Econ 202 Detailed Exam Study Notes
Macro Stability: The Aggregate Demand-Aggregate Supply Model
The Aggregate Demand-Aggregate Supply (AD-AS) model is a fundamental tool used to understand the stability of an economy. It helps in visualizing economic fluctuations and the overall equilibrium between the demand and supply side of the economy.
Determinants of Aggregate Demand
Aggregate demand (AD) is influenced by several factors, including consumer spending, investment, government expenditure, and net exports. Changes in these components can shift the aggregate demand curve, which in turn affects output and prices.
Determinants of Aggregate Supply
Aggregate supply (AS) is determined by factors such as wages, production costs, and technology. Like AD, shifts in these determinants will adjust the aggregate supply curve, impacting equilibrium price levels and output.
Equilibrium between Aggregate Demand and Aggregate Supply
In an ideal scenario, AD and AS intersect at equilibrium. However, negative shocks can disturb this balance:
Negative Demand Shock: A sudden decrease in AD leads to reduced output and lower price levels, resulting in economic contractions.
Negative Supply Shock: Conversely, a decrease in AS typically raises prices while output declines, leading to inflationary pressures.
Stagflation: A problematic situation that occurs when stagnant economic growth coincides with inflation. This poses significant challenges for policy responses.
Fiscal Policy
Fiscal Policy involves government spending and tax policies to influence economic activity.
Fiscal Policy Defined
The primary aim is to manage economic fluctuations through adjustments in government spending and taxation. In the context of the AD-AS model, fiscal policy seeks to address recessionary and inflationary gaps.
Recessionary vs Inflationary Gap
Recessionary Gap: Occurs when actual GDP is lower than potential GDP, indicating unused resources.
Inflationary Gap: Arises when actual GDP exceeds potential GDP, often resulting in upward pressure on prices.
Objections to Fiscal Policy
Some criticisms include:
Crowding Out: Increased government spending may crowd out private investment.
Ricardian Equivalence: Consumers anticipate future taxes due to increased deficit spending and adjust their savings accordingly.
Closing a Recessionary Gap
Strategies include:
Government Spending: Direct increases in expenditure.
Taxes: Reductions in taxes to increase disposable income.
Problems with Activist Fiscal Policy
Key issues include time lags in implementation, the diminishing multiplier effect, and political influences that can affect fiscal policy outcomes.
Automatic Fiscal Stabilizers
Automatic stabilizers, like income taxes and welfare, help buffer economic fluctuations without explicit government intervention.
The Deficit and Debt
Deficit: Representing the difference between government spending (G) and total revenues (T), minus transfers (TR). Calculated as BS = T - G - TR.
Structural vs Actual Deficit: A structural deficit occurs regardless of economic conditions, while an actual deficit reflects current economic realities.
Tax Revenues and Income: Impact fiscal health significantly.
Money and Banking
The financial system is integral for managing money, facilitating transactions through various mechanisms.
The Financial System
Three core functions include:
Facilitating the exchange of goods and services.
Providing a means to save and accumulate wealth.
Allocating and managing risk.
Types of Financial Assets
The four main types include:
Stocks
Bonds
Derivatives
Mutual Funds
Financial Intermediaries
Key intermediaries include commercial banks, investment banks, insurance companies, and pension funds.
Money
Money serves three primary functions:
Medium of exchange
Unit of account
Store of value
Types of Money
Money can be categorized into:
Fiat Money: No intrinsic value but accepted as legal tender.
Commodity Money: Has intrinsic value, such as gold or silver.
Measures of Money
M1: Includes cash and checking deposits.
M2: Broader measure, including M1 plus savings deposits and money market securities.
Commercial Banks
Key functions include accepting deposits and providing loans through fractional reserve banking. This process allows banks to create money through deposits and withdrawals, exemplified by T-accounts.
The Federal Reserve Bank
Established to provide stability and confidence in the financial system. The Fed’s key functions include overseeing monetary policy, regulating banks, maintaining financial stability, providing banking services, and managing currency.
Theories of Money and Monetary Policy
The Classical Model of Money and Prices
This theory posits a direct relationship between money supply and price levels, often articulated through the equation of exchange: , where:
M = Money supply
V = Velocity of money
P = Price level
Y = Real output
The Keynesian Liquidity Preference Theory
Focuses on the demand for money as an asset. The demand for money is influenced by factors including interest rates and income, leading to a vertical money supply curve at equilibrium.
Monetary Policy in Practice
Monetary policy employs tools like reserve requirements, open market operations, and the discount rate to manage the economy effectively. The Taylor Rule and inflation targeting provide frameworks for adjusting monetary policy based on prevailing economic conditions.
New Classical vs New Keynesian Economics
New Classicals
Emerged from critiques of Keynesian theories, incorporating rational expectations and offering insights into real business cycle theories.
New Keynesian Hypotheses
Suggest that price stickiness can lead to market imperfections, affecting responsiveness to economic changes.
The Phillips Curve
Developed by A.W. Phillips, it highlights the trade-off between inflation and unemployment, leading to debates on the short versus long-run implications. Friedman's and Lucas's critiques introduced the concepts of natural rates of unemployment and rational expectations, asserting that inflation expectations can alter the Phillips curve dynamics.