IS-LM and AS-AD analysis of the economy in the short- run Flashcards
Which three models are used to describe the stages of a business cycle?
1) The market for loanable funds. It shows how much real savings are available in an economy. Increased supply of real savings leads to lower interest rates, thereby encouraging firms to invest in more capital intense production.
2) The production possibility frontier: It shows the trade-off between investment and consumption. When artificial savings are induced, both consumption and investment increase at the same time, leading the economy on an unsustainable path.
3) The Hayekian triangle: The triangle shows how consumption and the capital structure of an economy is interrelated. If consumption and investment increase at the same time, the triangle gets a kink, indicating that the effected investments were not sustainable (i.e. malinvestments) and that the artificial boom will end.
Explain why malinvestments and overconsumption occur simultaneously.
The artificial low interest rate incentivizes both, the entrepreneur to invest more, as credit is cheaper available than before the new money was injected into the economy, and the consumer to spend more, as interest returns for his money balances are lower. Therefore, malinvestments and overconsumption occur simultaneously leading the economy on an unsustainable path.
Explain the terms Inflationary gap and deflationary gap.
Inflationary gap: occurs, if the actual level of expenditure is higher than the full employment output of an economy. The economy overheats meaning that inflationary pressure pushes the price level up. Total spending should be decreased.
Deflationary gap: occurs, if the actual level of expenditure is lower than the full employment output of an economy. This means that not all input factors of an economy are utilized. Total spending should be increased in order to bring the economy to a full employment output. The government might boost its spending or decrease taxes.
What is the marginal propensity to consume?
The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves.
Explain the multiplier effect
The multiplier effect relates to the shift in AD that results when expansionary fiscal policy increases income and thereby increases consumer spending. The amount of additional spending is driven by the MPC. The higher the MPC, the higher changes in consumption will be.
The multiplier can also be negative.
What, according the Keynes, was the main reason why recessions and depressions occurred?
because of insufficient demand for goods and services. Hence, he advises governments to boost aggregate demand/spending in times of a descending economy in order to cure mass unemployment (e.g. 1930s).
Use IS-LM analysis toe explain the following:
a. The government institutes significant cutes in public expenditures.
b. The central bank Institutes an asset purchasing facility which expands the money supply by €300 b.
c. The central bank fears that inflationary pressures are rising and increases interest rates.
d. the government increases taxation to try and reduce a large budget deficit.
a) IS curve shifts to the left, thereby decreasing national income.
b) LM curve shifts to the right thereby increasing national income (via lower
interest rates which encourages to more consumption and investment
spending)
c) LM curve shifts to the left, thereby national income decreases.
d) IS curve shifts to the left, thereby national income decreases.
Explain the so-called paradox of thrift! What do Keynesians believe and what are the counter arguments of classical economists regarding this paradox? Relate this discussion to the propositions “save and prosper” and “spend and prosper” respectively?
The paradox thrift means that although saving can have beneficial effects on an individual level , on an aggregate level it leads to an economic downturn as total spending must necessarily decrease thus decreasing national income. The proposition save and prosper refers to the classical argument that in the long-run an economy can only grow via an increased pool of real savings. Therefore, sacrifice today leads to a higher future income.
The proposition spend and prosper instead means that the higher total spending in an economy, the richer the economy will be.
Explain what Keynes meant by “sticky” wages/prices. What was the main conclusion he derived from this assumption?
Classical economic theory relies on the efficiency of markets and the assumptions that they would clear as long as prices are flexible! If unemployment or disequilibrium in markets exists, wages and prices would adjust to bring the economy back into equilibrium and full employment. Any unemployment that did exist was voluntary unemployment. Keynes instead believed that wages and prices might not adjust in the short run because they are “sticky”. Hence, the economy could remain in a situation where the level of demand was insufficient to bring about full employment. Because of the assumption that prices and wages are sticky, in the Keynesian model always volumes change not prices!
How does Keynes define equilibrium? Can involuntary unemployment exist in a Keynesian equilibrium?
Equilibrium in Keynes’ view was not the “best” or “desired” equilibrium – bringing about full employment and full utilization of capital in an economy. It is just a point where actual spending is equal to planned spending. Therefore, involuntary unemployment can exist in a Keynesian equilibrium.
Explain Keynes most famous quote “in the long run we are all dead”.
Keynes was critical about classical economics because it solely focused on long- run effects of economic decisions, thereby not caring about short-run mass- unemployment and economic misery. Hence he phrased, “in the long-run we are all dead” in order to make decision makers aware that they should actively manage the economy to cure depressions in the short-run.
Explain Say’s law: How can production (supply) actually open a demand for goods and services?
In other words, according to J.B. Say, there cannot be general overproduction or general unemployment on account of the excess of supply over demand because whatever is supplied or produced is automatically exchanged for money.
