Unit 3 Flashcards
Why is aggregate demand downward sloping?
- Real wealth effect
- Interest rate effect
- Exchange rate effect
Real wealth effect
Higher prices reduce purchasing power of money, assets worth less so people spend less. And vice versa, lower price levels increase purchasing power so people spend more.
Interest Rate Effect
Lender charge high interest rates to get REAl return on loans when price levels increase. Higher interest rate discourage consumers from spending and business investments which lower AD.
Foreign Trade Effect
When price levels rise, foreign buys purchase fewer goods and Americans buy more foreign goods. Decrease in exports and increase in imports causes real GDP to decrease.
Aggregate Demand Curve Shifters
C + I + G + XN
MPS - Marginal Propensity to Save (Always expressed as a fraction or decimal)
How much people save rather than consumer/spend when there is a change in disposable income.
MPS formula
Change in Savings divided by Change in disposable income
MPC - Marginal Propensity to Consume
How much people consume rather than save when there is a change in the disposable income. (Fraction or decimal)
MPC formula
Change in consumption divided by change in disposable income
Spending multiplier equation
1/MPS or 1/1-MPC
Tax multiplier equation
Always one less than the spending multiplier
MPC x 1/MPS OR MPC/MPS
Why is tax multiplier one less than spending multiplier?
People save a portion of a tax cut
shifters of SRAS
- Change in the price of resources
- Change in taxes, subsidies, and/or regulations
- Change in productivity
- Expectations
Expectations of inflation for SRAS
If people expect inflation to go up SRAS will shift to the left because wages and contracts all increase so suppliers have to spend more. This is because if a worker expects prices of things to increase they would want a raise to balance out. (This is all in the short run.)
LRAS output represents
Full-employment out put that a country produces (Natural rate of unemployment)
Negative output gap
A recessionary gap (but AP exams use the term negative output gap more)
Positive output gap
Inflationary gap but the AP exams prefer the term positive (or negative for recessionary) output gap.)
Negative supply shock
Producers run out of a key resource like oil or electricity. This causes SRAS to shift to the left and cause stagflation.
Stagflation
High unemployment and inflation because price levels go up but quantity decrease.
Positive supply shock
SRAS increases because suppliers have more of a key resource. Price levels go down and more output is produced.
Cost push inflation
Supply (SRAS) shifts to the lefts and there is higher inflation due to less production and higher cost of wages and raw materials.
Demand Pull Inflation
Demand is increasing and there is higher price level because people are buying more stuff. Demand for goods exceed the supply or amount of the goods. Too much money chasing too few goods. AD shifts to the right.
Real GDP is opposite of unemployment
If real GDP increases more stuff is being produce so unemployment decreases. If real GDP decreases then unemployment increases.
What happens in the long run if there is a negative output gap with high unemployment?
Eventually in the long run (if wages are flexible) the wages will go down and resource prices will go down. The SRAS shifts to the right/increase) which will put the economy back at long run equilibrium(full employment) This is self adjustment w/o gov’t action.
What happens in the long run if there is a positive output gap? (Unemployment is low, inflation is high)
Wages and resource prices will eventually go up. SRAS will shift to the left which puts the economy back at full employment. This is self adjustment w/o gov’t action.
SRAS usually shifts back to full employment unless:
The spending is on something that will cause economic growth in which case the LRAS will shifts to the right.
LRAS shifts to the right
With things like business investment spending on capital goods or gov’t spending on education that improves human capital.
Fiscal policy
When the government manipulates economy by changing gov’t spending, taxes, of transfer payments.
Transfer payments
Welfare, stimulus checks, they give directly to individuals
Expansionary Fiscal Policy
Laws that reduce unemployment and increase the GDP
1. Increase gov’t spending
2. Decrease taxes (increases the disposable income)
3. Combination of the two
Contractionary Fiscal Policy
Laws that reduce inflation, decreases the GDP
1. Decrease gov’t spending
2. Increase taxes (decrease disposable income.)
3. Combination of the two
Ex. If there is a negative output gap
More government spending or taxes could increase the AD and cause it to shift to the right.(expansionary fiscal policy) The gov’t does this when they don’t want to simply wait for the economy to sell adjust.
Ex. If there is a positive output gap
Gov’t can use contractionary fiscal policy to fight inflation by decreasing gov’t spending or increasing taxes. This shifts AD to the left.
Discretionary fiscal policy
Congress creates a new bill designed to change the AD through gov’t spending or taxation.
- One problem is that there is are large times and it takes time for Congress to act due to bureaucracy.
Ex of discretionary fiscal policy
In a recession, Congress increases spending.
Non-Discretionary fiscal policy (AKA automatic stabilizers)
Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy.
- When GDP goes down, gov’t spending automatically increases and taxes automatically fall.
Ex of non-discretionary fiscal policy (AKA automatic stabilizers)
Welfare, Unemployment, Income tax
Multiplier Effect
The idea that an initial change in spending(or taxes) results in a larger change in spending.
Difference between market demand curve and aggregate demand curve?
Market demand curve shows demand for only ONE good/service at different prices. Aggregate demand curve shows the demand for all goods/services at different price levels.
Difference between short run and long run aggregate supply?
Short run is sticky and not as flexible. It takes time for change which is why in the long run the wages/prices are much more flexible. In the long run wages and resource prices have time to adjust to change in price levels.
Why is short run aggregate supply upward sloping?
Wages and resource prices are not flexible in the short rune because the wages are sticky. *Sticky means resistant to change
Shifters of short run-aggregate supply
Anything that affects producers or production.
1. Availability/price or resources
2. Gov’t action - Business taxes, subsidies, and regulations.
3. Expected inflation - if workers expect inflation they demand higher wages
Subsidies
A direct or indirect payment to individuals/firms, usually in the form of a cash payment from the government or a targeted tax cut.
The MPC and MPS…
Must add up together to 1. So it should be a fraction/decimal.
Deflation
A decrease in the general price level. Opposite of inflation. Goods/services generally cost less and prices are decreasing. (Not necessarily a good thing)
Disinflation
Decrease in the rate of inflation. Prices are still increasing but not as fast. It is a temporary slowing of the rate of change/pace of inflation.
What happens to output and unemployment if investments falls?
The output decreases and unemployment increases.
Autonomous Consumption
Spending that must be done even if someone doesn’t have income. This is usually on things like food or basic living needs.
Disposable income
Income remaining after the deduction of taxes and other mandatory charges. This income is the remaining income that can be spend on anything else.
Describe how the economy self-adjusts in the long run when there is a negative output gap.
A decrease in wages and resource prices will eventually cause production costs to fall and the SRA will shift to the right returning the economy to equilibrium.
Describe how the economy self adjusts in the long run when there is a positive output gap.
An increase in expected inflation causes wages to increase and SRAS to shift to the left. This happens in the long run because in the short run wages are much more sticky.
An economy can only self adjust if…
Wages and resources prices are flexible.
Economic Growth
An increase in the production off service and goods in a country. Things like increase capital goods, technology, human capital all contribute to economic growth.
When an economy experiences economic growth…
The LRAS will shift to the right and output will increase because economic growth means the economy’s potential is increasing and the LRAS is a vertical line at the economy’s current potential.
If an economy experiences economic growth, the natural rate of unemployment…
Does not change, there is no relationship between economic growth and natural rate of unemployment. Only changes in labor force characteristics do.
Examples of expansionary fiscal policy
- More government spending
- Less taxation/taxes
- Increase in transfer payments.
Examples of contractionary fiscal policy
- Less government spending
- More taxation/taxes
- Decrease in transfer payments
Why does an increase in gov’t spending lead to more total spending than a decrease in taxes by the same amount?
People save a portion of tax cuts which causes the tax multiplier to be less than the spending multiplier.
Difference between discretionary and non-discretionary fiscal policy.
Discretionary is when the Congress gathers to pass a law, it takes a long. Non-discretionary is automatic and happens because of already unplaced laws/bills.
Examples of automatic stabilizers
- Unemployment benefits
- welfare
- progressive income taxes (the tax you pay increases as your income increases)
Why are there lags when the government uses discretionary fiscal policy?
Discretionary fiscal policy requires new laws that require time to be developed, vote on, and then implemented.
An increase in expected inflation will…
Decrease the SRAS as workers ask for better wages.
When the MPC increases…
The spending multiplier increases
Contractionary fiscal policy would cause the natural rate of unemployment…
To stay the same
