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Macroeconomic Theory > Chapter 9 > Flashcards

Chapter 9 Flashcards

1
Q

What is the relationship between the FE Line and the full employment level of output?

A

The FE Line represents the equilibrium in the labor market, leading to both full employment level of employment and full employment level of output (Y-bar).

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2
Q

What is the equation that represents the full employment level of output (Y-bar)?

A

Y-bar = AF(K, N-bar), where A represents total factor productivity, K represents the capital stock, and N-bar represents the level of labor input.

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3
Q

Why is the FE Line vertical?

A

The FE Line is vertical because the full employment level of output (Y-bar) does not change with real interest rates.

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4
Q

What factor(s) would shift the FE line to the right?

A

Beneficial supply shock, increase in labor supply, and increase in the capital stock.

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5
Q

What is the reason behind the shift in the FE line due to a beneficial supply shock or an increase in labor supply?

A

More output can be produced for the same amount of capital and labor. If the MPN (Marginal Product of Labor) rises, labor demand increases, which raises employment. Full-employment output increases for both reasons.

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6
Q

What is the reason behind the shift in the FE line due to an increase in the capital stock?

A

Equilibrium employment rises, raising full-employment output. More output can be produced with the same amount of labor. In addition, increased capital may increase the MPN, which increases labor demand and equilibrium employment.

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7
Q

What does the IS curve represent?

A

The IS curve represents the equilibrium in the goods market.

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8
Q

What is the equation that represents the good market equilibrium condition?

A

Y = C^d + I^d + G, where Y represents output, C^d represents desired consumption, I^d represents desired investment, and G represents government spending.

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9
Q

What does the equilibrium condition
S^d = I^d signify?

A

The equilibrium condition S^d = I^d in the goods market implies that desired saving and desired investment are equal, indicating a state of equilibrium in the goods market.

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10
Q

What does the IS curve show?

A

The IS curve shows the relationship between output and the real interest rate that clears the goods market.

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11
Q

Why is the IS curve downward sloping?

A

The IS curve is downward sloping because a lower real interest rate makes investment more attractive, leading to increased desired investment and higher output. Conversely, a higher real interest rate reduces desired investment, resulting in decreased output. This relationship is captured by the downward sloping IS curve.

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12
Q

How does an increase in the real interest rate affect the goods market equilibrium according to the IS curve?

A

An increase in the real interest rate reduces desired consumption (C^d) and desired investment (I^d), leading to a decrease in aggregate demand. If output (Y) remains constant, this would result in a situation where quantity supplied exceeds quantity demanded, requiring a reduction in quantity supplied for the goods market to reach equilibrium at the higher real interest rate.

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13
Q

What factors can shift the IS curve?

A

Any economic forces that change the value of the goods-market clearing interest rate will cause the IS curve to shift.

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14
Q

How does a change in aggregate demand affect the IS curve?

A reduction in desired saving

A

Any change that reduces desired saving (Sd) relative to desired investment (Id), increasing aggregate demand, will raise interest rates and shift the IS curve up and to the right.

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15
Q

How does a change in aggregate demand affect the IS curve in the opposite direction?

A

Any change that increases desired saving (Sd) relative to desired investment (Id), reducing aggregate demand, will lower interest rates and shift the IS curve down and to the left.

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16
Q

How does a temporary increase in government spending (G) affect the IS curve?

A

A temporary increase in government spending (G) reduces desired saving (Sd), causing the Sd curve to shift up and to the left. Consequently, the interest rate (r) that clears the goods market increases, leading to a shift in the IS curve up and to the right.

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17
Q

How does a temporary increase in government spending affect the equilibrium in the goods market?

A

A temporary increase in government spending increases aggregate demand relative to the constant aggregate supply (Y). To restore equilibrium, the interest rate (r) must increase to eliminate the excess demand in the market, resulting in the IS curve shifting up and to the right.

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18
Q

What factor(s) would shift the IS curve up and to the right?

A

An increase in expected future output, wealth, government purchases (G), and the expected future marginal product of capital (MPK) would shift the IS curve up and to the right.

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19
Q

What factor(s) would shift the IS curve down and to the left?

A

An increase in the effective tax rate on capital would shift the IS curve down and to the left.

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20
Q

How does an increase in expected future output affect the goods market equilibrium?

A

An increase in expected future output leads to a decrease in desired saving (desired consumption rises), raising the real interest rate that clears the goods market, resulting in a shift of the IS curve up and to the right.

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21
Q

What is the impact of an increase in government purchases (G) on the goods market equilibrium?

A

An increase in government purchases (G) causes desired saving to fall (demand for goods rises), raising the real interest rate that clears the goods market, which shifts the IS curve up and to the right.

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22
Q

How does the effective tax rate on capital affect investment and the goods market equilibrium?

A

An increase in the effective tax rate on capital leads to a decrease in desired investment, lowering the real interest rate that clears the goods market, resulting in a shift of the IS curve down and to the left.

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23
Q

What are the two basic equilibrium conditions in the IS-LM model?

A

The two basic equilibrium conditions in the IS-LM model are Investment = Saving and Money demand = Money supply.

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24
Q

Which economic approach is commonly associated with the IS-LM model?

A

The IS-LM model is commonly identified with the Keynesian approach, as it assumes that prices are fixed.

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25
Q

Can the conventional IS-LM model accommodate rapidly adjusting wages and prices?

A

Yes, the conventional IS-LM model can be easily adopted to allow for rapidly adjusting wages and prices.

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26
Q

In what type of economy is the chapter’s discussion based on?

A

The chapter’s discussion is based on a closed economy case.

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27
Q

How is the price of a nonmonetary asset related to its interest rate or yield?

A

The price of a nonmonetary asset is inversely related to its interest rate or yield. For example, if the current price of a bond in the market falls, its yield will rise.

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28
Q

What is the relationship between the price of a nonmonetary asset and the real interest rate, given a level of expected inflation?

A

For a given level of expected inflation, the price of a nonmonetary asset is inversely related to the real interest rate. The real interest rate is equal to the nominal interest rate (i) minus the expected inflation rate (π^e).

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29
Q

What is the equation that represents the equality of money demanded and money supplied in the asset market?

A

The equation is M / P = L (Y, r+ π^e), which represents the asset market equilibrium condition.

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30
Q

How is real money supply affected by the real interest rate?

A

Real money supply is determined by the central bank and is not affected by the real interest rate.

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31
Q

How does real money demand change in response to changes in the real interest rate?

A

Real money demand falls as the real interest rate rises.

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32
Q

Why is the money supply (MS) represented as a vertical line in graphical models?

A

The money supply is represented as a vertical line in graphical models because it is determined by the actions of the central bank and is considered exogenously fixed in the short run.

33
Q

What is the purpose of deriving the LM curve?

A

The LM curve is derived to plot the relationship between output and the real interest rate that clears the asset market.

34
Q

How does real money demand change with the level of output?

A

Real money demand rises as the level of output increases.

35
Q

How is the LM curve derived?

A

The LM curve is derived by plotting real money demand for different levels of output and analyzing the resulting equilibrium.

36
Q

What does the LM curve represent?

A

The LM curve represents the combinations of output and the real interest rate at which the money demanded equals the money supplied in the asset market.

37
Q

What does the LM curve represent?

A

The LM curve represents the graphical relationship between output and the real interest rate that clears the asset market.

38
Q

What factors can cause the LM curve to shift?

A

Any change that reduces real money supply relative to real money demand shifts the LM curve up and to the left. Conversely, a change that increases real money supply relative to real money demand shifts the LM curve down and to the right.

39
Q

How does a decrease in real money supply relative to real money demand affect the LM curve?

A

A decrease in real money supply relative to real money demand shifts the LM curve up and to the left.

40
Q

How does an increase in real money supply relative to real money demand affect the LM curve?

A

An increase in real money supply relative to real money demand shifts the LM curve down and to the right.

41
Q

What happens to the LM curve when there is an increase in money supply?

A

For a given level of output, an increase in real money supply lowers the real interest rate and shifts the LM curve down and to the right.

42
Q

What causes a shift in the LM curve due to an increase in money supply?

A

The LM curve shifts down and to the right when there is an increase in real money supply. This occurs when the nominal money supply (M) changes at a different rate than the price level, leading to a change in real money supply (M/P).

43
Q

What happens to the LM curve when there is an increase in money demand?

A

For a given level of output, an increase in real money demand raises the real interest rate and shifts the LM curve up and to the left.

44
Q

What causes a shift in the LM curve due to an increase in money demand?

A

The LM curve shifts up and to the left when there is an increase in real money demand. This occurs when there is an increased desire for holding money relative to the level of output.

45
Q

What is the definition of general equilibrium in economics?

A

All markets in the economy are simultaneously in equilibrium.

46
Q

What are the two curves that intersect to determine the general equilibrium in the complete IS-LM model?

A

FE and IS.

47
Q

What curve shifts to reach the general equilibrium in the complete IS-LM model?

A

LM shifts to reach this point of intersection.

48
Q

What is the effect of a temporary adverse supply shock on the labor demand curve?

A

Fall in A, reduces MPN and shifts the labor demand curve, so, both equilibrium wages and employment decrease.

49
Q

What is the effect of a temporary adverse supply shock on the labor supply curve?

A

The shock is temporary, so, no effect on workers’ wealth or expected future wage, and hence no effect on labor supply

50
Q

What is the effect of a temporary adverse supply shock on the full employment output?

A

Full employment output Ȳ decreases due to both lower N and drop in A

51
Q

What is the effect of a temporary adverse supply shock on the FE curve?

A

FE shifts to the left due to lower Y.

52
Q

What is the effect of a temporary adverse supply shock on the IS curve?

A

Since supply shock is temporary it only affects current Y without affecting expected future income or wealth or MPKf … So, no shift in the IS curve occurs, instead, it is a movement along the IS curve

53
Q

What is the effect of a temporary adverse supply shock on the LM curve?

A

Temporary supply shock does not have a direct effect on the demand or supply of money and hence no direct effect on the LM curve.

54
Q

What is the effect of a temporary adverse supply shock on desired consumption and desired investment in the model?

A

Both Decrease

55
Q

What is the effect of a temporary adverse supply shock on inflation in the model?

A

It increases during the period at which prices are rising and then it will subside when prices stabilize at the higher level (rises temporarily)

i.e Prices Increase

56
Q

A temproray adverse supply shock causes a leftward shift in the FE line and a movement along the IS curve. Accordingly, how the market reaches equilibrium?

A

LM curve shifts up and
to left. Prices go up and (M/P)
declines

57
Q

A temproray adverse supply shock causes a leftward shift in the FE line and a movement along the IS curve. Accordingly, how the market reaches equilibrium?

There is no point of intersection between the FE’, IS and LM

A

LM curve shifts up and
to left. Prices go up and (M/P)
declines

58
Q

What is the effect of a temporary adverse supply shock on equilibrium wages and employment in the model?

A

Temporary adverse supply shock reduces equilibrium real wages and employment

59
Q

What happens to the general equilibrium when any change or disturbance occurs in the economy?

A

The economy will be no longer in general equilibrium.

60
Q

What needs to adjust to return to equilibrium after a change or disturbance?

A

To return to equilibrium, prices need to adjust (LMcurve shifts).

61
Q

Which market is the fastest to adjust to a change or disturbance?

A

The asset market is the one that adjusts quickly to retain equilibrium, as financial markets respond quickly to economic changes.

62
Q

Which market is the slowest to adjust to a change or disturbance?

A

labor market is the slowest to adjust as the process of matching workers with jobs and negotiating wages takes some time.

63
Q

What is the effect of a monetary expansion on the FE line?

A

No effect

64
Q

What is the effect of a monetary expansion on the IS curve?

A

No effect

65
Q

What is the effect of a monetary expansion on the LM curve?

A

Increase in M with P constant causes M/P to increase by 10%, causing LM curve to shift down and to the right

66
Q

What is the name of the point where the IS and LM curves intersect after a monetary expansion?

A

Point at which the economy comes to rest before price adjustment takes place.

67
Q

What is the difference between short-run and long-run equilibrium in the IS-LM model?

A

Short-run eqilibrium occurs when Occurs when the economy is not in general equilibrium, yet, both goods and assets market are in equilibrium.

68
Q

What happens to the interest rate ® when the money supply (M) increases?

A

r falls as holders of wealth use their money to buy nonmonetary assets.

69
Q

What happens to consumption demand (Cd) and investment demand (Id) when r falls?

A

Cd and Id increase as borrowing becomes cheaper and saving becomes less attractive

70
Q

What happens to aggregate demand (AD) when Cd and Id increase?

A

AD increases as the total demand for goods and services rises.

71
Q

What happens to output (Y) when AD increases?

A

Y increases as firms respond by increasing their supply.

72
Q

What do firms try to do when they are not at the profit maximizing point?

A

Firms try to increase prices.

73
Q

What is the effect of an increase in prices?

A

An increase in prices leads to a lower M/P (money supply divided by price level) and a shift in the LM curve

74
Q

What is the relationship between M/P and the LM curve?

A

M/P is the real money supply, which determines the position of the LM curve. A higher (lower) M/P shifts the LM curve downward and to the right (upward and to the left)

75
Q

What happens to the LM curve if M and P change by the same proportion?

A

The LM curve does not shift, because M/P remains constant.

76
Q

What happens to the LM curve if M grows faster than P?

A

The LM curve shifts downward and to the right, because M/P increases.

77
Q

What does it mean for changes in M or P to be relative to the expected or trend rate of growth of money and inflation?

A

It means that changes in M or P are compared to what people expect them to be based on their past behavior or future projections. For example, a reduction in prices does not necessarily mean that prices will decrease in absolute terms, but it may mean that they will increase at a slower rate than expected.

78
Q

What is the main difference between classicals and Keynesians regarding the adjustment of prices?

A

lassicals assume that prices are flexible and adjust rapidly to changes in demand or supply, while Keynesians assume that prices are sticky and adjust sluggishly to changes in demand or supply.

79
Q

What is the main difference between classicals and Keynesians regarding the role of monetary policy?

A

Classicals support monetary neutrality, which means that changes in the money supply only affect nominal variables, such as prices and wages, but not real variables, such as output and employment. Keynesians reject monetary neutrality, especially in the short run, and argue that changes in the money supply can affect real variables through their effects on interest rates, investment, and aggregate demand.

Macroeconomic Theory (8 decks)

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