Economic Concepts Study Guide

Economic Concepts Related to Gaps and Policies

Recessionary Gap

  • Definition: A recessionary gap occurs when the economy is producing below its potential output, leading to higher unemployment.
  • Short-Run Aggregate Supply (SRAS):
    • Movement to the right indicates an increase in output leading to potential closure of the gap.
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Policy Response to Recessionary Gap

  • Fiscal Policy:
    • Increase Government Spending: This injects more money into the economy, potentially boosting growth and closing the gap.
    • Decrease Taxes: Reducing taxes increases disposable income, which encourages consumer spending and can stimulate economic activity.
    • Movement of SRAS to the left can likewise occur if fiscal policy is contractionary (i.e., decrease spending, increase taxes).

Monetary Policy

  • Definitions:
    • Decrease Required Reserves (RR): This increases the amount of money banks have available to lend out, thus boosting money supply.
    • Decrease Discount Rate (DR): Borrowing from the central bank becomes cheaper for banks, enhancing liquidity in the market.
    • Increase Required Reserves: Results in decreased availability of money to lend out, potentially tightening the money supply.
    • Increase Discount Rate: Leads to more expensive borrowing for banks, constraining their lending capacity.
  • Open Market Operations:
    • Buying Bonds: This injects money into the economy ("buy big") and mitigates an inflationary gap.
    • Selling Bonds: This withdraws money from circulation ("sell small"), which can help control inflation.

Money Supply and Demand

  • Definitions:
    • M0: Cash in circulation.
    • M1: Checkable bank deposits (immediate cash equivalents).
    • M2: M1 + savings and time deposits (near money).
  • Controlled by the Federal Reserve (FED): Implements monetary policy to manage the economy by shifting the money supply.

Interest Rates and Quantity Demanded

  • Interest Rates (IR): When interest rates increase, people are incentivized to save more, leading to a decrease in the quantity demanded of loans.
  • Inverse Relationship: As IR rises, the quantity demanded of money decreases, reflecting the principles of demand.

Demand Shifters in the Money Market

  • Price Level: Fluctuations in price levels can shift demand.
  • Income: Higher income generally increases demand for money.
  • Technology: Advancements may affect how money is utilized in various transactions.
  • As interest rates increase, demand for loans decreases due to higher repayment costs, leading to tighter credit conditions in a recession.

Loanable Funds Market

  • Real Interest Rate (RIR): Refers to the interest rate adjusted for inflation. Fewer people desire loans when these rates are high, affecting overall investments.
  • Government Deficit Spending: Results in higher demand for loanable funds, potentially increasing the RIR.
  • Deficit Effects:
    • Decreased taxes on businesses can spur investment due to greater after-tax income.
    • When businesses are optimistic about future profits, demand for loanable funds shifts to the right (increases).
  • Conversely, if businesses anticipate lower future profits, demand shifts left due to reduced investment opportunities.

Understanding Shifts in Investment Demand

  • Investment Demand Shifts:
    • Right Shift: Generally occurs when firms expect better future profitability.
    • Left Shift: Happens during recessions or when government borrowing decreases.
  • Net Effects of Policies:
    • Government surplus can lead to increased savings, enhancing the available capital for investments.