the money

supply. It includes the M0 as well as checkable deposits

and, since May 2020, most demand deposits (i.e. savings

accounts).

M2

is the standard “broad” measure of the money

supply. It includes the M1 as well as several “near monies”

like money market mutual funds and small-denomination

time deposits (CDs).

Near money

is a very liquid asset that is not itself used

as a medium of exchange.

CD: certificates of deposits

Money MRK mutual funds

central bank

is the government institution that creates

money, monitors financial institutions, and conducts

monetary policy.

Since 1935, the Fed has been comprised by three

important “layers”:

12 districts with Federal Reserve Banks

2 A 7-member Board of Governors

3 A 12-member Federal Open Market Committee

main job print fed Reserve Notes

Banks for Banks

Holds Reserves for commercial banks

lend to commercial banks as leaderette of last resort.

The largest and most important district bank is

the New York Federal Reserve Bank in District 2

The Federal Reserve is governed by

the Board of

Governors. There are seven Fed governors

Federal Open Market Committee

The FOMC is comprised of 12 individuals, including the 7

members on the Board of Governors, and 5 of the 12

presidents of Federal Reserve Banks.

The Board of Governors and the president of the New

York Federal Reserve Bank are always on the FOMC. The

other 4 bank presidents rotate on a yearly basis.

Monetary policy

is use of changes in a nation’s money

supply and interest rates to affect macroeconomic

conditions. The Fed has four main tools which is uses to

conduct monetary policy:

1 Open market operations (FOMC)

2 The discount window/rate (BOG)

3 The reserve requirement (BOG)

4 Interest on reserve balances (BOG)