Week 1 Flashcards
Claim: It is possible to describe the economy without including a policymaker’s behaviour.
TRUE
Nominal rigidities include:
- price rigidities
- wage rigidities
- in a more complex model, financial rigidities
- all of the above
- none of the above
all of the above
The Phillips Curve shows the relationship between:
- the interest rate and investment
- the price of electricity and economic output
- inflation expectations, inflation and potential output
- none of the above
none of the above
The Phillips curve represents the relationship between the rate of inflation and the unemployment rate
What does the WS curve represent?
1.The supply of labour at a given wage
2.How much wage needs to be paid to induce adequate effort
3.The number of people that are in the labour force
4.How big the supply of goods is in the economy at a certain price level
How much wage needs to be paid to induce adequate effort
Studying a 3 equation model helps us to:
- get a good grade in the second period of the program
- get a sense of how to interpret news through an analytical framework
- help us forecast movements in interest rate, which drives financial forecasts and prices
- All of the above
All of the above
Present value calculations:
- are the basis for stock valuation
- have nothing to do with expectations
- are normally used in financial context
- none of the above
- all of the above
all of the above
“In the IS curve, Savings are irrelevant”
FALSE
An example of a demand shock is:
- Brexit (UK leaving the European market)
- global warming dries agricultural land into no produce
- the invention of a material resilient enough for nuclear fusion makes energy super cheap
- none of the above
Brexit (UK leaving the European market)
Tobin’s q:
1. has nothing to do with finance
- is a useful rule to measure investment
- measures GDP as a function of
stock prices - none of the above
is a useful rule to measure investment
an example of a supply shock is:
1.the arab spring and its impact on oil prices
2.the new i-phone
3.Brexit (UK leaving the European market)
4.none of the above
the arab spring and its impact on oil prices
1.1 What is the IS curve? Why does it slope downwards? give example
The IS curve refers to planned investment and savings decisions representing the demand side.
It shows the combinations of the interest rate and output at which aggregate spending in the economy is equal to output.
This is a downward-sloping relationship because of the inverse relationship of interest rate with Aggregate Demand (output) throught investment (hence consumption via income).
E.g. if a firm increases spending on equipment, production increases which leads to higher employment. The higher employment leads to more wages, increasing consumption and thus increasing output in these sectors. Thus, employment and output have increased until the point that I and S equal each other again.
An increase in interest rates … the cost of financing and creates an incentive to save, therefore … spending.
increases
decreasing
Claim: Aggregate demand does not include second-hand products
True
What may lead the GDP to differ between the value added method, expenditure method and the income method?
GDP under all three methods should be equal, however they may differ due to
1.measurement error
2.black markets
3.tax evasion.
The great moderation is…
… the calmer macroeconomic conditions from the 1980s with fewer and shorter recessions and lower GDP volatility.
Claim: Consumption includes only durable (laptop, car) goods.
FALSE
Consumption includes both durable (laptop, car) and non-durable goods (theatre show, groceries)
Claim: Consumption is independent of interest rates
TRUE
What is Forward looking behaviour?
Forward looking behaviour means that consumption and investment spending decisions are influenced by expectations of the future.
Households adjust their current spending based on their expected income.
E.g. low income now, but higher income expected with a new job. He will borrow now and consume more, and pay back when they start the job. This is called consumption soothing.
Firms make decisions based on a business plan which includes forecasts about future demand.
E.g. it might build a factory in China if a rise in Chinese income is expected (hence, increasing consumption there).
A rise in the marginal propensity to consume, c1, or a fall in the tax rate, t, will …. the multiplier.
increase
What will happen to the IS curve in response to a crash in the stock market?
This should decrease fixed investment since it signals a fall in the value of companies relative to their replacement cost.
The IS curve is expected to shift to the left.
What will happen to the IS curve in response to a decrease in the rate of depreciation?
(Tobin’s marginal q) A decrease in the rate of depreciation will boost investment and thus shift the IS curve to the right.
What will happen to the IS curve in response to an increase in the rate of technological progress?
(According to Tobin’s marginal q) An increase in the rate of technological progress should boost the marginal product of capital thus investment and, in turn, shift the IS to the right.
What will happen to the IS curve in response to an increase in the cost of oil?
Assuming the economy is a net oil importer, then the higher cost of oil will depress expected future profits of firms, thus reducing Tobin’s Q and shifting the IS curve to the left.
What is the permanent income hypothesis (PIH):
The PIH states that individuals optimally choose how much to consume by allocating their resources (assets and income) across their lifetime.
Aggregate Demand is…
…the real expenditure on goods and services produced in the home economy.
yD = C + I + G + (X - M)
Monetary policy seeks to…
…stabilise aggregate demand by changing interest rates, which affect the investment decisions of firms and the purchase decisionts of households.
For example, a rise in the interest rate increases the cost of financing investment projects, and projects that would have gone ahead with lower interest rates are postponed or cancelled.
Claim: Investment is much more volatile than consumption and government spending. explain.
True:
Investment depends on expected post-tax profits and is very dependent on how optimistic firms are, so it tends to flourish in boom periods and collapse in recessions.
Also, investment can be more easily delayed than C and G.
In the IS equilibrium…
… the aggregate demand is equal to the economy output.
yD = y
What is the paradox of thrift?
The paradox of thrift is a situation where encouraging people to save more during a recession may actually worsen the economic downturn.
If everyone saves more and spends less, it can lead to a decrease in overall demand, causing a decline in income and worsening the recession.
This happens because the reduction in consumption can outweigh any positive effects of increased savings, especially if the saved money is not being invested to boost economic activity. In simpler terms, trying to save more during tough economic times might end up hurting the economy instead of helping it.
A higher multiplier k means…
(for Investment sensitivity)
…investment is more sensitive to interest rate.
An IS with larger multiplier k is…
…flatter
A rise in the marginal propensity to consume, c1, or a fall in the tax rate, t, will … the multiplier, making the IS…
increase
flatter
If the interest rate sensitivity a1 increases then the IS…
becomes flatter.
Which curve reflects supply side of labor and which demand?
The supply side of labour is reflected by the ws (wage setting) curve.
The demand side of labour is reflected by the ps (price setting) curve.
In the WS-PS equilibrium the real wage is …
… at the right level to secure sufficient labor (WS - Supply side). and profitable production (PS - Demand side)
What do we refer to as Nominal rigidities?
Nominal rigidities is the effect of nominal wages and prices not adjusting immediately to fluctuations in aggregate demand (to keep the economy at equilibrium unemployment).
What is the output gap?
The difference between the actual and expected output.
It reflects the difference between unemployment and the equilibrium rate of unemployment.
Claim: Demand shocks affect the IS curve and supply shocks affect the WS and PS curve.
True
What does monetary policy do?
Monetary policy seeks to stabilize aggregate demand by changing interest rates, which affect the investment decisions of firms and the purchase of durable goods like new cars and houses by households.
A rise in the interest rate increases the cost of financing investment projects, and projects that would have gone ahead with lower interest rates are postponed or cancelled.
If there is a decrease in government spending of ΔG, by how much does this decrease output?
Using the equilibrium output equation in (a), output will decrease by 1 / (1-c1*(a-t)) * ∆𝐺
2.6 Evaluate the following statement:
“When the economy is in equilibrium in the WS−PS model, there is only voluntary unemployment, because no agent has an incentive to change their behaviour”.
The statement is incorrect.
Even though neither wage nor price setters have a reason to change their behavior at equilibrium, it doesn’t mean that unemployment is voluntary.
In the WS − PS model, wages at equilibrium unemployment are higher than what workers would willingly accept, leading to involuntary unemployment.
Claim: Fluctuations in AD do not affect unemployment and inflation
False!
Fluctuations in AD affect unemployment and inflation
The demand side captures the spending decisons of…
Households (C)
Firms (I)
Government (G)
Why might the PHI fail?
- Credit constraints
- Impatience
- Uncertainty about future income.
What is Tobin’s q theory of investment?
Tobin’s q theory of investment compares the benefits of investment in an increase in the capital stock with the costs of doing so.
If benefits > costs, investment should take place.
Marginal Q:
q = marginal benefits of investment / marginal costs of investment
According to Tobins Q, a drop in the marginal productivity of capital fk will swift the IS to the …
Left
The supply side of labor is reflected by the … curve
Wage - Setting WS curve
The demand side of Labor is reflected by the … curve
Price - Setting Ps curve
Labour Market Equilibrium: WS = PS is where …
…the wage is consistent with securing sufficient labor (WS) and for production to be profitable (PS)
If unemployment benefits U increase which curve of the supply side is affected and how?
the WS wage setting swifts to the right.
The Phillips Curve (adaptive expectations) shows that …
Current inflation depends on inflation in the previous period and the output gap.
πt = πt-1 + α (yt - ye)
The Phillips curve shows that there is a … relationship output and inflation
Positive
The Phillips curve shows that there is a … relationship inflation and unemployment
negative
A positive AD Shock under no stabilizing policy (𝑟 𝑒 constant) will lead to …emplyment and …inflation
Increase Employment and continually rising Inflation.
A positive SS Shock under no stabilizing policy (𝑟 𝑒
constant) will lead to …emplyment and …inflation
Increase Employment and continually falling Inflation.
The IS Curve shows combinations of the …. under goods market equilibrium.
Real interest rate (r) and Output (y)
Consumption demand (C):
Expenditure by individuals on goods and services; on durables and non-durables
Investment demand (I):
Firm expenditure on capital goods, Household expenditure on new houses, Government expenditure on infrastructure.
Government purchases (G):
Government expenditure on salaries, goods and services.
Policy makers use monetary and fiscal policy to influence the demand side as they worry about …
…fluctuations in the aggregate demand as they affect unemployment and inflation.
Monetary policy changes … which affect investment decisions.
interest rates
Fiscal policy uses … to influence the demand side.
taxation
Multiplier effect is:
An effect which causes total output to be greater than the change in spending which caused it.
The Multiplier (k) determines …
the change in output due to a change in autonomous
demand. ( Δy = k*Δ(AD) , change in AD being I, or G )
he IS summarizes the way that aggregate output in the economy is affected by …
…changes in spending decisions
In the 3 eq model, larger multiplier
causes a cut in interest rates to have a … effect on output.
larger
When does the IS swift?
Two reasons:
-When autonomous consumption c0, autonomous investment a0, or government spending G change.
-When the multiplier changes.
What changes the level of AD?
The level of aggregate demand will be affected by:
-Income
-Expectations about the future
-The extent of credit constraints
-Interest rate
Under the Fisher equation:
real interest rate = ?
real interest rate = nominal interest rate - expected inflation
Investment depends … on expectations about future after-tax profits and … on real interest rate (cost of financing).
positively
negatively
Tobin’s q predicts that the following factors will shift the IS curve rightwards (by increasing Marginal Benefit of I or decrease Marginal Cost of I) :
-Increase in prices (P)
-Increase in the marginal productivity of capital (fK)
-Reduction in the depreciation rate (δ)
Claim: The size of the multiplier depends on the permanency of the income shock. Justify your answer.
True.
In temporary income shocks, the marginal propensity to consume (MCP) from temporary unanticipated changes in income is r / (1 + r) and thus the multiplier is very close to 1.
For permanent income shocks, the multiplier is larger than 1 as consumption is updated to reflect the new permanent income (mpc = 1).
The relationship between unemployment and inflation is shown by the …
Phillips
Curve.
The Phillips Curve represents equilibria in the … side of the economy.
supply
There is an … relationship between unemployment and (unexpected) inflation.
inverse
Why under the Philips Curve there is a negative relationship inflation and unemployment?
Because if prices increase unexpectedly, the real wage (W/P) goes down and labour is suddenly cheap: firms hire more labour and unemployment goes down.
Why is there a positive relationship output and inflation under the Philips Curve?
More output –>
less unemployment –>
higher wages–>
higher prices
In what sense is unemployment is costly for the economy?
Unemployment is costly to the economy, it is a waste of resources, and is associated with unhappiness and psychological distress.
Why the labour market does not clear?
When a market clears, the price is such that there is **neither excess supply, nor demand. **If there is excess demand, prices rise.
In real life, the market does not clear. This is because employers offer wages above the reservation level as the worker is only useful if it exerts effort.
The employer wants to incentivize the worker to work hard by creating a cost of losing his job. This is called efficiency wage setting. At the prevailing real wage, additional workers would be prepared to work.
When output is above equilibrium and unemployment is below equilibrium creates …
upward inflationary pressure.
In the 3eq model with the labor market included, Demand shocks affect the … curve and supply shocks affect the … curve.
IS
WS and PS
