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Econ 1012 > Part 3 > Flashcards

Part 3 Flashcards

1
Q

Price level P

A

The price of a basket of goods measured in money

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2
Q

1/p

A

The value of money measured in goods

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3
Q

As P increases, 1/P…

A

Decreases

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4
Q

Quantity theory of money

A

Asserts that the quantity of money determines the value of money

Has two approaches:

Supply demand diagram, (money market)

An equation

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5
Q

Money supply Ms (money market diagram)

A

Money supply in he real world determined by the fed, the banking system, and households

In this model, we assume that the Fed controls Ms and sets it at some fixed amount

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6
Q

Money demand Md (money market) and what does it depend on

A

Refers to how much wealth people want to hold in liquid form

Depends on P: an increase in P means to purchase the same amount of goods and services, one needs more money

The quantity of money demanded is positively related to P and negatively related to the value of money 1/p

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7
Q

Why might an increase in the money supply cause P to rise

A

An increase in Ms causes an excess supply of money

People get rid of excess money by spending it on goods and services or by loaning it to others who want to spend it

This increases a demand for goods but supply does not increase so prices must rise (bid up by those who demand them)

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8
Q

Real vs nominal variables

A

Nominal variables are measured in monetary units

Real variables: measured in physical units or measured excluding inflation

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9
Q

Relative price

A

The price of one good relative to another good

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10
Q

Real wage

A

W/P

W= nominal wage
p= price level

Real wage is the price of labor relative to the price of output

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11
Q

Classical dichotomy

A

Theoretical separation of nominal and real variables

-states monetary developments affect nominal variables but not real variables

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12
Q

Money neutrality

A

The proposition that changes in the money supply do not affect real variables

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13
Q

Under classical dichotomy and money neutrality how does change in money supply affect W/P

A

The real W/P does not change because of money neutrality so when supply increases quantity of labor supplied does not change

Labor demanded does not change

Employment of labor does not change
And employment of capital and other resources does not change

Total output is not changed

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14
Q

Most economists believe the classical dishotomy and neutrality describe the economy in the short run or the long run??

A

Long run

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15
Q

The quantity theory equation

A

MV = PY

P*Y = nominal GDP (price level times real GDP

m = money supply

V = velocity of money

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16
Q

The quantity theory equation— how do P and M relate and what does this imply

A

MV= PY

usually assume V is stable
M Does not affect Y bc of neutrality (Y determined by technology and resources)

Sooo P must change by same amount as M to keep the equality

The equation implies rapid money supply growth causes rapid inflation

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17
Q

What is velocity and what is the formula

A

The rate at which money changes hands

V= PY/M

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18
Q

Lessons abt the quantity theory of money

A

If real GDP is constant then inflation rate = money growth rate

If real GDP is growing, then inflation rate < money growth rate

Inflation rate = money growth rate - output growth rate

Excessive money growth causes inflation

Economic growth increases # of transactions, and bc velocity stays constant, money growth is needed for these extra transactions

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19
Q

Inflation tax

A

The revenue the government raised by creating money (today the inflation tax only accounts for less than 3% of total revenue

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20
Q

The fisher effect

A

An increase in the rate of money growth raises the rate of inflation but does not affect any real variable

(An extensions of the principle of money neutrality)

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21
Q

Why does the fisher effect exist

A

Real interest rate= nominal interest rate -inflation rate

Nominal interest rate = real interest rate + inflation rate

One for one adjustment of nominal interest rate to inflation rate

If inflation rate goes up, nominal interest rate will go up, but no change in interest rate

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22
Q

When the fed increases the rate of money growth, the long run result is:

A

Higher inflation rate

Higher nominal interest rate

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23
Q

Inflation fallacy

A

When prices rise, buyers pay more, and sellers get more, so inflation does not itself reduce people’s real purchasing powers

Inflation causes CPI and nominal wage to rise together

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24
Q

Costs of inflation

A

Shoe leather costs, menu costs, misallocation lf resources from relative price variability, confusions dn inconvenientes, tax distortions, unexpected inflation

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25
Q

Shoe-leather costs (cost of inflation

A

Resources wasted when inflation encourages people to reduce thnjeir money holdings

This means they have to go to the bank to get money out for transactions to incur more transaction costs (hence wearing out their shoes)

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26
Q

Menu costs

A

Costs of changing prices (think having to print out me menus

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27
Q

Misallocation of resources

A

Firms don’t all raise prices at the same time, so relative prices can vary, distorts the allocation of resources

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28
Q

Tax distortions ( cost of inflation)

A

Inflation makes nominal income grow faster than real income, taxes are based on nominal income, inflation causes people to pay more taxes when their real incomes don’t increase

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29
Q

Unexpected inflation does what

A

Redistributes wealth among the population not by merit or by need

Redistributes wealth from debtors to creditors (debtors pay less in real terms while creditors receive less in real terms

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30
Q

How do costs of inflation affect diffeeent countries?

A

Costs are high to economies experiencing hyper inflation

Low for economies with low inflation

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31
Q

Closed economy

A

Economy that does not interact with other economies

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32
Q

Open economy

A

Economy that interacts with other economies around the world, buys and sells goods and services in the world product market, and buys and sells assets such as stocks and bonds in world financial market

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33
Q

Trade surplus

A

Exports greater tan imports

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34
Q

Trade deficit

A

Imports are greater than exports

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35
Q

Balanced trade

A

Exports = imports

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36
Q

Factors that might influence a country’s exports and imports

A

Incomes of consumers at home and abroad
Consumers preferences for foreign and domestic goods
Prices of goods at home and abroad
Exchange rates at which currency traded for domestic currency
Government policies
Transportation costs

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37
Q

NCO

A

Net capital outflow

Amount of foreign assets held by domestic residents — amount of domestic assets held by foreigners

38
Q

When NCO > 0

A

Capital outflow

39
Q

When NCO < 0

A

Capital inflow

40
Q

Variables that influence NCO

A

Real interest rates paid in foreign assets
Real interest rates paid on domestic assets
Perceived risk of holding foreign assets
Government policies affecting ownership of domestic assets

41
Q

Accounting identity relating to NCO and NX

A

NCO = NX

42
Q

Open economy identity including saving, investment and NCO

A

S= domestic investment + NCO

43
Q

Nominal exchange rate

A

Rate at which one country’s currency trades for another

Units of foreign currency per unit of domestic currency

44
Q

Appreciation

A

Increase in the value of currency as measured by the amount of foreign currency it can buy

45
Q

Depreciation

A

Decrease in the value of a currency as measured by the amount of foreign currency it can buy

46
Q

Real exchange rate

A

Rate at which the goods and services of one country trade for the goods and services of another

Real exchange rate = q= eP*/ P

P = domestic price 
P* = foreign price 
E = nominal exchange rate (foreign currency per unit of domestic currency)
47
Q

Law of one price

A

Assumes trade is frictionless around the world —

Says a good should sell for the same price in all markets when the prices are expressed in the same currency

48
Q

Arbitrage

A

The act of taking advantage of price differences for the same item in different markets

Equalizes prices and ensures Law lf one price holds

49
Q

Purchasing power parity

A

A unit of any given currency should be able to buy the same quantity of goods in all countries (based on the law of one price)

50
Q

If ppp holds, then q=

A

1

51
Q

If ppp holds, e =

A

P*/P

52
Q

When central bank increases money supply: price level will… and that country’s currency will

A

Price level will rise and the country’s currency will depreciate relative to other currencies

53
Q

Why light ppp not hold

A

Transaction costs
Some goods are non-tradable
Imperfect competition and legal obstacles
Price stickiness (prices may not adjust right away when supply and demand changes

54
Q

The business cycle

A

Irregular fluctuations in GDP and corresponding fluctuations in other macroeconomic variables

55
Q

Booms

A

Happens from trough to peak and are periods of increasing real incomes and decreasing unemployment

56
Q

Recessions

A

Happen from peak to trough, are periods of falling real incomes and rising unemployment

57
Q

Depressions

A

Severe recessions

58
Q

The classical dichotomy

A

The separation of variables into two groups (real vs nominal)

59
Q

The neutrality of money

A

Changes in money supply affect nominal but not real variables

60
Q

AD curve

A

Shows the quantity of all goods and services demanded in the economy at any given price level

61
Q

Why does AD slope downward

A

The wealth effect (C), the interest effect (I) and the exchange rate effect (NX)

An increase in P decreases, output (Y) increases for all of these

62
Q

The wealth effect

A

Price level P declines—

Increase in the real value of money, consumers are wealthier, increase in consumer spending C, increase in quantity demanded of goods and services , y goes up

63
Q

The interest rate effect

A

If P declines,

Buying same amount of goods and services requires fewer dollars

People reduce monetary holdings and instead hold interest bearing assets like bonds

Higher demand for assets like bonds drive down the interest rate

Lower interest rate cheaper to borrow so investment increases

Increase in quantity demanded of goods and services

So as price level goes down, output goes up

64
Q

The exchange rate effect

A 
Suppose the price level P declines
Real exchange rate declines 
Is dollar depreciates in real terms 
Stimulates US net exports NX
Increase in quantity demanded of goods and services 
So as P decreases, Y increases
65
Q

What shifts AD

A

Any event that changes C, I, G, NX except for a change in P or Y will shift the AD curve

66
Q

AS

A

The AS curve shows the quantity of all goods and services firms produce and sell in the economy at any given price level (can be upward sloping or vertical)

Upward slipping in short run vertical in long run

67
Q

LRAS

A

The potential level of output (Y bar) is the amount of output the economy produced when all available resources are employed

Productivity (L, K, H, N, A)

It is the maximum amount of output the economy can produce given existing resources

Any change in P does not affect productivity

68
Q

What shifts LRAS

A

Any event that changes any of the determinants of potential output (productivity) (l k h n a) will shift LRAS

69
Q

SRAS

A

The SRAS is upward and it is over the short run.

An increase in P will cause an increase in the quantity of goods and services supplied

70
Q

Why is SRAS upward sloping?

A

Sticky wage theory, misperception theory, sticky price theory

71
Q

Sticky wage theory

A

Says that nominal wages are sticky in the short run, they adjust sluggishly

(When firms set nominal wages in advance, they do not take into consideration changing price level)

If price level remains the same as the equilibrium price level then output is at potential

How ever, in the future, if Price level is higher than Price equilibrium, workers are still getting paid the same nominal wage while the firm is receiving more profit from the higher price level (same cost but more profit means firms increase output so Y increases

72
Q

The misperception theory

A

Firms may confuse changes in P with changes in the relative price of the products they sell

If P = Pe, output is st potential

I P rises above Pe, a firm is not sure if price for its own product has gone up or if general price level has gone up

If firm believes that the price increase may be indicative of a rise in demand, it’ll increase production and employment

Hence, an increase in P can cause an increase in Y so SRAS slopes upward

73
Q

Sticky price theory

A

Assume firms get to set their own prices based on expectation of what their competitors will charge and the level of demand

Assume economy starts off at potential with two types of firms:

Flexible price firms adjust prices immediately to changing economic conditions

Sticky price firms set prices in advance based on Pe and then prices will stay the same for some time

Reasons for sticky prices (menu costs, cost of adjusting prices)

General P is a weighted avg of prices set by these two types of firms

If Y deviated form potential output,

Flexible price firms raise their prices immediately

Sticky price firms will wait to raise prices

P> Pe (bc flexible raises immediately)

Higher P is associated with higher Y, SRAS slopes upward

74
Q

SRAS Equation

A

Y = Y bar (potential LRAS) + a (P -Pe)

Y= output 
Y bar= potential output (long run) 
a > 0 measures how much Y responds to undexpected changes in P (price elasticity of supply)
P= actual price level 
Pe = expected price level

Pe shifts SRAS, if Pe rises, workers and firms set higher wages

75
Q

What happens overtime

To sticky wages and misperceptions

A

Sticky wages and prices become flexible

Misperceptions are corrected

In the long run, Pe = P and Y = Y bar

76
Q

How do LRAS and SRAS shifters relate

A

Everything that shifts LRAS shifts SRAS too, but not everything that shifts SRAS shifts LRAS

77
Q

The general theory of employment, interest, and money

A

Argued recessions and depressions can result form inadequate demand, policy makers should shift AD

Famous critique of classical theory: the long run is a misleading guide to current affairs

78
Q

fiscal policy

A

Setting the level of government spending and taxation by government policy makers

79
Q

Expansionaryfiscal policy

A

An increase in G and/ or decrease in T (which stimulates C, shifts AD

80
Q

Contractionary fiscal policy

A

A decrease in G and or increase in T, shifts AD left (less consumption)

81
Q

Fiscal policy has two effects on AD

A

The multiplier effect and the crowding out effect

82
Q

Multiplier effect on AD

A

The additional shifts in AD that result when fiscal policy increases Y and then C increases from the increase in Y

83
Q

The crowding out effect

A

Government budget deficits reduced supply of loanable funds in the loanable funds market which lead to an increase in interest rate and a reduction in investment

84
Q

Marginal propensity to consume

A

MPC = change in C/ change in Y

Fraction of extra income that households consume rather than save

Relates to the multiplier effect Bc the multiplier effect depends on how much consumers respond to increases in income

85
Q

How to calculate the multiplier

A

It is the Chang in Y divided by the change in government spending

Change in y / change in G

Also,

1/ 1-MPC

86
Q

Tax policy: tax cut vs tax hike

A

Tax cut is expansionary tax hike is contractionary

87
Q

Tax cut effect on AD

A

Tax cut increases households take home pay, respond by spending a portion of this extra income, shifting AD to the right (affected by the multiplier effect and crowding out effects)
Permanent tax cut is large impact on AD temporary tax cut is small impact on AD

88
Q

Case for active stabilization policy

A

Pessimism and optimism among households and firms lead to shifts in AD and fluctuations in output and employment

(Fluctuations also cause by booms and recessions and supply side disturbances)

If policy makers do nothing, these fluctuations are destabilizing to businesses, workers, consumers

Governments should use policy to reduce these fluctuations

89
Q

When GDP fall below potential, gov should use what types of policies

A

Expansionary monetary or fiscal policy

90
Q

When GDP rises above potential, what kinds of Policies should gov implement

A

Contractionary policy

91
Q

The case against active stabilization policy

A

Firms make investment plans in advance, takes time to respond to changes in real interest rates

It takes at least 6 months for monetary policy to affect output and employment

Fiscal policy works with lag Bc of politics (require acts of congress legislative processs)

Critics say Bc of these lags, active policy could actually destabilize the economy Bc by the time these policies affect AD, the economy’s condition may have changed

92
Q

What should congress consider when cutting taxes

A

Should consider the short run effects on AD and employment

And the long run effects on saving and growth

When the fed reduces the rate of money growth, must take into account not only long run effect on inflation but also the short run effects on output and employment

Econ 1012 (3 decks)

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