week 7

Question 1

when understanding fluctuations:

it’s easiest to imagine the economy begins in _____

Answer 1

LR equilibrium:

(intersection of AD+LRAS);

• output = natural output
• expected price level = actual prices

Question 2

AD + SRAS curves intersect too if expected price level = ___________

Answer 2

expected price level = actual price level

Question 3

Draw the long run equilibrium

Answer 3

Question 4

Short run fluctuations occur due to:

Answer 4

1. Demand Driven
2. Supply Driven

Question 5

Possible causes of demand driven fluctuations?

Answer 5

Wave of pessimism,
stock-market bust,
drop in exports (recession abroad),
monetary contraction, etc.

Question 6

What happens after a demand driven contraction?

Answer 6

1. Output falls (hence employment falls)
2. Price level falls

Question 7

With time, how does a d-d contraction revert back? Diagram.

Answer 7

Question 8

With a contraction in AD… what happens to actual prices?

Answer 8

They drop below expected prices

Question 9

with a demand driven contraction, we would expect prices to ______. It is _______

Answer 9

fall . It is deflationary.

Question 10

What is a supply driven fluctuation?

Answer 10

Cost push

A shift in AS.

Question 11

Possible causes for SRAS shift/supply driven fluctuation?

Answer 11

Sudden inc. in production costs
Increase in price expectations

Question 12

What happens right after a SRAS driven contraction?

Answer 12

1. Output falls
2. Price level increases

= STAGFLATION

Question 13

Define stagflation

Answer 13

Stagflation is like having the worst of both worlds in the economy. It happens when there’s a mix of two bad things at the same time: stagnant growth and high inflation.

Stagnation: This means the economy isn’t growing much, or even shrinking. Businesses might not be expanding, people might not be getting jobs, and overall, things feel sluggish.
Inflation: This means prices are rising rapidly. So, while the economy might not be doing well, the cost of goods and services keeps going up. This can make it harder for people to afford things, even if they’re not making more money.
When you put stagnation and inflation together, you get stagflation. It’s a tricky situation for policymakers because the usual tools they use to fix one problem can sometimes make the other problem worse. So, it’s like trying to solve two puzzles at once, and it’s not easy.

Question 14

How does a SRAS fluctuation revert back to normal?

Answer 14

• Short-run AS shifts back to right
• Output reverts to its natural rate as price level falls

Question 15

What is an example of an AD driven recession?

Answer 15

The great depression. Real GDP fell by 27%, unemployment rose from 3 to 25%, prices fell by 22%. Money supply decreased by 28% (this lowered AD and most scholars think was the principal cause of the depression).

Question 16

Example of demand pull?

Answer 16

Early 1940s, boom caused by increased wartime expenditures (increases AD). Unemployment dropped from 17 to 1%, prices rose by 20%.

Question 17

Cost push example?

Answer 17

The Oil Crisis in the 70ies

Question 18

Cost pull example?

Answer 18

More difficult to identify, but an example would arguably be new technologies (computers) driving expansion in the 90s

Question 19

Why was the COVID pandemic a special contraction?

Answer 19

caused markets to shut down completely

Question 20

Why is 2022/23 complicated?

Answer 20

1. There was an element of negative AS shock - higher prices of oil and gas
2. BUT combined with aggregate demand already being shifted “TOO far to the right” due to pandemic policies

It caused inflation to shift AD to the left, Central Banks raised interest rates.

Question 21

If we consider a shift to left in the SRAS curve e.g oil price increase… it will lead to ____?

Answer 21

stagflation, though over time output will revert to its natural rate and prices “drop back down”

Question 22

To immediately counter the drop in output from SRAS shifting left (and employment), policy makers may elect to do what?

Answer 22

May elect to shift the AD curve to the right so that output returns quickly to its natural rate.

Question 23

What is the cost of shifting AD to the right to combat SRAS shift to left?

Answer 23

Higher inflation.

Question 24

Draw a diagram of accommodating an adverse shift in SRAS

Answer 24

Question 25

How do policy makers in practice shift the AD curve? [2]

Answer 25

1. Monetary Policy 2. Fiscal Policy

Question 26

What are monetary and fiscal policy?

Answer 26

Monetary policy is changing the supply rate + interest rates Fiscal policy are changes in government spending + taxation

Question 27

How do changes in money supply affect interest rates?

Answer 27

A change in the money supply shifts the AD curve (C,I, XM) - An increase in money supply leads to **lower interest rates** which is expansionary (shifts AD to the right for any given price level) - A decrease in money supply leads to higher interest rates which is contractive (shifts AD to the left for any given price level) — Note: We can also understand this via the LM curve from the IS-LM model (“theory of liquidity preference”)

Question 28

How does purchasing government bonds increase AD?

Answer 28

Central Banks: These are the main banks of a country. They're responsible for managing the country's money supply, interest rates, and sometimes, overall economic stability. Government Bonds: These are like IOUs issued by the government. When you buy a government bond, you're essentially lending money to the government. In return, the government promises to pay you back the amount you lent (the principal) plus interest over a specified period of time. So, when a central bank purchases government bonds, it's like the central bank lending money to the government by buying these IOUs. This is one of the ways central banks can influence the economy, such as by injecting money into the financial system to stimulate economic activity.

Question 29

Draw diagram of expansive monetary policy

Answer 29

Question 30

How does fiscal policy work?

Answer 30

This directly shifts the AD curve (to the right if fiscal policy is expansionary; to the left if fiscal policy is contractive)

Question 31

Wether a £1 increase on net government spending leads to AD rising by MORE or LESS than £1 depends on...?

Answer 31

The relative size of two **opposing effects**: 1. Multiplier effect 2. Crowding out effect

Question 32

What is the multiplier effect?

Answer 32

Multiplier effect amplifies the effect on AD of an increase in NET EXPENDITURE

Question 33

What is the crowding-out effect?

Answer 33

it diminishes the effect on AD of an increase in net expenditure why? because Increased government spending 1.**raises interest rates** 2. discouraging private sector spending 3. and offsetting the initial boost to aggregate demand.

Question 34

How does increased government spending raise interest rates?

Answer 34

When the government increases its spending, it often needs to finance this spending by borrowing money through the issuance of bonds. As the government issues more bonds to fund its spending, the supply of bonds in the financial markets increases. Now, when there is an increase in the supply of bonds, it creates upward pressure on interest rates. This is because investors, who are willing to lend money to the government by buying these bonds, demand higher interest rates as compensation for the increased supply of bonds and the associated risk. Therefore, while government spending itself doesn't directly raise interest rates, the increased demand for borrowing resulting from government borrowing can lead to higher interest rates in the financial markets.

Question 35

What do central banks do to directly change the interest rate?

Answer 35

most CBs adjust the Repo/refinancing/discount rate or conducts OMOs to directly change the interest rate.

Question 36

adjusting the money supply or changing the interest rate are “two sides of the same coin”... what does this mean?

Answer 36

To achieve an interest rate target, the central bank’s bond traders are told to supply enough money (buy/sell enough bonds in OMOs) to ensure the target is met. **So changing the money supply and changing the interest rate amounts to the same!**

Question 37

What is the multiplier effect with a diagram?

Answer 37

The multiplier effect of an increase in government purchases by £20 billion: - Aggregate-demand curve shifts right by £20 billion - Consumers respond by increasing spending (spending multiplier) and firms respond by increasing investments (investment accelerator) *Which leads to a further shift to the right in AD, and so on and on*

Question 38

What does the spending Multiplier's size depend on?

Answer 38

Depends on the marginal propensity to consume MPC

Question 39

What is MPC?

Answer 39

the **fraction of extra income** that consumers spend on consumption

Question 40

The larger the MPC...

Answer 40

The larger the multiplier!

Question 41

If expansionary policy leads to income increases for people who are likely to spend it all (MPC close to 1), the multiplier will be ______

Answer 41

Higher

Question 42

Due to the multiplier effect, 1£ of government purchases can...

Answer 42

Generate more than 1£ in aggregate demand

Question 43

Crowding out effect with shifts? + Diagram

Answer 43

When aggregate demand curve shifts right: 1. leads to an increase in income 2. which leads to an increase in money demand 3. which increases the interest rate thereby reducing investment spending …and the AD curve shifts back towards the left

Question 44

Why does higher demand for money increase interest rates?

Answer 44

Increased demand for money means people are willing to pay higher interest rates to get it, pushing up interest rates.

Question 45

Crowding-out also happens in the long run as we saw in the loanable funds market – but only if _____________

Answer 45

The government continuously runs a deficit

Question 46

Draw the crowding out effect

Answer 46

Question 47

What is **active stabilisation policy**?

Answer 47

when authorities use fiscal and monetary policy to stabilise the economy in the face of shocks to the economy — the objective is to ensure full-employment and stable inflation

Question 48

Actual effect on AD curve (how much it shifts) depends on

Answer 48

size of the multiplier effect **relative** to the crowding-out effect

Question 49

What are the arguments **for** active stabilisation?

Answer 49

Keynesians: stress the key role of AD in explaining short-run economic fluctuations and so the government **should actively stimulate aggregate demand** To maintain production at its full-employment level! *Obviously, this is because unemployment is a **bad **thing which we should avoid if we can!*

Question 50

Points **against** active stabilisation?

Answer 50

1. AD difficult to control so policy affects the economy w ‘long and variable’ lags 2. Policy would be based on **unreliable economic forecasts**which leads to *mistakes* (e.g. expansionary policy may cause overheating, bubbles or run-away inflation) 3. corruption and waste hence better to LEAVE ECONOMY ALONE + let market mechanisms deal w short-run fluctuations instead - policy instruments should be used to achieve long run goals

Question 51

waht happened in 2008-09?

Answer 51

financial crisis. severe downturn in economic activity worst macroeconomic event in more than half a centrury

Question 52

What were the large contractionary shifts in AD during FC?

Answer 52

- Real GDP fell sharply — By 4% in 2007-9 - Employment fell sharply — Unemployment rate rose from 4.4% to 10.1% 2007-9 (in May 2007 to 10.1% in October 2009)

Question 53

What were the 3 policy actions that were aimed in part at returning AD to its previous level during FC?

Answer 53

1. The Central Banks in US, UK and Europe **cut their targets for the repo rate** *(essentially to about 0 in late 2008)* 2. Started **buying government bonds**, mortgage-backed securities and other private loans - In open-market operations - Provided banks with additional funds 3. October 2008, In the US, **Congress appropriated $700 billion** - For the Treasury to use to rescue the financial system - To stem the financial crisis on Wall Street ~ make loans easier to obtain - Equity injections into banks - U.S. and U.K. governments – temporarily (?) became a part owner of some banks

Question 54

January 2009, Barack Obama did what?

Answer 54

Increased government spending $787 billion stimulus bill, February 17, 2009

Question 55

Even without active stabilisation policy, what will always stabilise fluctuations?

Answer 55

automatic stabilisers will to a greater or lesser extent always stabilise fluctuations

Question 56

Automatic stabilisers are?

Answer 56

Automatic changes in spending that stimulate aggregate demand when the economy goes into a recession Eg progressive income tax *As income decreases during an economic downturn, individuals move into lower tax brackets, reducing their tax liabilities.*

Question 57

automatic stabilisers operate principally through _____ and ______

Answer 57

auto stabilisers operate principally through TAXES and TRANSFERS

Question 58

How do automatic stabilisers operate through taxes + transfers?

Answer 58

– Fewer taxes collected in a recession (AD↑) – More unemployment benefits paid out in a recession (AD↑) – The opposite happens when there is a boom (automatic stabilisers become contractive)

Question 59

But the issue with automatic stabilisers?

Answer 59

1. Are not sufficiently strong to prevent business cycles completely 2. how strong they are depends on public sector’s size relative to GDP (so strong in, say, Scandinavia, weak in the US with the UK somewhere in-between)

Question 60

but without automatic stabilisers what would be the effect on output + employment?

Answer 60

Output and employment would be more volatile than is the case

Question 61

in the long run Inflation depends only on ______

Answer 61

growth in the money supply

Question 62

in the long run unemployment will tend to its natural rate which depends on ----?

Answer 62

minimum wages, unions, efficiency wages, search, etc.

Question 63

in the short run in the AD/AS model, the classical dichotomy breaks down: Inflation and output/unemployment are related how?

Answer 63

expansionary policy increases output and inflation

Question 64

What does the phillips curve show?

Answer 64

short-run trade-off between inflation and unemployment *a clear negative correlation between unemployment and the rate of (price and/or wage) inflation*

Question 65

Draw the phillips curve

Answer 65

Question 66

What does this show?

Answer 66

Question 67

What does the long run Phillips curve look like?

Answer 67

Vertical. Like the LRAS

Question 68

Draw the LR Phillips curve

Answer 68

Question 69

How does AD/AS curve and phillips curve relate?

Answer 69

AS curve slopes upward due to **actual prices differing from expected prices** Thus, Phillips curve slopes downwards *only* when **actual inflation is different from expected inflation** SO, when actual = expected inflation, phillips curve (like AS) will be vertical

Question 70

it’s important to realise that the REASON why economic policy in the AD/AS model has any effect on output is that ___________

Answer 70

it generates “surprise”/unexpected inflation or disinflation

Question 71

A monetary expansion can create surprise price increases (inflation) in the short-run and therefore raise output and employment What happens in long-run?

Answer 71

In the long-run, people expect this higher level of inflation to persist, and so expectations will catch up with actual inflation… And that’s NOT good (a move up the long-run Philips curve).

Question 72

Draw a diagram of Expect Inflation + Phillips Curve

Answer 72

Question 73

Shifts in the short-run Phillips curve are primarily influenced by...?

Answer 73

changes in expectations, supply shocks, and monetary and fiscal policy

Question 74

Phillips curve can be summarised in an equation:

Answer 74

Unemployment rate = Natural rate of unemployment – a(Actual inflation – Expected inflation) (actual > expected → lower unemployment)

Question 75

In light of the Phillips curve equation, it is _____ to view the PC as offering a menu of choices between inflation and unemployment

Answer 75

Wrong