Exam 3 Review Flashcards
aggregate economic activity
refers to the macroeconomic indicators such as GDP and employment
business cycle
regular fluctuations in AEA
contraction or recession
period in which AEA is falling
depression
severe recession
expansion or boom
period of time during which AEA grows
classical economists view on business cycle
natural phenomena and therefore do not see the need for policy intervention
Keynesian economists view on business cycle
recessions may last for long periods (since prices are sticky in the short run) and therefore there is a need for policy intervention
what caused economists to start questions classical views on the business cycle?
- motivated after the great depression in the 1930s
- -unemployment was 25%
- GDP has fallen by 30% in the past 5 years
- no change in factors of production
natural level of output
level of output produced when the economy operates at its maximum potential
-we want economy to operate here
in the long run, the natural level of output is equal to ……
the level of output
why are economists concerned about recessions?
- high unemployment
- low investment
- low household consumption
why are economists concerned about booms?
- leads to inflation
- resources are over-utilized, factories may operate an extra shift
- upward pressure on prices and wages: to prevent workers from quitting and moving to other employers, firms may be forced to pay higher wages
what determines whether a downturn in the economy is severe enough to be deemed a recession?
a recession is a period of at least 2 consecutive quarters (6 months) of declining REAL GDP
during recessions, both consumption and I declines (less income, business spend less). Which one generally declines more?
Investment generally declines more than C
is the unemployment rate a good indicator of a recession ending?
NO, the unemployment rate often lags changes in GDP growth
real GDP growth in the US averages about what per year?
3%
Okun’s law
the negative relationship between GDP and unemployment
unemployment rises during recessions and falls during expansions
% change in Real GDP = 3%-2% change in unemployment rate
Leading Economic Indicators
- The Conference Board meets each month and aims to forecast changes in economic activity 6-9 months into the future
- used in planning by businesses and government
components of LEI index (read 279-280)
- average work week in manufacturing
- initial weekly claims for unemployment insurance
- new orders for consumers goods and materials
- new orders, non-defense capital goods
- vendor performance
- new building permits issued
- index of stock prices
- m2
- yield spread on treasuries
- index of consumer expectations
is the LEI a good predictor tool?
turns downward a few months to a year before each recession
turns upward just prior to the end of almost every recession
fiscal policy
changes in taxes and government spending
monetary policy
changes in the money supply
expansionary fiscal policy
an increase in G or a decrease in T
contractionary fiscal policy
a decrease in G or an increase in T
expansionary monetary policy
increase in the money supply
contractionary monetary policy
a decrease in the money supply
factors that shift the AD curve
- changes in household consumption (increase in consumption shifts AD curve to the right)
- changes in the demand for investment by firms (increase in the demand for investment shifts the AD curve to the right)
- fiscal policy: an increase G or a decrease in T shifts the AD curve to the right
- monetary policy: an increase in the money supply shifts the AD curve to the right
- a positive demand shock shifts the AD curve to the right
aggregate supply curve
shows the amount of output firms are willing to produce at any given price level
(since prices are sticky in the short run, we must consider SRAS curve and the LRAS curve)
in the long run, output is determined by what?
in the long run, output is determined by factor supplies and technology Y = F (K, L)
Y being full employment or the natural level of output
LRAS curve is vertical because it does not depend on prices
long run equilibrium
point where AD and the LRAS curve intersect
how do changes in AD affect output and price level in the long run?
in the long run, changes in AD affects only the price level, but not the level of output
why is the SRAS curve horizontal?
the SRAS curve is horizontal because prices are sticky in the short run and firms are willing to sell as much at that price level as their customers are willing to buy
shifts in the SRAS curve
-a supply (or price) shock is an event that alters the cost of producing goods and services, and as a result, the price that the firms charge
an adverse supply shock shifts the SRAS curve up
a favorable supply shock shifts the SRAS curve down
how do changes in the aggregate demand affect output and the price level in the short run?
in the short run, changes in AD affects only the level of output but NOT the price level
stabilization policy
a public policy (monetary or fiscal policy) aimed at reducing the severity of macroeconomic fluctuations
suppose the price of oil increases. what kind of stabilization policy should be pursued?
since SRAS moves up, policy makers must work to increase AD to move the level of output back to it’s original level
what two markets must we use concurrently to derive the IS-LM model?
market for goods and services
loanable funds
what makes up the loanable funds graph?
x axis: S, I
y axis: r
downward sloping I(r) demand curve
completely vertical savings supply curve
how do we derive the IS curve from the loanable funds graph?
- money market graph tells us that a decrease in Y implies an increase in R
- hence, the IS curve slopes DOWNWARD
describe the IS curve and graph
x axis: Y or output
y axis: r
downward sloping linear IS curve
factors that shift the IS curve
any factor that increases consumer spending will shift the IS curve upward
-an increase in the demand for investment by firms will shift the IS curve upward
fiscal policy: an increase in G or a decrease in T will shift the IS curve upward
definition of the LM curve
the LM curve shows the combinations of the interest rate and the level of income which the monkey market is in equilibrium
ie: demand for real money balances = supply of real money balances
money market graph description
x axis: M/p or real money balances
y axis: interest rate
downward sloping L(r) curve
vertical M/P line
how do we derive the LM curve?
according to the money market graph, an increase in income raises the money demand and causes interest rates to rise
therefore, we can conclude that LM curve slopes upward
describe the LM curve and it’s graph
x axis: y or output
y axis: r
LM curve slopes upward
factors that shift the LM curve
a decrease in the demand for real money balances shift the LM curve upward
an increase in the price level results in a decrease in real money balances and shifts the LM curve upwards
monetary policy: for a fixed level of income, a decrease in the money supply shifts the LM curve upward
short run equilibrium of the economy as a whole
the point in which LM and IS curves interest…gives us our equilibrium level of income and equilibrium interest rate
what does the IS curve represent in the IS-LM model?
the IS curve represents equilibrium in the goods market
y = C(Y-T) + I(r) + G
what does the LM curve represent in the IS-LM model?
the LM curve represents the money market equilibrium
M/P = L(r,y)
an increase in government purchases causes what to shift in the IS-LM model?
IS curve shifts right, causing Y and r to rise
a tax cut causes what to shift in the IS-LM model?
IS curve shifts right, causing Y and r to rise
according to the IS-LM model, a tax cut effect is (greater, less, or equal) to a change in government spending
since consumers are a part of the tax cut, the effects on r and Y are smaller for tax changes than for an equal government spending change
a monetary policy designed to increase the money supply does what in the IS-LM model?
- shifts the LM curve down (or to the right)
- this causes the interest rate to fall
- increases investment, causing output and income to rise
in response to a change in government spending greater than 0, what can the Feds do?
- hold M constant
- hold r constant
- hold Y constant
- effects are different for each case
in response to a change in government spending, if the Feds hold the money supply constant, what happens according to the IS-LM model?
if congress raises G,
the IS curve shifts right
if Fed holds M constant,
then LM curve doesn’t shift right
(you still still see an increase in output and interest rate)
in response to a change in government spending, if the Feds hold the r constant, what happens according to the IS-LM model?
if congress raises G,
the IS curve shifts right
to keep R constant, Fed increases M to shift the LM curve right
results: change in y = Y3-Y1
change in r = 0
in response to a change in government spending, if the Feds hold y constant, what happens according to the IS-LM model?
if congress raises G,
the IS curve shifts right
to keep Y constant,
Fed reduces M to shift LM curve left
results:
change in Y = 0
change in r = r3 - r1
hypothetical: there is a housing market crash
IS shifts left, causing r and Y to fall
C falls due to lower wealth and lower income
I rises because r is lower
u rises because Y is lower
when faced with an adverse supply shock, what two options do the feds have? What are the trade offs of these options?
- hold aggregate demand constant: results in output and employment being lower than the natural level…eventually prices will fall to restore full employment at the old price level, but the cost of this process is a painful recession
- expand aggregate demand (accommodating the supply shock): price level is made permanently higher, there is no way to adjust AD to maintain full employment and keep the price level stable
what happens when we have a positive shock to aggregate demand?
in the short run, output increase. Over time, the high levels of ad pulls up the wages and prices. As the price level rises, the quantity of output demanded declines, and the economy gradually approaches the natural level of production.
what can the Feds do to dampen a boom in AD?
The Feds can reduce the money supply as a way to offset the increase in velocity. Thus, the Fed can reduce or even eliminate the impact of demand schoks on output and employment.
in the LS-IM model, an increase in government spending increases the interest rate and crowds out what?
investment
in the IS-LM analysis, the increase in income resulting from a tax cut is usually (greater than, less than, equal to) the increase in income resulting from an equal rise in government spending
less than
if taxes are raised, but the Fed prevents income from falling by raising the money supply, then what happens to investment and consumption?
investment rises, but consumption falls because of the lower interest rate and the fact that people will have to spend that extra money on the raised taxes
According to the IS-LM model, when the government increases taxes and government purchases by equal amounts…what happens to the income, interest rates, consumption, and investment?
income and interest rates rise, consumption and investment fall
if the government wants to raise investment but keep output constant, it should have what type of fiscal and monetary policy?
adopt a loose monetary policy but a tight fiscal policy
a narrowing of the interest rate spread between 10-year treasury notes and 3-month treasury bill is typically an indicator of a slowdown or increase in economic production?
slowdown
when an unfavorable supply shock occurs, Feds can use monetary policy to return output to natural rate or allow the price level to return to it’s natural level with time. What are the tradeoffs of both?
higher price levels if feds intervene, lower level of output and a recession in the short run with no intervention
