General

Question 1

What does the Classical Model infer?

Answer 1

The economy is free flowing, and prices adjust freely. IE - “the economy is self-correcting”

The major assumption of the model is an economy is always at full-employment.

If an economy is allowed to perform, it will tend toward its potential output.

Question 2

What does the Keynesian Model infer?

Answer 2

An economy can be above or below its full employment level, and economies can get stuck and require assistance to “regenerate”.

Question 3

When is the Classical Model most useful?

Answer 3

Long-run: To describe an economy in the Long-Run

Question 4

When is the Keynesian Model most useful?

Answer 4

Short-run: When an economy is in an expansion or contraction (above or below its potential).

Governments can help an economy in the short-run.

Question 5

What does the Aggregate Demand Curve denote?

Answer 5

It shows the relationship between Inflation, pi, and real output, y.

Question 6

T or F: Equilibrium output equals planned spending?

Answer 6

True - given by the AD curve.

Question 7

What can lead to increased inflation?

Answer 7

One reason: an expansionary output gap where equilibrium short-run output exceeds the potential output of an economy. When this occurs, firms will produce at a greater level to meet customer demands Firms may be willing to keep prices fixed in the short term, but eventually they will raise prices; contributing to inflation.

Question 8

Why is the aggregate demand curve downward sloping?

Answer 8

Typically - reserve banks will tend to act against inflation by increasing interest rates which will curve spending. Hence, when an increase in inflation is experience, a rate increase will occur and decrease the planned spending of an economy.

Question 9

What are the two (primary) considerations that shift a demand curve?

Answer 9

1 - changes in spending caused by factors OTHER than interest rates or output; exogenous factors.
2 - changes in the RBA’s monetary policy; a shift in the Policy Reaction Function.

Question 10

List examples of “exogenous” events

Answer 10

1 - Fiscal policy changes - government infrastructure expenditure.
2 - technological changes increasing investment
3 - increase in foreigners willingness to purchase domestic products.

Question 11

What is a key assumption of the AD curve?

Answer 11

It reflects that fact that “all other things held constant” a higher level of inflation will lead to a lower level of planned spending.

Question 12

T or F: The Policy Reaction function is built in to the AD curve?

Answer 12

True - it accounts for the curve’s downward slope.

Question 13

Can a exogenous change occur in the Policy Reaction Function?

Answer 13

Yes - because Governments may elect to change the PRF depending on the economy’s reaction to prior monetary policy adjustments. This includes “tightening” policy, which means setting a higher interest rate for given levels of inflation.

Question 14

What is equilibrium output?

Answer 14

Equilibrium Output is where demand equals supply.

Question 15

What are the 3 (main) factors that cause inflation?

Answer 15

1 - Output Gap
2 - Inflation Shock - (factor that directly effects prices)
3 - Shock to potential Output

Question 16

What is “Inflation Inertia”?

Answer 16

That fact that Inflation tends to change relatively slowly from year to year.

Question 17

Why does Inflation adjust relatively slowly in modern industrial economies?

Answer 17

1 - Inflation Expectations; expected salary rise passed on

2 - Long-term wage and price contracts

Question 18

What happens to inflation if equilibrium output equals potential output?

Answer 18

Inflation is likely not to change because suppliers have no incentive to either increase or decrease the price of their goods relative to other goods.