Unit 3

Question 1

Why is AD Downward Sloping?

Answer 1

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

Question 2

Short Run Aggregate Supply

Answer 2

Shows the quantity of goods and services firms will produce at each price level

Question 3

Aggregate Demand

Answer 3

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

Question 4

Why is SRAS Upward Sloping?

Answer 4

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

Question 5

Shifters of AD

Answer 5

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

Question 6

Shifters of AS

Answer 6

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)

Question 7

LRAS

Answer 7

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.

Question 8

Recessionary Gap

Answer 8

When actual output (Y) is less than potential output (Yₚ), leading to higher unemployment and lower inflation.

Question 9

Inflationary Gap

Answer 9

When actual output exceeds potential output, leading to lower unemployment but higher inflation.

Question 10

Classical Theory

Answer 10

• 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.

Question 11

Keynesian Theory

Answer 11

• 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.

Question 12

Demand Pull Inflation

Answer 12

• Inflation caused by an increase in aggregate demand (e.g., due to increased consumer spending or government expenditure)
• AD shifts right

Question 13

Stagflation

Answer 13

• A combination of high inflation and high unemployment, often caused by a supply shock (e.g., an increase in oil prices)
• AS shifts left

Question 14

Cost-push inflation

Answer 14

• Inflation caused by an increase in the cost of production (e.g., higher wages, rising raw material costs).
• AS shifts left

Question 15

Expansionary Fiscal Policy

Answer 15

• used to close a negative output gap
• Increase in government spending.
• Decrease in taxes (to boost consumption and investment)

Question 16

Contractionary Fiscal Policy

Answer 16

• to close a positive output gap
• Decrease in government spending.
• Increase in taxes (to reduce consumption and investment)

Question 17

Automatic Stabilizers

Answer 17

• 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

Question 18

Advantages of Automatic Stabilizers

Answer 18

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.

Question 19

Discretionary Fiscal Policy

Answer 19

Active stabilizing policies like new laws

Question 20

Government Spending on Automatic Stabilizers

Answer 20

During a recession: Government spending on automatic stabilizers (e.g., unemployment insurance) increases.
During an inflationary period: Government spending on automatic stabilizers decreases.

Question 21

Tax Changes as Automatic Stabilizers

Answer 21

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.

Question 22

Deficit vs. Debt

Answer 22

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.

Question 23

Budget Surplus vs. Budget Deficit

Answer 23

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.

Question 24

Effect of Fiscal Policy on the Government Deficit

Answer 24

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.

Question 25

Marginal Propensity to Consume (MPC)

Answer 25

The fraction of additional income that is spent on consumption.

Question 26

Marginal Propensity to Save (MPS)

Answer 26

The fraction of additional income that is saved.

Question 27

Spending Multiplier

Answer 27

1/(1-MPC)

Question 28

Tax Multiplier

Answer 28

-MPC/(1-MPC)

Question 29

If the government increases taxes and spending by the same amount, what happens to AD?

Answer 29

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.

Question 30

Which Will Cause a Greater Change in GDP: Change in Spending or Change in Taxes?

Answer 30

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.

Question 31

Why Is the Tax Multiplier Less Than the Spending Multiplier?

Answer 31

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.