Untitled Flashcards Set

3.1 - Aggregate Demand

3.2 -  Multipliers

Difference between a market demand curve and the aggregate demand curve?

• The market demand curve shows the quantity of a good or service that consumers are willing to purchase at different prices in a specific market. It focuses on individual goods or services.

• The aggregate demand curve shows the total quantity of goods and services demanded in an economy at different price levels. It includes the sum of all individual markets in the economy (consumer spending, investment, government spending, and net exports).

2. Three concepts explaining why aggregate demand is downward sloping:

1. Wealth effect: As the price level falls, the real value of wealth increases, leading to more consumption.

2. Interest rate effect: As the price level falls, people and businesses demand less money for transactions, leading to lower interest rates and more investment.

3. Exchange rate effect: When the domestic price level falls, domestic goods become cheaper relative to foreign goods, leading to an increase in exports.

3. Shifters of aggregate demand:

• Consumption (C): Changes in consumer confidence or taxes.

• Investment (I): Changes in interest rates, business confidence, or investment incentives.

• Government Spending (G): Changes in government spending or fiscal policies.

• Net Exports (X - IM): Changes in exchange rates or foreign income.

1. What is the multiplier effect?

• The multiplier effect is the idea that an initial change in spending leads to a larger final change in national income. For example, an increase in government spending can lead to more consumption, which further boosts economic activity.

2. Define marginal propensity to consume (MPC):

• MPC is the proportion of any additional income that a consumer spends on goods and services. It's the change in consumption divided by the change in income.

3. Define marginal propensity to save (MPS):

• MPS is the proportion of any additional income that a consumer saves rather than spends. It's the change in savings divided by the change in income.

4. Equation for the simple spending multiplier:

• Multiplier = 1 / (1 - MPC)

5. Equation for the tax multiplier:

• Tax Multiplier = -MPC / (1 - MPC)

7. Fill in the blanks below:

3.3 - Short-Run Aggregate Supply (SRAS)

1. Why is short-run aggregate supply upward sloping?

• In the short run, as output increases, firms may have to use more expensive resources or increase prices to cover higher production costs, leading to an upward sloping SRAS curve.

2. Shifters of short-run aggregate supply:

• Changes in resource prices (e.g., oil prices, wages).

• Changes in productivity or technology.

• Supply shocks (e.g., natural disasters).

3.4 - Long-Run Aggregate Supply (LRAS)

1. Why is long-run aggregate supply vertical?

• In the long run, the economy is at full employment, and output is determined by the availability of resources and technology, not by the price level.

3.5 - Equilibrium in the AD-AS Model

1.Draw an economy with a negative output gap

2. Draw an economy at full

employment

3. Draw an economy with a

positive output gap

3.6 - Changes in the AD-AS Model in the Short-Run

3. Identify the short-run equilibrium price level and output after a negative supply shock?

• A negative supply shock (such as an increase in the price of oil or a natural disaster) reduces the economy’s ability to produce goods and services, causing the Short-Run Aggregate Supply (SRAS) curve to shift left.

• When SRAS shifts left, the economy experiences higher prices and lower output in the short run.

• The new equilibrium will occur at a higher price level (inflation) and a lower output (recession), which is a form of stagflation.

Graphically:

• The SRAS curve shifts left, resulting in a higher price level and lower output at the new equilibrium.

4. What happens to output and unemployment if investment falls?

• A fall in investment decreases aggregate demand (AD) because investment is one of the components of AD.

• As AD shifts to the left, both the price level and output will decrease in the short run.

• Lower output leads to higher unemployment, since firms need fewer workers to produce fewer goods and services.

Graphically:

• The AD curve shifts left, causing the equilibrium price level to fall and equilibrium output to fall. The increase in unemployment occurs because the economy is producing less output, so firms reduce hiring.

5. Use the graph to explain the difference between demand-pull and cost-push inflation.

• Demand-pull inflation occurs when aggregate demand (AD) increases, causing the economy to produce beyond its potential output. The AD curve shifts to the right, leading to an increase in both the price level and output in the short run.

  • Graphically: AD shifts right, and the economy moves along the SRAS curve to a new equilibrium with a higher price level and output. This is "pulling" the economy's demand beyond its productive capacity.

• Cost-push inflation occurs when there is a negative supply shock that reduces the economy’s ability to produce goods and services, causing the short-run aggregate supply (SRAS) curve to shift left. The economy faces higher prices and lower output.

  • Graphically: SRAS shifts left, and the economy moves to a higher price level but lower output, resulting in a stagflation scenario (higher inflation and unemployment).

What is the short-run equilibrium price level and output?

• Short-run equilibrium price level and output occur where the Aggregate Demand (AD) curve intersects the Short-Run Aggregate Supply (SRAS) curve. At this point, the quantity of goods and services demanded in the economy equals the quantity of goods and services supplied, and the economy is in a temporary equilibrium.

• The equilibrium price level is the price at which the total quantity of goods and services demanded equals the quantity supplied in the short run.

• The equilibrium output is the level of output (real GDP) where the AD curve intersects the SRAS curve.

In a typical graph, this intersection shows the actual output (GDP) and the price level in the economy. If there is a positive output gap, it means actual output is above potential output (indicating inflationary pressures), and if there’s a negative output gap, actual output is below potential output (indicating a recession).

2. Identify the short-run equilibrium price level and output if consumption increased?

• Increase in consumption shifts the Aggregate Demand (AD) curve to the right (since consumption is a component of AD).

• When AD shifts right, the economy moves to a new short-run equilibrium with a higher price level and higher output.

• The exact movement depends on the steepness of the SRAS curve, but generally, higher consumption leads to higher aggregate demand, which pushes up both the price level and output in the short run.

Graphically:

• The AD curve shifts right.

• The new equilibrium occurs at a higher price level and higher output, reflecting the increased demand for goods and services.

Key differences:

• Demand-pull inflation: Caused by an increase in aggregate demand (shift of the AD curve right), leading to higher prices and output.

• Cost-push inflation: Caused by an increase in production costs or supply shocks (shift of the SRAS curve left), leading to higher prices and lower output.

6. What is a negative supply shock?

• A negative supply shock is an event that causes a sudden and significant decrease in the economy’s ability to produce goods and services. This usually leads to an increase in production costs, which shifts the Short-Run Aggregate Supply (SRAS) curve to the left.

• Common examples include natural disasters, a sudden increase in the price of key resources (like oil), or disruptions in supply chains. A negative supply shock results in higher prices (inflation) and lower output (recession), often causing stagflation.

7. What is a positive supply shock?

• A positive supply shock is the opposite of a negative supply shock. It refers to an event that increases the economy's ability to produce goods and services, often lowering production costs. This shifts the Short-Run Aggregate Supply (SRAS) curve to the right.

• Examples include technological advancements, decreases in the price of key inputs (like oil or raw materials), or improvements in productivity. A positive supply shock generally leads to lower prices (disinflation) and higher output in the economy.

8. Define stagflation

• Stagflation is an economic condition where the economy experiences high inflation (rising prices) and high unemployment (rising joblessness) at the same time, along with slowing economic growth or stagnation.

• It usually occurs when there is a negative supply shock that increases costs and reduces production, shifting the SRAS curve to the left. This results in higher prices and lower output, leading to inflation and rising unemployment simultaneously.

9. Define deflation

• Deflation is the opposite of inflation and refers to a decrease in the general price level of goods and services in an economy over time.

• It often occurs during economic recessions when there is a decrease in aggregate demand or overproduction. As demand falls, businesses reduce prices to clear excess inventory, leading to a general reduction in prices. While deflation may sound beneficial, it can lead to economic stagnation as people delay consumption and businesses reduce investment, worsening the economic downturn.

10. What is autonomous consumption?

• Autonomous consumption is the level of consumption that occurs in an economy regardless of the level of income. In other words, it is the consumption level that happens even when a person has no income, such as when they rely on savings, credit, or government transfers.

• Autonomous consumption is typically represented as the intercept of the consumption function on a graph, where consumption occurs even when disposable income is zero. This can include basic consumption needs like food or shelter that are needed for survival.

11. What is disposable income?

• Disposable income is the income available to individuals after taxes and other mandatory deductions (such as social security contributions) have been subtracted. It is the income available to spend or save.

• In other words, it’s the amount of money that individuals have after paying their income taxes and other mandatory charges that can be used for consumption or saving.

3.7 - Long-Run Self-Adjustment

1. Explain how the economy self-adjusts in the long run when there is a negative output gap.

• A negative output gap occurs when actual output is less than potential output, meaning the economy is operating below full capacity (i.e., high unemployment and underutilized resources).
  
  

• Self-adjustment happens because, in the long run, wages and resource prices are flexible.
  
  

• Here’s the adjustment process:
  
  

  • Unemployment is higher than the natural rate, so there is downward pressure on wages. As wages fall, production costs decrease, making it cheaper for firms to produce goods and services.

  • As wages and resource prices decrease, the Short-Run Aggregate Supply (SRAS) curve will shift right. This increases output and reduces prices, moving the economy back toward full employment.

  • Eventually, the economy moves to its natural level of output, where it is at potential output, and the output gap closes.

2. Explain how the economy self-adjusts in the long run when there is a positive output gap.

• A positive output gap occurs when actual output is greater than potential output, meaning the economy is operating above full capacity (leading to inflationary pressures).
  
  

• Self-adjustment happens because, in the long run, wages and resource prices are flexible.
  
  

• Here’s the adjustment process:
  
  

  • Unemployment is below the natural rate, causing upward pressure on wages. As wages rise, the cost of production increases for firms.

  • As production costs increase, the Short-Run Aggregate Supply (SRAS) curve will shift left. This will decrease output and increase prices, helping to cool down the economy and reduce inflationary pressures.

  • The economy moves back toward its potential output, and the positive output gap is closed.

3. Assuming wages and resource prices are flexible, show how each economy below will self-adjust in the long run.

• In both cases of negative and positive output gaps, the flexibility of wages and resource prices leads to shifts in the SRAS curve:

  • Negative output gap: In the long run, falling wages and resource prices shift the SRAS curve right, increasing output and bringing the economy back to potential output.

  • Positive output gap: In the long run, rising wages and resource prices shift the SRAS curve left, reducing output and returning the economy to potential output.

4. Assume instead that Economy #2 experiences economic growth. What happens to LRAS and output?

• Economic growth leads to an increase in the economy's productive capacity (potential output), typically due to advancements in technology, increases in resources, or improvements in productivity.

• This growth causes the Long-Run Aggregate Supply (LRAS) curve to shift right.

  • LRAS shifts right because the economy can now produce more goods and services at every price level.

  • As a result, output increases at full employment, and the economy's potential output (long-run output) grows.

5. Does the natural rate of unemployment increase, decrease, or stay the same when the LRAS shifts right?

• When the LRAS shifts to the right (due to economic growth), the natural rate of unemployment stays the same.
  
  

• Why?
  
  

  • The natural rate of unemployment is determined by factors like frictional and structural unemployment, which are not directly affected by short-term changes in output or economic growth.

  • Even with an increase in potential output (shifting LRAS to the right), the natural rate of unemployment is more influenced by labor market conditions (e.g., job search friction, skill mismatches) rather than the overall level of output.

Thus, economic growth increases the economy's capacity but does not directly change the natural rate of unemployment in the long run.

3.8 - Fiscal Policy

1. Define expansionary fiscal policy

Expansionary fiscal policy refers to government actions aimed at increasing aggregate demand in the economy to stimulate economic activity, typically in times of recession or economic downturn. The government does this by increasing government spending and/or reducing taxes.

The goal is to boost consumer spending and business investment, leading to higher output (GDP) and lower unemployment.

• Government spending directly increases aggregate demand.

• Tax cuts leave consumers and businesses with more disposable income, which encourages more consumption and investment.

2. Define contractionary fiscal policy

Expansionary fiscal policy refers to government actions aimed at increasing aggregate demand in the economy to stimulate economic activity, typically in times of recession or economic downturn. The government does this by increasing government spending and/or reducing taxes.

The goal is to boost consumer spending and business investment, leading to higher output (GDP) and lower unemployment.

• Government spending directly increases aggregate demand.

• Tax cuts leave consumers and businesses with more disposable income, which encourages more consumption and investment.4. Is there a recessionary gap or inflationary gap?

• Recessionary gap occurs when the actual output of the economy is less than the potential output, meaning the economy is producing below its capacity. This results in high unemployment and unused resources. It typically happens in periods of economic downturn.
  
  

• Inflationary gap occurs when the actual output is greater than the potential output, meaning the economy is producing beyond its capacity, causing inflationary pressures. It typically happens in periods of economic expansion when the economy is overheating.

5. What happens to the price level and output in the long run if no policy action is taken?

• If no policy action is taken and the economy is in either a recessionary gap or inflationary gap, the economy will self-adjust in the long run due to flexible wages and resource prices:

  • In a recessionary gap: Over time, wages and resource prices will decrease, which will shift the Short-Run Aggregate Supply (SRAS) curve to the right, increasing output and reducing the price level, bringing the economy back to its potential output.

  • In an inflationary gap: Wages and resource prices will increase, shifting the SRAS curve to the left, reducing output and increasing the price level, bringing the economy back to its potential output.

Thus, in both cases, the economy will eventually return to full employment (long-run equilibrium), but in the meantime, the price level and output may fluctuate.

6. Assume instead that the government decides to use fiscal policy. Identify two policies that could close the gap.

• To close a recessionary gap (increase output and reduce unemployment), the government could use expansionary fiscal policy, which includes:

  1. Increasing government spending on infrastructure projects, education, defense, etc., to directly boost aggregate demand.

  2. Cutting taxes to increase disposable income, leading to higher consumption and investment.

• To close an inflationary gap (reduce output and curb inflation), the government could use contractionary fiscal policy, which includes:

  1. Decreasing government spending to reduce aggregate demand.

  2. Raising taxes to reduce disposable income, leading to lower consumption and investment.

7. If the MPC is 0.5, what is the least amount of government spending that could close the gap?

8. If the MPC is 0.5, what is the least amount the government could cut taxes to close the gap?

9. Assume instead that the MPC is 0.9. What is the least amount of government spending that could close the gap?

10. Would an increase in private saving increase or decrease the effectiveness of fiscal policy?

• An increase in private saving would decrease the effectiveness of fiscal policy.

  • When consumers save more, it reduces consumption, which in turn reduces the marginal propensity to consume (MPC). A lower MPC means that less of the government spending or tax cuts will be spent on goods and services, reducing the overall multiplier effect.

  • As a result, fiscal policy (whether expansionary or contractionary) becomes less effective because the change in aggregate demand is smaller than expected.

11. Why are there lags when the government uses discretionary fiscal policy?

• Discretionary fiscal policy has several types of lags:

  • Recognition lag: The time it takes for policymakers to recognize that the economy is in a recession or inflationary gap and that action is needed.

  • Implementation lag: The time it takes for the government to decide on and implement the policy (such as passing a budget or implementing new tax policies or spending programs).

  • Impact lag: The time it takes for the policy to have a noticeable effect on the economy. Even after implementation, it may take time for the changes to ripple through the economy and influence aggregate demand.

3.9 -Automatic Stabilizers

1. Define Discretionary Fiscal Policy

• Discretionary fiscal policy refers to deliberate government actions aimed at influencing the economy, typically by changing government spending or taxation levels. These actions are decided upon and implemented by policymakers (such as the government or Congress) in response to current economic conditions (like recessions or inflation).

• Unlike automatic stabilizers, discretionary fiscal policy requires active decision-making and is typically enacted through laws or budget changes. Examples include stimulus packages, tax cuts, or increased government spending during a recession to boost demand.

2. Define Non-Discretionary Fiscal Policy

• Non-discretionary fiscal policy (also known as automatic stabilizers) refers to government policies that automatically adjust with the economy without the need for active intervention by policymakers. These policies help stabilize the economy by automatically increasing or decreasing aggregate demand based on economic conditions.

• The most common examples of non-discretionary fiscal policy are programs that automatically increase government spending or reduce taxes when the economy enters a downturn, or vice versa. These adjustments occur without new legislation.

3. Identify Three Different Examples of Automatic Stabilizers

Here are three common examples of automatic stabilizers:

1. Unemployment Insurance:

   • When the economy enters a recession, unemployment rises. As more people lose their jobs, government spending on unemployment benefits automatically increases. This provides individuals with income, which helps to sustain consumer spending even during economic downturns, helping to stabilize demand.

2. Progressive Income Taxes:

   • In a recession, people's incomes tend to fall. Because income taxes are progressive (higher income = higher taxes), as incomes decline, the amount of taxes individuals owe automatically decreases. This leaves people with more disposable income, which can be spent, thus supporting aggregate demand.

3. Welfare Programs (e.g., food assistance, Medicaid):

   • Programs like food stamps (SNAP) or Medicaid automatically increase government spending as more people qualify for assistance when the economy weakens, and people’s incomes fall below certain thresholds. These programs help individuals maintain a basic standard of living, which supports consumption even in difficult economic times.

These automatic stabilizers are crucial because they help smooth out economic fluctuations without requiring any active policy decisions or new laws.

Unit Review

True or False

1.___ An increase in expected inflation will decrease

the short-run aggregate supply.

2.___ An increase in interest rates will increase

investment and aggregate demand.

3.___ The spending multiplier is weaker than the tax

multiplier.

4.___ Fiscal policy includes government spending and taxation.

5.___ If the MPS is .2 the tax multiplier is 4.

6.___ When the MPC increases, the spending

multiplier decreases.

To determine when to multiply or divide by the spending multiplier, you need to consider what you are trying to calculate. The spending multiplier shows how an initial change in spending is magnified in the economy, leading to a larger change in aggregate demand and national income (GDP)1....

Here's a breakdown:

1. When to Multiply by the Spending Multiplier:

You multiply an initial change in spending by the spending multiplier to find the maximum total change in GDP that will result from that initial change3....

•

Scenario: You know the initial change in spending (e.g., an increase in government spending, a decrease in investment) and you want to find the total impact on GDP.

•

Formula: Total Change in GDP = Spending Multiplier × Initial Change in Spending4...

•

Example: If the marginal propensity to consume (MPC) is 0.75, the spending multiplier is 1 / (1 - 0.75) = 43.... If the government increases spending by $10 million, the maximum change in GDP will be 4 × $10 million = $40 million increase3.

2. When to Divide by the Spending Multiplier:

You divide the desired total change in GDP (such as closing a GDP gap) by the spending multiplier to find the minimum initial change in spending required to achieve that goal3.

•

Scenario: You know the size of a recessionary or inflationary gap (the difference between current GDP and potential GDP) and you want to determine how much the government or other components of spending need to change initially to close that gap.

•

Formula: Required Initial Change in Spending = Total Change in GDP Needed (GDP Gap) / Spending Multiplier3

•

Example: If the marginal propensity to save (MPS) is 0.25, the spending multiplier is 1 / 0.25 = 43. If there is a $6 million negative GDP gap (meaning GDP needs to increase by $6 million), the minimum government spending change needed to close the gap is $6 million / 4 = $1.5 million increase3.

In summary:

•

If you have an initial change in spending and want to find the resulting total change in GDP, multiply by the spending multiplier.

•

If you know the desired total change in GDP (like closing a gap) and want to find the necessary initial change in spending, divide by the spending multiplier.

Remember that the spending multiplier is calculated as 1 / (1 - MPC) or 1 / MPS1..., where MPC is the marginal propensity to consume (the fraction of extra income spent)1... and MPS is the marginal propensity to save (the fraction of extra income saved)1.... Also note that MPS = 1 - MPC10.

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