UNIT 6 VOCABULARY: INFLATION, UNEMPLOYMENT, AND STABILIZATION

Question 1

Cyclically Adjusted Budget Balance:

Answer 1

• Definition: The government’s budget balance is adjusted to remove the effects of the economy’s ups and downs. It shows what the budget surplus or deficit would be if the economy were performing at its full potential.
• Example: If the economy is in a recession, the government might run a larger deficit due to lower tax revenues and increased spending. The cyclically adjusted budget balance adjusts for these factors to show a more accurate picture of the government’s fiscal position.

Question 2

Fiscal Year:

Answer 2

• Definition: A 12-month period used by the government or businesses for budgeting and financial reporting. It doesn’t always align with the calendar year and is used to keep track of financial performance.
• Example: The U.S. government’s fiscal year runs from October 1 to September 30 of the following year, so Fiscal Year 2024 would start on October 1, 2023, and end on September 30, 2024.

Question 3

Public Debt:

Answer 3

• Definition: The total amount of money that the government owes to creditors. This debt accumulates from borrowing money to cover budget deficits and finance government spending.
• Example: When the government issues bonds to raise money for various projects, the total amount of these bonds represents the public debt.

Question 4

Debt-GDP Ratio:

Answer 4

• Definition: A measure that compares a country’s total public debt to its Gross Domestic Product (GDP). It shows how manageable the debt is relative to the size of the country’s economy.
• Example: If a country has a public debt of $500 billion and a GDP of $1 trillion, its debt-GDP ratio is 50% ($500 billion divided by $1 trillion). A higher ratio indicates more debt relative to the economy.

Question 5

Implicit Liabilities:

Answer 5

• Definition: Future financial obligations that the government is expected to pay, such as pensions and social security benefits. These are promises made to citizens that aren’t fully accounted for in current budgets.
• Example: Social Security benefits promised to retirees are an example of implicit liabilities because the government has committed to paying these benefits in the future, even though they are not explicitly listed in the current budget.

Question 6

Target Federal Funds Rate:

Answer 6

• Definition: The interest rate that the central bank (e.g., the Federal Reserve) aims for in the federal funds market, where banks lend reserves to each other overnight. It is a key tool for influencing overall economic activity and controlling inflation.

For example: If the Federal Reserve sets a target federal funds rate of 2%, it means it wants the interest rate that banks charge each other for overnight loans to be around 2%.

Question 7

Expansionary Monetary Policy:

Answer 7

• Definition: A type of monetary policy used to stimulate economic growth by increasing the money supply and lowering interest rates. It is typically used during periods of economic slowdown or recession.

Example: When the central bank lowers the target federal funds rate and buys government bonds to inject more money into the economy, it is implementing expansionary monetary policy to boost spending and investment.

Question 8

Contractionary Monetary Policy:

Answer 8

-Definition: A type of monetary policy aimed at reducing the money supply and increasing interest rates to control inflation and slow down an overheating economy.

Example: If the central bank raises the target federal funds rate and sells government bonds to take money out of circulation, it is using contractionary monetary policy to cool off excessive economic growth and reduce inflation.

Question 9

Taylor Rule:

Answer 9

• Definition: A formula used by central banks to set interest rates based on economic conditions. It adjusts the target interest rate based on deviations from the inflation target and the output gap (the difference between actual and potential economic output).

Example: According to the Taylor Rule, if inflation is higher than the target or if the economy is operating above its potential, the central bank should increase the interest rate to stabilize the economy.

Question 10

Inflation Targeting:

Answer 10

• Definition: A monetary policy strategy where the central bank sets a specific inflation rate as its primary goal and adjusts its policies to achieve and maintain that rate.

Example: If the central bank sets an inflation target of 2%, it will use tools like adjusting interest rates and managing the money supply to keep inflation close to 2% and stabilize the economy.

Question 11

Monetary Neutrality:

Answer 11

• Definition: The idea that changes in the money supply only affect nominal variables (like prices and wages) and have no long-term impact on real variables (like output and employment). In the long run, an increase or decrease in the money supply will result in proportional changes in the price level, but not in the real economy.

Example: If the central bank increases the money supply, prices may rise, but the overall level of goods and services produced in the economy remains unchanged in the long run.

Question 12

Classical Model of the Price Level:

Answer 12

• Definition: An economic theory that suggests the price level is determined by the supply and demand for money. According to this model, in the long run, changes in the money supply directly affect the price level but not real output or employment.

Example: In the classical model, if the money supply doubles, prices are expected to double, assuming the demand for money and the amount of goods and services remain constant.

Question 13

Inflation Tax:

Answer 13

• Definition: The economic cost of inflation on individuals holding cash or money balances. As prices rise due to inflation, the real value of money held by individuals decreases, effectively acting like a tax on their wealth.

Example: If inflation is 5%, and you hold $1,000 in cash, the real purchasing power of that $1,000 decreases by 5% over the year.

Question 14

Cost-Push Inflation:

Answer 14

• Definition: Inflation that occurs when the costs of production for businesses increase, leading to higher prices for goods and services. This can be caused by rising wages, higher raw material costs, or supply chain disruptions.

Example: If the price of oil rises, it increases production costs for many goods and services, which can lead to higher prices for consumers.

Question 15

Demand-Pull Inflation:

Answer 15

• Definition: Inflation that results from an increase in aggregate demand (total demand for goods and services) that outstrips the economy’s capacity to produce goods and services. This excess demand leads to higher prices.

Example: During an economic boom, if consumer and business spending increase significantly, the higher demand can drive up prices, resulting in demand-pull inflation.

Question 16

Short-Run Phillips Curve:

Answer 16

• Definition: A graphical representation showing the inverse relationship between inflation and unemployment in the short run. According to this curve, as unemployment decreases, inflation tends to increase, and vice versa. This is because lower unemployment can lead to higher wages, which may drive up prices.

Example: If the economy is experiencing low unemployment, firms might raise wages to attract workers, leading to higher prices and thus higher inflation.

Question 17

Nonaccelerating Inflation Rate of Unemployment (NAIRU):

Answer 17

• Definition: The level of unemployment at which inflation remains stable. It is the unemployment rate where inflation is neither accelerating nor decelerating. If unemployment falls below this rate, inflation tends to rise; if it is above this rate, inflation tends to fall.

Example: If NAIRU is estimated to be 5%, then at 5% unemployment, inflation is stable. If unemployment drops below 5%, inflation might increase due to higher wage pressures.

Question 18

Long-Run Phillips Curve:

Answer 18

• Definition: A graphical representation that shows there is no long-term trade-off between inflation and unemployment. In the long run, the Phillips Curve is vertical, indicating that inflation and unemployment are not directly related and that the economy returns to its natural rate of unemployment regardless of the inflation rate.

Example: In the long run, the economy may experience high inflation, but unemployment will return to its natural rate (e.g., NAIRU) due to adjustments in wages and prices.

Question 19

Debt Deflation:

Answer 19

• Definition: A situation where a decrease in the general price level (deflation) increases the real value of debt, making it more difficult for borrowers to repay their loans. This can lead to reduced spending and economic contraction.

Example: If a borrower has a fixed-rate loan and deflation causes prices to fall, the real burden of the loan increases because the borrower must repay the loan with money that is now worth more.

Question 20

Zero Bound:

Answer 20

• Definition: The situation where nominal interest rates are at or near zero, making it difficult for central banks to lower them further to stimulate economic activity. At this point, traditional monetary policy becomes less effective.

Example: During a severe recession, if the central bank lowers interest rates to 0% and cannot reduce them further, it hits the zero bound, limiting the ability to use interest rates to boost the economy.

Question 21

Liquidity Trap:

Answer 21

• Definition: A situation where monetary policy becomes ineffective because people hoard cash and are unwilling to invest or spend, even when interest rates are very low. This can happen during periods of extreme economic uncertainty.

Example: During a financial crisis, even if the central bank lowers interest rates to near zero, people might still prefer to hold cash rather than spend or invest it, leaving monetary policy less effective.

Question 22

Monetarism:

Answer 22

• Definition: An economic theory that emphasizes the role of governments in controlling the amount of money in circulation. Monetarists believe that variations in the money supply have major influences on national output and inflation. They argue for a steady, predictable increase in the money supply to ensure stable economic growth.

Example: Monetarists might advocate for a rule where the money supply grows at a constant rate, irrespective of short-term economic fluctuations.

Question 23

Discretionary Monetary Policy:

Answer 23

• Definition: The approach where central banks actively adjust interest rates and other monetary policy tools in response to economic conditions and changes. This policy allows for flexible and responsive actions based on current economic data.

Example: During a recession, a central bank might lower interest rates and engage in open-market operations to stimulate the economy.

Question 24

Monetary Policy Rule:

Answer 24

• Definition: A systematic approach where central banks follow a predefined rule or formula to guide monetary policy decisions. This rule often aims to provide consistency and reduce uncertainty in policy-making.

Example: The Taylor Rule, which adjusts interest rates based on deviations from inflation targets and output levels, is a type of monetary policy rule.

Question 25

Quantity Theory of Money:

Answer 25

• Definition: A theory that states the amount of money in an economy is directly proportional to the price level of goods and services. According to this theory, if the money supply increases, prices will rise, assuming velocity and output are constant.

Example: If the money supply doubles, and output and velocity remain the same, the price level is expected to double.

Question 26

Velocity of Money:

Answer 26

• Definition: The rate at which money circulates through the economy, measured by how often a unit of currency is used for transactions over a period. It helps to understand the relationship between the money supply and the price level.

Example: If the velocity of money is high, it means that each dollar is spent frequently, potentially contributing to higher inflation if the money supply increases.

Question 27

Natural Rate Hypothesis:

Answer 27

• Definition: The idea that there is a specific level of unemployment, known as the natural rate of unemployment, that is consistent with stable inflation. It suggests that in the long run, the economy will return to this natural rate regardless of monetary policy.

Example: Even if the central bank attempts to reduce unemployment below the natural rate, inflation might rise without reducing the long-term unemployment rate.

Question 28

New Classical Macroeconomics:

Answer 28

• Definition: A school of thought that emphasizes the importance of rational expectations and market-clearing in understanding economic fluctuations. It argues that economic agents use all available information to make decisions, which leads to efficient markets and responses to policy changes.

Example: According to New Classical theory, if the government announces a policy change, rational agents will anticipate its effects and adjust their behavior accordingly, potentially neutralizing the policy’s impact.

Question 29

Rational Expectations:

Answer 29

• Definition: The theory that individuals form their expectations about the future based on all available information and past experiences. These expectations are typically accurate and adjust quickly to new information.

Example: If people expect inflation to rise based on new data, they will adjust their spending and wage demands accordingly, making it harder for the central bank to surprise them with monetary policy changes.

Question 30

New Keynesian Economics:

Answer 30

• Definition: A school of thought that builds on Keynesian economics by incorporating elements like sticky prices and wages, and imperfect competition. It emphasizes that short-term fluctuations and rigidities can cause market inefficiencies and justify government intervention.

Example: New Keynesians argue that prices and wages do not adjust instantly to changes in economic conditions, leading to temporary periods of unemployment and inflation that monetary policy can help address.

Question 31

Real Business Cycle Theory:

Answer 31

• Definition: A theory that attributes economic fluctuations primarily to real (as opposed to monetary) shocks, such as changes in technology or resource availability. It emphasizes that business cycles are a natural response to these shocks and that policy intervention is often unnecessary.

Example: According to the Real Business Cycle theory, a technological innovation that boosts productivity can lead to economic growth, while a negative shock, like a natural disaster, can lead to a downturn in economic activity.