Unit 3 Flashcards
Why is AD Downward Sloping?
Wealth Effect (C): Lower price levels increase purchasing power and increase consumption expenditures. (and vice versa)
Interest Rate effect (I): lower price levels decrease interest rates which wil increase investment spending by firms and consumption spending by households (and vice versa)
Exchange Rate Effect (Xn): Lower price levels will cause foreign buyers to purchase more US goods so export spending will increase
Short Run Aggregate Supply
Shows the quantity of goods and services firms will produce at each price level
Aggregate Demand
Shows the relationship between the price level and the quantity of goods and services demanded by households, firms, government, and the rest of the world
Why is SRAS Upward Sloping?
Sticky wages – wages and input prices will stay constant in the short run
If price level increases, wages stay constant so firms will earn more profit and produce more
Shifters of AD
C+I+G+Xn
C - changes in consumer spending
I - changes in investment spending like capital stock, new homes, or inventories
G - changes in gov spending
Xn - changes in export or import spending
Shifters of AS
PEAR
P - productivity changes (workers more or less productive)
E - expectations of inflation (producers will supply less so they can take advantage of increased prices)
A - actions taken by the gov’t (subsidies, taxes, regulations, specific to PRODUCERS)
R - resource prices (oil, coal, fossil fuels, WAGES)
LRAS
natural output level (where the economy is producing at full capacity). represents the economy’s potential output, where the labor market is at full employment. In the long run, the economy produces at full capacity, and output is independent of the price level.
Recessionary Gap
When actual output (Y) is less than potential output (Yₚ), leading to higher unemployment and lower inflation.
Inflationary Gap
When actual output exceeds potential output, leading to lower unemployment but higher inflation.
Classical Theory
- The economy is self-correcting in the long run. Any recessionary or inflationary gap will eventually close due to flexible wages and prices.
- LRAS is vertical at full employment, and the economy will return to full employment without government intervention.
Keynesian Theory
- The economy may remain in a recessionary gap for an extended period due to sticky wages and prices.
- Government intervention (fiscal policy) is necessary to increase aggregate demand and return the economy to full employment.
Demand Pull Inflation
- Inflation caused by an increase in aggregate demand (e.g., due to increased consumer spending or government expenditure)
- AD shifts right
Stagflation
- A combination of high inflation and high unemployment, often caused by a supply shock (e.g., an increase in oil prices)
- AS shifts left
Cost-push inflation
- Inflation caused by an increase in the cost of production (e.g., higher wages, rising raw material costs).
- AS shifts left
Expansionary Fiscal Policy
- used to close a negative output gap
- Increase in government spending.
- Decrease in taxes (to boost consumption and investment)
Contractionary Fiscal Policy
- to close a positive output gap
- Decrease in government spending.
- Increase in taxes (to reduce consumption and investment)
Automatic Stabilizers
- These are automatic changes in government spending or taxation that help stabilize the economy without the need for new policy actions
- Ex: Unemployment benefits: Increase during a recession as more people lose jobs. Progressive income taxes: Tax receipts fall when incomes fall during a recession and rise when incomes rise during an expansion
Advantages of Automatic Stabilizers
Quick response: They automatically respond to changes in the economy, providing immediate relief during recessions and cooling effects during booms.
Reduced need for discretionary policy: Less reliance on politicians to react to economic changes.
Discretionary Fiscal Policy
Active stabilizing policies like new laws
Government Spending on Automatic Stabilizers
During a recession: Government spending on automatic stabilizers (e.g., unemployment insurance) increases.
During an inflationary period: Government spending on automatic stabilizers decreases.
Tax Changes as Automatic Stabilizers
During a recession: Tax revenues automatically fall due to lower incomes, which acts as an automatic stimulus.
During an inflationary period: Tax revenues automatically rise due to higher incomes, which acts as a natural restraint on the economy.
Deficit vs. Debt
Deficit: The annual shortfall between government revenue and government spending.
Debt: The total accumulated amount the government owes, which is the sum of all past deficits.
Budget Surplus vs. Budget Deficit
Budget Surplus: Occurs when government revenue exceeds government spending in a given year.
Budget Deficit: Occurs when government spending exceeds government revenue in a given year.
Effect of Fiscal Policy on the Government Deficit
Expansionary fiscal policy (increased government spending or tax cuts) usually increases the deficit.
Contractionary fiscal policy (decreased government spending or tax increases) reduces the deficit.
Marginal Propensity to Consume (MPC)
The fraction of additional income that is spent on consumption.
Marginal Propensity to Save (MPS)
The fraction of additional income that is saved.
Spending Multiplier
1/(1-MPC)
Tax Multiplier
-MPC/(1-MPC)
If the government increases taxes and spending by the same amount, what happens to AD?
The increase in government spending has a larger positive effect on AD than the reduction in consumption caused by higher taxes, because the spending multiplier is larger than the tax multiplier.
Which Will Cause a Greater Change in GDP: Change in Spending or Change in Taxes?
Changes in government spending cause a greater change in GDP because they directly affect AD, while changes in taxes have an indirect effect by influencing consumption.
Why Is the Tax Multiplier Less Than the Spending Multiplier?
The tax multiplier is smaller because a tax cut doesn’t translate into the full amount of additional consumption; people save part of the extra income (determined by the MPC), whereas government spending directly increases aggregate demand.
