Unit 3: National Income and Price Determination Flashcards
WHAT IS THE DIFFERENCE BETWEEN A MARKET DEMAND CURVE AND THE AGGREGATE DEMAND CURVE?
Market demand curves address the short run, and they are shifted by a different set of things than when looking at long run big picture aggregate demand.
Aggregate Demand (AD) looks at EVERYTHING in the economy and graphs it against real GDP. It is shifted based on the things included in GDP (C, I, G, X-M)
Aggregate Demand is ALL the goods and services (real GDP) that buyers and willing and able to purchase at different price levels.
WHAT THREE CONCEPTS EXPLAIN WHY THE AGGREGATE DEMAND CURVE IS DOWNWARD SLOPING?
The AD curve is downward sloping for the following reasons:
1) THE WEALTH EFFECT, which states that when price levels go up and inflation occurs, the value of people’s assets and purchasing power will decrease causing them to spend less, which then decreases demand.
2) THE INTEREST RATE EFFECT, which states that hen price levels go up and inflation occurs, it causes interest rates to go up, which then decreases investments ad consumer spending and decreases demand.
3) FOREIGN TRADE EFFECT, which states that other countries buy less and it reduces exports, decreasing demand.
WHY DO INTEREST RATES GO UP WHEN THE PRICE LEVEL GOES UP AND INFLATION OCCURS?
When inflation occurs as price levels rise, people’s purchasing power decreases and they require more money to buy things. This leads them to borrow more or liquidate more of their assets, which then leaves less money overall for lenders to loan out and so interest rates rise.
EXPLAIN THE AGGREGATE DEMAND AND SUPPLY GRAPH
Along the x axis goes the price level, and the y axis represents the “output” (or the real GDP)
Aggregate Demand (AD) is downward sloping, while Aggregate Supply (AS) is upward sloping.
Equilibrium Price Level and Quantity are graphed, being the point at which AD and AS intersect. Through the equilibrium point is the LRAS, the vertical line representing the economy at full employment (ideal output), the Long Run Aggregate Supply.
EXPLAIN THE CONCEPT OF LONG RUN AGGREGATE SUPPLY (LRAS)
The LRAS indicates that in the long run, an increase in prices WILL NOT lead to a permanent increase in output.
In the long run, prices of resources will increase when there is inflation (shifting AS to the left).
In the long run, prices of resources will fall when there is a recession (shifting AS to the right).
But supply will always trend back towards the ideal LRAS.
WHAT IS THE DIFFERENCE BETWEEN AN INFLATIONARY AND RECESSIONARY GAP?
In an INFLATIONARY GAP, the output is beyond full employment, and actual GDP is greater than potential GDP. This is shown on the AD/AS graph as the LRAS to the left of current equilibrium.
In a RECESSIONARY GAP, the output is below full employment, and actual GDP is less than potential GDP. This is shown on the AD/AS graph as the LRAS to the right of current equilibrium.
WHAT ARE THE FISCAL POLICIES AVAILABLE TO GOVERNMENTS TO LIMIT INFLATION (ADDRESSING AN INFLATIONARY GAP)?
They can DECREASE government spending, or they can INCREASE taxes on consumers. These will DECREASE AD.
WHAT ARE THE FISCAL POLICIES AVAILABLE TO GOVERNMENTS TO ADDRESS A RECESSIONARY GAP?
They can INCREASE government spending, or they can DECREASE taxes on consumers. They will INCREASE AD.
WHAT ARE THE MONETARY POLICIES AVAILABLE TO GOVERNMENTS TO LIMIT INFLATION AND ADDRESS AN INFLATIONARY GAP?
They could DECREASE the money supply.
Doing so would increase interest rates, which would then decrease INVESTMENT. This would DECREASE AD
WHAT ARE THE MONETARY POLICIES AVAILABLE TO GOVERNMENTS TO ADDRESS A RECESSIONARY GAP?
They could INCREASE the money supply.
Doing so would decrease interest rates, which would increase investment. This would INCREASE AD.
WHAT IS THE DIFFERENCE BETWEEN FISCAL POLICY AND MONETARY POLICY?
FISCAL POLICY refers to changes in government spending or taxation designed to impact demand through increasing or decreasing government and consumer spending (G and C)
MONETARY POLICY refers to increases or decreases in the money supply designed to impact demand through increasing or decreasing interest rates and investment. (I)
EXPLAIN THE CONCEPT OF THE SPENDING MULTIPLIER
The spending multiplier is the concept by which initial government spending is then saved in portions, but spent by consumers and businesses, and on and on.
An initial change in government spending leads to additional spending and an increase in TOTAL SPENDING. The size of that multiplier can then be calculated, and depends upon how much people spend or save when they receive that new income.
WHAT IS THE DIFFERENCE BETWEEN THE MARGINAL PROPENSITY TO CONSUME (MPC) AND THE MARGINAL PROPENSITY TO SAVE (MPS)?
The MPC and the MPS together always equal 1, and they tell us what percentage of money is being spent vs. saved by consumers.
These are used to calculate the spending multiplier, and are expressed as numbers (for example, if MPC is 0.75, then MPS will be 0.25).
WHAT IS THE DIFFERENCE BETWEEN THE MARGINAL PROPENSITY TO CONSUME (MPC) AND THE MARGINAL PROPENSITY TO SAVE (MPS)?
The MPC and the MPS together always equal 1, and they tell us what percentage of money is being spent vs. saved by consumers.
These are used to calculate the spending multiplier, and are expressed as numbers (for example, if MPC is 0.75, then MPS will be 0.25).
If the MPC is high, the amount of government spending needed to close a recessionary gap is less.
EXPLAIN THE CONCEPT OF THE TAX MULTIPLIER
The TAX MULTIPLIER is used to show what happens when the government cuts taxes.
It is WEAKER than the spending multiplier.
The formula to calculate it is MPC / MPS, but it is also always 1 less than the spending multiplier. This is because there is one less ripple effect, since consumers save a portion of their tax cut.
