Week 1 - Basic concepts

Question 1

Goods market equilibrium

Money market equilibrium

Answer 1

Aggregate supply (AS) = aggregate demand (AD)

Money supply = money demand

Question 2

Keynesian multiplier effect

Answer 2

Overall income increases MORE THAN the initial increase in govt spending G
- b/c the initial boost to income induces SECOND ROUND EFFECTS on consumer spending

Question 3

Crowding out

Answer 3

Overall change in income is SMALLER THAN the full effect of the Keynesian multiplier.
- increase in income induces excess demand for money, hence INTEREST RATE INCREASES in money market to reduce excess money demand
- but this DECREASES INVESTMENT SPENDING by firms, which partially offsets the increase in AD due to the fiscal expansion

The stronger the effect of crowding out, then the LESS EFFECTIVE FISCAL POLICY is for expanding AD & STABILISING the economy against AD shocks.

Question 4

Why does the AS curve become vertical in the long run?

Answer 4

Aggregate supply is FIXED and only depends on productive potential of economy, NOT PRICE levels in long run.
ie. labour supply, capital stock, productivity

Question 5

Phillips curve

Answer 5

Inverse relationship between inflation and unemployment

1. in SHORT RUN, Policymakers face an inevitable TRADE-OFF between inflation & unemployment
2. in LONG RUN, unemployment is FIXED at the natural rate of unemployment -> PC becomes vertical