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Test Taking Tips for Essay 1. Read question carefully and answer all questions directly, following the Roman numerals and letters. 2. Draw a relevant graph for every answer if possible noting guidelines below: A. Use the clearest graph for illustrating the point
B. Label the graph carefully, including the x/y axis and all points of intersection C. D. Show movement with arrows and letters Relate the graph clearly to the text, noting how movement occurs
3. Use economic terms to describe situations (e.g. contradictionary fiscal policy, real wages, allocative efficiency) 4. Analyze the information carefully to determine what sort of situation they are describing. Be careful not to go beyond the scope of the question or over-answer. However, clearly demonstrate the logic of your response 5. Analyze the information you are given to figure out what sort of situation they are describing. The following is a guideline for AP Macroeconomics questions: Inflation (CPI Growth) Unemployment GDP Growth
Low 0-2% Acceptable Target 3-4% High 5-7%
0-2% 3-4% 5-10%
2-3% 4-6% 7-10%
Recessionary Economy 1% and lower
7% and above
Inflationary Economy varies Stagflation above
7% and above 7% and above
4% and below 7% and
1% and lower
AP Summary Outline of Macroeconomics I. Basic Economic Concepts 5-10% (3-6 Questions) A. B. C. Scarcity: The Nature of Economic Systems Opportunity Costs and Production Possibilities Specialization and Comparative Advantage
D. The Functions of an Economic System (What, how, when and for whom to produce) E. Demand, Supply and Price Determination
II. Measurement of Economic Performance 8-12% (5-7 Questions) A. B. C. Gross National Product, Gross Domestic Product, and National Income Inflation and Price Indices Unemployment
III. National Income and Price Determination 70-75% (42-45 Questions) A. 1. 2. 3. B. 1. 2. 3. Aggregate Supply Classical Analysis Keynesian Analysis Rational Expectations Aggregate Demand Circular Flow Components of Aggregate Demand Multiplier
4. 5. C. 1. 2. D. 1. 2. 3. E. 1. 2. 3.
Fiscal Policy Monetary Policy Money and Banking Definition of Money and its Creation Tools of Central Bank Policy Fiscal-Monetary Mix Interaction of Fiscal and Monetary Policies Monetarist-Keynesian Controversy Deficits Trade Offs between Inflation and Unemployment Long Run vs. Short Run Supply Shocks Role of Expectations 8-12%
IV. International Economics and Growth (5-7 Questions) A. B. Balance of Payments, International Finance, and Exchange Rates Economic Growth
Basic Economic Systems Chapter 2 The Economic Problem 1. Full Employment is the use of all available resources 2. Full Production is the employment of resources so that they provide the maximum possible satisfaction of our material wants. Includes two types of efficiency: a) Productive Efficiency (P=AC) is the production of any particular mix of goods/services in the least costly way b) Allocative Efficiency (P(=MB)=MC) is the production of that particular mix of goods/services most wanted by society. 3. A Production Possibilities Curve/Frontier represents some maximum combination of two products, which can be produced if full employment and
and/or technological advance.2 pg 12 4. 5. There are three explanations for the law of demand: a) The Law of Diminishing Marginal Utility states that each buyer of a product will derive less satisfaction (utility) from each successive units of a good consumed and thus will only buy additional units if the price is reduced. The Law of Demand states that. as the price falls. The Opportunity Cost of a specific good is the amount of other products that must be forgone or sacrificed. Chapter 3: Understanding Individual Markets: Demand and Supply 1. Key Graph Figure 1. 2. land. c) The Substitution Effect indicates that at a lower price. 3.5 pg 15 6. Determinants of Demand are non-price factors that will increase demand (shift right) or decrease demand (shift left) at all prices. b) The Income Effect indicates that a lower price increases the purchasing power of a buyer’s money income. Demand is a curve or schedule showing the various amounts of a product consumers are willing and able to purchase at a series of possible prices during a specific period. rent and profit. the quantity demanded rises and as price rises. 1. enabling the buyer to purchase more of the product. The law of increasing opportunity costs states that the more of a product produced.2 pg 40) portrays an exchange between businesses and households in two markets: a) Resource or Factor Market: Households supply factors of production or resources (labor.full production are achieved. buyers have the incentive to substitute the now cheaper good for similar goods. entrepreneurship) in exchange for resource payments (wages. or WIRP) b) Product Market: Businesses supply finished goods/ services in exchange for money from households. improvements in resource quality. the quantity demanded falls. A Circular Flow Model (Key Graph Figure 2. capital. the greater its opportunity cost. Fig. Economic Growth is the ability of an economy to produce a larger total output as a result of increases in the supply of resources. Note that a Change in Demand is a shift of the entire demand curve due to one of the following demand determinants whereas a Change in Quantity Demanded is a . interest. which are now relatively more expensive.
Determinants of Supply are non-price factors that will increase supply (shift right) or decrease supply (shift left) at all prices. The following are key determinants of demand: a) Change in the Price of a Complement. 4. the corresponding quantity supplied rises and as price falls. if the good is an inferior good. 6. The Law of Supply states that as price rises. To a supplier. increase profits. and increase supply at each product price . 5.an increase in population will result in more customers and increase demand.movement along the curve due to price change. the quantity supplied falls. increase profits. capital.As income increases. Note that a change in supply is a shift in the entire supply curve due to one of the following demand determinants whereas a change in quantity supplied is a movement along the curve do to a price change.consumer expectations of higher prices or higher income will increase the demand for the good in the present.A decrease in the price of a complement (jelly) will result in an increase in demand for the good in question (peanut butter).An item that is popular or desired will increase in demand f) Change in Consumer Expectations. c) Change in Income. land) decrease production costs. d) Change in Number of Buyers. consumers will decrease their demand as their income increases. The following are key determinants of supply: a) Resource Prices. e) Change in Consumer Tastes.improvements in technology decrease production costs. b) Technology. and increase supply at each product price.lower resource prices (labor. However. higher prices represent higher revenue and thus an increased incentive to produce and sell. Supply is a schedule or curve showing the amounts of a product a producer is willing and able to produce and make available for sale at a series of possible prices during a specific period. b) Change in the Price of a Substitute. a consumer’s ability to afford a normal product peanut butter increases and the demand for the product increases.An increase in the price of a substitute (bagel) will result in an increase in demand for the good in question (donut).
Change in Supply Change in Demand Effect on Eq. At any price above equilibrium. decrease profits and decrease supply ate each product price. Decrease Increase Increase Indeterminate 3. 7. Changes in supply and changes in demand will result in a new equilibrium price and output. a surplus will occur as the quantity supplied is greater than the quantity demanded and at any price below equilibrium.c) Taxes and Subsidies -Whereas taxes will raise production costs. Figure 3. See table below and Figure 3. subsidies will have the opposite effect. a shortage will occur as the quantity demanded is greater than the quantity supplied.6 Page 55 8. The Market Clearing or Equilibrium Price occurs where the quantity demanded is equal to the quantity supplied. Price Effect on Eq. Increase Increase Indeterminate Increase 4. d) Number of Sellers. Quantity 1. Decrease .an increase in the number of suppliers will increase market supply.7 Page 58. Increase Decrease Decrease Indeterminate 2.
The price level in all other years is expressed as a percentage of the price level in the base year. bonds). GDP can be calculated in two ways: the amount spent to purchase this year’s output (expenditures approach) or the money income derived from producing this year’s total output (incomes approach). 2. and the price level in that year is given an index number of 100. a) Expenditures Approach: Consumption (C)+Investment (I)+Government (G)+Net Exports (Xn) b) Incomes Approach: Wages (W)+Interest (I)+Rent (R)+Profit (P) 3.g. and the Price Level 1. Price Indices are used to measure price changes in the economy. A price index has a base year.g. unemployment insurance). Gross Domestic Product (GDP) is the total market value of all final goods/services produced within a country in one year. As a formula: Nominal GDP Real GDP= Price Index (In Hundredths) . financial transactions (e. GDP does NOT count in intermediate goods/services. Nominal GDP is expressed in current dollars and is unadjusted for price changes whereas real GDP is deflated or inflated for price-level changes. transfer payments (e. they are used to compare the prices of a given “market basket” of goods/services in one year with the prices of the same “market basket” in another year. Current Year Prices x 100 Price Index Number= Base Year Prices 4. National Income. stocks. secondhand goods. profits/income earned by US companies/individuals overseas.Decrease Indeterminate Decrease Measurement of Economic Performance Chapter 7: Measuring Domestic Output. social security.
g. for every 1-percentage point at which the actual unemployment rate exceeds the natural rate. There are four types of unemployment a) Frictional Unemployment includes people who are temporarily between jobs. 3. For example. a GDP gap of about 2% occurs. The GDP Gap is the amount by which actual GDP falls short of potential GDP. it may be caused by too little spending in an economy. The unemployment rate is the percentage of the labor force (including both those employed and those who are unemployed but actively seeking work.) Unemployment Rate= Unemployed x100 Labor Force 2. c) Structural Unemployment involves mismatches between job seekers and job openings.Chapter 8: Macroeconomic Instability: Unemployment and Inflation 1. d) Seasonal Unemployment affects workers who have worked during the past year but are unemployed during other parts of the year due to seasonal conditions (e. weather related jobs). Potential GDP is the real output produced when the economy is fully employed. According to Okun’s Law. Figure 9. The Full-Employment unemployment rate is equal to the total frictional and structural unemployment and occurs when cyclical unemployment is zero. They may have quit one job to find another or they could be trying to find the best opportunity after graduating from High School or College. Unemployment occurs when people who are willing and able to work cannot find jobs.3 Page 174 5. . b) Cyclical Unemployment rises in a recession. Unemployed people who lack skills or have a poor education are structurally unemployed. Inflation is a general rising in the level of prices whereas deflation is a falling general level of prices. It is currently estimated to be around 4-6% 4.
While inflation reduces the purchasing power of the dollar (i. and profit received in current dollars whereas real income measures the amount of goods/services nominal income can buy. As an equation: %Change in Real Income= %Change in Nominal Income . The amount of goods and services produced and therefore the level of employment depend directly on the level of total/aggregate expenditures.%Change in Price Level 8. Aggregate expenditures include C+I+G+Xn. If people consumed all of their disposable income. in symbols S=DI-C. 7.6. and lenders. Nominal Income includes wages. galloping. The Nominal Interest Rate includes the Real Rate of Interest (the % increase in purchasing power which the borrower pays the lender for the privilege of borrowing) and the expected rate of inflation. it does not necessarily decrease a person’s real income if nominal income rises with the price level. Unanticipated inflation will hurt the following groups: those with fixed incomes. savers. Graphically. 1. Disposable income is personal income – taxes. 2. Savings equals disposable income less consumption. Three types of inflation include creeping. Figure 10. As a formula: Nominal Interest Rate= Expected Rate of Inflation + Real Rate of Interest 10. 9. although this explores only C & I.1 Page 189 3. Consumption is the largest component of aggregate expenditures. The inflation rate is calculated by the Consumer Price Index (CPI) which measures the prices of a market basket of 300 goods/services purchased by a typical urban consumer.e. and hyperinflation National Income and Price Determination Chapter 9: Building the Aggregate Expenditures Model 1. the amounts of goods/services each dollar will buy). savings is represented as the difference between the 45-degree line and consumption. interest.1 Page 189 . A Consumption Schedule shows the various amounts households would plan to consume at each of the various levels of disposable income. Figure 10. C=DI and this would be represented graphically as a 45 degree line. rent.
10. MPC= Change in Consumption Change in Income 8.a. b. DI>C and S is positive 4. The Marginal Propensity to Save is the change in savings due to a change in income.2 Page 191 5. The Marginal Propensity to Consume is the change in consumption due to a change in income. c. At higher levels of income. Where C=DI the consumption schedule intersects the 45 line and savings is zero (break-even level). MPS= Change in Saving Change in Income OR MPS= 1-MPC 9. The sum of MPC and MPS must equal 1 . At low levels of disposable income. dissavings (consuming in excess of disposable income) occurs as people draw upon accumulated wealth. APC= Consumption Income 6. A savings schedule shows the various amounts households would plan to save at each of various levels of disposable income Key Graph 10. APS=Saving or APS=1-APC 7. Average propensity to consume is the percentage of any specific level of total income consumed. Average Propensity to Save is the percentage of any specific level of total income saved.
d) Taxes: A decrease in taxes will increase both consumption and savings at all levels of DI 12. Thus adding Planned I to the consumption schedule (C=I) will shift the consumption schedule upward by the amount of the planned investment. Businesses’ investment in capital goods occurs only if the marginal benefit from the investment (i. There are Non-Income Determinants of consumption and saving that will increase (shift up) or decrease (shift down) consumption and savings at all levels of disposable income.e. We assume that investment is fixed.e. the interest rate on the investment loan). The Investment Schedule shows the amounts business firms collectively intend to invest at each possible level of GDP. The major non income determinants are: a) Wealth: an increase in wealth will increase consumption and decrease savings at all levels of DI b) Expectations: Consumer expectations of rising prices or shortages will increase consumption and decrease savings at all levels of DI. Although we assume investment is fixed. most likely at higher levels of GDP there is some induced investment as excess capacity disappears and firms have incentives to add to their capital stock. c) Household Debt: An increase in household debt will increase consumption and decrease savings at all levels of disposable income. The aggregate expenditures-domestic output model (AKA the incomesexpenditures model) Key Graph 11.2 page 212 is used to determine equilibrium GDP 16. Figure 11.1 Page 210 14. independent of the level of current disposable income or real output.6 Page 198 13. the expected rate of return) exceeds or is equal to the marginal cost (i. Figure 10. Equilibrium Output is that output where the total quantity of goods . 15.11. that is. Investment is the second component of aggregate expenditures.
where savings exceed planned investment. Net Exports. Actual Investment = Planned Investment and Unplanned Investment (i. inventories (i.3-11. the Multiplier. c) Only at equilibrium does S=Planned I and the unplanned investment is zero.e. Businesses will cut back on production until equilibrium (S=planned I) occurs. Equilibrium GDP can be determined using the leakages-injections approach Figure 11.6 19. the 45 line shows potential GDP equilibrium where C+I=GDP 17. Chapter 10: Aggregate Expenditures. where savings is less than planned investment. At equilibrium GDP where C+I=GDP. Multiplier= Change in Real GDP Initial Change in Spending (C or I or G or Xn) Thus the change in real GDP= Multiplier x Initial Change in spending The Expenditure Multiplier= 1 MPS or 1 1-MPC 2. unplanned investment) will rise until savings equals actual investment. The actual equilibrium level of GDP is the GDP that corresponds to the intersection of the aggregates expenditures schedule and the 45-degree line.2 Page 212 18. S=I (In a closed economy with no public sector) 20.e. inventories (i. which equates the actual amounts. Net Exports (Xn)= Exports(X) – Imports (M). unplanned investment) will fall and businesses will increase production until equilibrium (S=planned I) occurs.e. Positive Net Exports (X>M) will increase aggregate expenditures whereas negative net exports (X<M) will . The Multiplier Effect is that a change in a component of aggregate expenditures leads to a larger change in equilibrium GDP. On the model. saved and invested in any period. Savings is a leakage or withdrawal of spending from the incomeexpenditures stream whereas investment is an injection. and Government 1. b) At all below-equilibrium points.produced (GDP) equals the total quantity of goods purchased (C+I). Unplanned investment acts as a balancing item. Figure 11. unplanned changes in inventory investment). a) At all above-equilibrium points.
aggregate expenditures would have to be reduced by $25 billion ($250 billion/10) to solve the inflationary gap. the government spending would increase equilibrium GDP by $200 billion ($40 billion x 5) whereas the increased lump sum tax of $40 billion would first lower disposable income by $32 billion ($40 billion x . the multiplied effect would increase GDP by $60 billion ($15 billion x 4). if the government reduces taxes by a lump sum of $20 billion at all levels of disposable income and the MPC is . Contrast this to an increase in government spending by $20 billion. Figure 11.8. which would increase GDP by $80 billion ($20 billion x 4). A Recessionary Gap is the amount by which aggregate expenditures at the full-employment level of GDP fall short of those required to achieve the full-employment GDP. equilibrium GDP would increase by $40 billion.7 Page 223 7. Changes in taxes will have a smaller multiplied effect on equilibrium than the expenditure multiplier above because taxes initially change disposable income before affecting consumption. Increases in public or government spending (G) will increase aggregate expenditures whereas decreases in G will decrease aggregate expenditures Figure 11. Government spending affects aggregate expenditures more powerfully than a tax change of the same size.75.4 Pg 216 3.$160 billion = $40 billion. For example.9. Equal increases in government spending and taxation increases the equilibrium GDP by the amount of the increase.7 Page 223 Chapter 11: Aggregate Demand and Aggregate Supply . Thus. Thus the tax multiplier is only 3. people will only spend $15 billion and save $5 billion. $200 billion. If the government increased both taxes and spending by $40 billion.decrease aggregate expenditures Fig.5 Page 219 4. If the full-employment GDP were $500 billion and the actual equilibrium GDP $750 billion and the MPC .8. The Tax Multiplier= -MPC 1-MPC 5. An Inflationary Gap is the amount by which an economy’s aggregate expenditures at the full-employment GDP exceed those necessary to achieve the full-employment GDP. The Balanced Budget Multiplier=1 6. Figure 11. If the MPC were . 11. aggregate expenditures would have to increase by $20 billion ($100 billion/5) to solve the recessionary gap. If full employment GDP was $500 billion and actual equilibrium GDP was $400 billion and the MPC .8) and then reduce equilibrium GDP by $160 billion ($32 billion x 5).
2. labor. When per-unit costs decrease.e.1 Page 231 a) Wealth Effect: A higher price level reduces the real value or purchasing power of the public’s accumulated financial assets. Factors that will increase AD include: a) Consumption Spending (increase in consumer wealth. exports relatively expensive and foreign imports relatively cheap. Figure 12. and foreign buyers collectively desire to purchase at each possible price level. a component of aggregate demand. There are three regions of the AS curve: a) horizontal or Keynesian b) upward sloping and c) vertical or classical. real output) that domestic consumers.5 Pages 236 and 237 4.6 Page 239.S.1.3-12.) c) Government Spending d) Net Export Spending (rising foreign national income. businesses. government. excess capacity. Some aggregate supply determinants include: a) Lower input prices (for land. Determinants of Aggregate Supply will increase (shift right) or decrease (shift left) AS at all price levels.2 Page 233 3. There are three reasons for the downward slope of AD where higher price level will decrease the quantity of real GDP demanded and a lower price level will increase the quantity of real GDP demanded. Determinants of Aggregate Demand will increase (shift right) or decrease (shift left) AD at all price levels. lower business taxes. c) Foreign Purchases Effect: A higher price level makes U. Aggregate Supply is a schedule or curve showing the level of real domestic output which will be produced at each price level. expectations of future price increases. aggregate supply will increase and when per-unit costs increase. Figure 12. depreciation of US dollar) Figure 12. AS will decrease. which reduces consumption and investment. Aggregate Demand is a schedule or curve showing the various amounts of goods/services (i. new technology. and capital) will increase AS . b) Interest Rate Effect: A higher price level increases the demand for money and (assuming a fixed supply of money) raises the interest rate. reducing net exports (X – M). household debt and taxes) b) Investment Spending (decrease in interest rate. higher expected returns on investment. Figures 12.
The effect of changes in AD on equilibrium price level and output depend upon which of the three ranges the shift of AD occurs. Figures 12.8 +12. 3.9 Page 243 If AD increased. Discretionary Fiscal Policy is the deliberate manipulation of taxes and government spending to alter GDP and employment. b) Contractionary Fiscal Policy is used to counteract and inflationary gap and reduce AD in order to return the economy to full employment. Stabilization policies in the short run involve the following two option: a) Expansionary Fiscal Policy is used to eliminate a recessionary gap and stimulate AD in order to return the economy to full employment.b) An appreciation of the dollar will lower the price of imported resources and increase AS c) Increased productivity= total output/total inputs will lower costs and increase AS d) Supply-side economic policies that lower business taxes will reduce costs and increase AS 5. the following table summarizes the effects: Range Multiplied Effect Horizontal Full Effect Intermediate Reduced Effect Vertical None Price Level No Change Moderate Increase Large Increase Real GDP Large Increase Moderate Increase No Increase Chapter 12: Fiscal Policy 1. The equilibrium price level and equilibrium real GDP occur where AD=AS Figure 12. Fiscal Policy Options Gov’t Spending Effect on Prices* Effect on Budget Taxes Effect on GDP .7 Page 242 6. 2. control inflation and stimulate growth.
The crowding out effect is an argument that an expansionary fiscal policy (deficit spending) will increase the interest rate and reduce private investment. reducing the stimulus of the fiscal policy Figure 13. a) For example. The Net Export Effect further reduces the impact of expansionary fiscal policy as higher domestic interest rates.8 Page 269. as GDP rises during prosperity. here are the linkages a) Government spending and/or tax reduction increases the budget deficit b) The budget deficit is financed through government borrowing of funds in the money market c) d) The increase in the demand for money raises the interest rate The higher interest rate discourages or “crowds out” private investment e) Economic growth in the long run (LRAS) will be reduced due to smaller private capital stock 5. Contractionary decrease decrease toward surplus *Effect on prices assumes in an intermediate or vertical region of AS (In a horizontal region.g. tax revenues under a progressive income tax system automatically increase and transfer . no change) 4. Expansionary increase increase toward deficit lower raise increase decrease b.. a) b) Increase foreign demand for dollars The increased demand for dollars results in an appreciated dollar c) The appreciated dollar makes exports more expensive and imports cheaper d) Net exports decline partially offsetting the expansionary fiscal policy 6. progressive income tax and transfer payments such as unemployment conversation) that automatically counteract both recessions and high inflation.a.Specifically. Non Discretionary Fiscal Policy or Built-In Stabilizers are counter cyclical government programs (e.
Change in $ Supply Equilibrium Interest Increase Decrease Change in $ Demand No Change No Change Change in Decrease Increase . The budget will automatically move towards a surplus b) Conversely.g. The budget will automatically move toward a deficit.e. The purchasing power of money is the amount of goods/services money will buy. If higher prices increase nominal GDP. Higher prices lower the value of the dollar because more dollars will be needed to buy a particular amount of goods/services. 6. the public will choose to hold a large amount of money as assets whereas when the interest rate is high. people will hold less money as assets. and Store of Value 2. both reducing consumer spending and restraining economic expansion. M1 is the most liquid category of money and includes currency and checkable deposits 3. M2 includes M1 and near monies (e. such as unemployment insurance. 5. The public demands money for two reasons: to make purchases with (transaction demand) and to hold as an asset. savings.1 Page 309 The total demand curve for money includes two components: a) The assets demand for money varies inversely with the rate of interest. When the interest rate (i. Figure 16. stimulating consumer spending and preventing a prolonged recession.payments. automatically decrease. Money serves three functions: Medium of Exchange. b) The transactions demand for money varies directly with nominal GDP. Unit of Account. as GDP falls during a recession. Money Market Equilibrium occurs where the vertical supply curve of money intersects the downward sloping demand curve. Thus. Chapter 13: Money and Banking 1. the demand curve for money is downward sloping. money market mutual funds) 4. tax revenues automatically decline and transfer payments automatically increase. time deposits. the opportunity cost of holding money) is low. the transaction demand for money will shift the total money demand curve to the right at all levels of interest.
$100 billion of excess reserves would multiply to $500 billion Higher Reserve Ratios mean lower money multipliers and therefore less creation of a new deposit money via loans whereas smaller reserve ratios mean higher money multipliers and thus more creation of new deposit money via loan Two limitations that reduce the full effect of the money multiplier include: a) Money received by a borrower may not be deposited into the banking system b) Bankers may hold excess reserves above the required reserve ratio. 2. The Federal Reserve requires that banks keep a specific percentage of its own demand deposit liabilities on reserve. Bank liabilities include demand deposits (checking) and savings accounts. Where m= money multiplier and R= required reserve Chapter 15 Monetary Policy 1. the required reserve ratio was . m= ratio 1 R Maximum Demand-Deposit Creation = Excess Reserves x m If. for example.No Change No Change Increase Decrease Increase Decrease Chapter 14: How Banks Create Money 1. A balance sheet is a statement of what the bank owns (assets) and what the bank owes (liabilities). Bank assets include cash reserves. and loans. The Reserve Ratio= Commercial Bank’s Required Reserves Commercial Bank’s Demand-Deposit Liabilities 3.2. The money multiplier indicates the maximum amount of new demanddeposit money that can be created in the banking system by a single dollar of excess reserves. Excess Reserves= Actual Reserves. As a formula. Monetary Policy consists of altering the economy’s money supply to . bonds.Required reserves 4.
raising bond prices and lowering interest rates. When the Fed buys government bonds the supply decreases.2 Page 256 Easy Money Policy Tight Money Policy Problem: Inflation Problem: Unemployment and Recession Federal Reserve buys bonds. increase aggregate demand. commercial banks are encouraged to obtain additional reserves by borrowing from Federal Reserve Banks. and the price level. The three major tools of monetary policy and the effect on real GDP and the price level include: a) Open Market Operations involves the buying and selling of government bonds (securities) by the Federal Reserve Banks in the open market. Selling securities to banks and/or the public will decrease bank reserves and thus the money supply. or lowers the discount rate rate Federal Reserve sells bonds. Buying securities from banks and/or the public will increase bank reserves and thus the money supply. A tight or contractionary monetary policy is an attempt by the Fed to lower the supply of money in order to encourage spending. When the discount rate is decreased. and increase employment. 2.stabilize aggregate output. lowering bond prices and raising the interest rates. employment. c) The Discount Rate: The Fed charges commercial banks for loans. lowers reserve increases reserve ratio ratio. Figure 13. or increases the discount Excess Reserves Increase Excess Reserves Decrease . b) The Reserve Ratio: Lowering the reserve ratio decreases the amount of required reserves banks must maintain increasing excess reserves and the money supply via new loans. the supply increases. When the Fed sells government bonds. Raising the reserve ratio increases the amount of required reserves banks must maintain decreasing excess reserves and the money supply.
any change in the interest rate will have a larger impact on investment --and hence aggregate demand and the GDP—the flatter (more elastic) the demand curve. The effectiveness of monetary policy depends upon the elasticity of the demand for money and the investment. Furthermore. The steeper (more inelastic) the demand curve for money. r0 r1 MS MS’ r MD I Q$ .Money Supply Rises Money Supply Falls Interest Rate Falls Interest Rate Rises Investment Spending Increases Investment Spending Decreases Aggregate Demand Increases Aggregate Demand Decreases Real GDP rises by a multiple of the Income investment Inflation Declines 2. the larger the effect of any change in the money supply on the equilibrium rate of interest.
The net export effect of monetary policy. Problem: inflation slow growth Problem: Inflation Expansionary Fiscal Policy Problem: Recession. Easy Money Policy Tight Money Policy Contractionary Fiscal Policy Problem: Recession. unlike fiscal policy.I0 I1 3. slow growth Easy money policy Tight money policy Contractionary Fiscal policy (lower interest rate) (higher interest rate) Expansionary Fiscal Policy Decreased demand for Increased demand for interest rate Lower domestic interest rate foreign dollars foreign dollars Higher domestic Dollar depreciates Dollar appreciates Decreased foreign demand for dollars Increased foreign demand for dollars Xn increases (Aggregate Dollar Depreciates Demand Increases strengthening the easy Net Exports increase Xn decreases (Aggregate demand decreases strengthening the tight Dollar Appreciates Net Exports decline . will increase net exports if expansionary and decrease net exports if contractionary.
the economy will selfcorrect without government intervention (laissez-faire) A. 4. The long run is a period in which nominal wages are fully responsive to changes in the price level. profits rise and output will increase. prices. new technology. Classical Model Assumptions i) The economy operates at full-employment (Qf) where long run aggregate supply curve is vertical (LRAS) ii) Wages. ii. The short run aggregate supply curve (SRAS) is upward sloping because if the prices rise while the nominal wages are fixed. profits fall and output will decrease. etc.money policy) money policy) Chapter 16 Extending the Analysis of Aggregate Supply and Aggregate Demand Chapter 17 Disputes in the Macro Theory and Policy 1. 2. The short run is a period in which nominal wages (and other input prices) are fixed as the price level changes. Note that the LRAS is the production possibilities curve (PPF) in an economy. 3. Theory of Self-Correction Scenario A: Inflationary Gap (Model A on Left) i. As a result. economic growth only occurs when the LRAS shifts to the right due to increased productivity. AD increases from AD1 to AD2 In short run (SR) prices increase revenue increases profit . If prices fall while nominal wages are fixed. Although aggregate demand and SRAS may intersect beyond the LRAS in the short run. lower input costs for business. and interest rates are fully flexible (long run assumption) iii) Aggregate demand is relatively stable iv) If there is an inflationary or recessionary gap. the long run aggregate supply curve (LRAS) is perfectly vertical (inelastic) as higher prices result in higher wages and no change in output.
increases (as nominal wages and other input costs are fixed in the short run) real output increases (Point b at Q2 PL2) iii. prices fall revenue falls profit falls (as nominal wages and other input costs are fixed in the short run) real output falls (point d at Q3. PL4) c) In long run (LR). In long run (LR). an economy self-corrects as nominal wages and other input costs fall d) SRAS curve shifts right (AS3) and prices fall to PL5 (point e) Price Level real output increases and returns to Qf Price Level ASLR AS2 . SRAS curve shifts left (AS2) and prices increase to PL3 (point c) real output falls and returns to Q1 B. Theory of Self-Correction Scenario B: Recessionary Gap (Model B on Right) a) AD decreases from AD1 to AD3 b) In short run (SR). economy self corrects as nominal wages and other input costs increase iv.
P1 P3 c d P2 e b P4 P1 a P5 AD2 AD1 .
iii. Government intervention (fiscal/ monetary policy) manipulating aggregate demand is often necessary to help the economy reach and remain at full employment (stabilization policies) A. Critique of Theory of Self-Correction Scenario B: Recessionary Gap (Model B on above Right) i. However the SRAS will not shift right to Qf (contrast classical view) because wages are also sticky v. Surpluses result as AS>AD and prices fall to point d (AS1 and AD3) on graph iv. Wages. Expansionary fiscal and monetary policies will enable shift AD right and the economy will return to full employment. low RDGP with a recession vi. Prices. Economy may operate below Qf in equilibrium for extended periods of time where AS is horizontal ii. Keynesian Model Assumptions i. and Interest are often “sticky” Aggregate demand (especially investment) is volatile iv. AD falls from AD1 to AD3 ii. Macroeconomic Policy Dilemmas . The economy will be “stuck” at point d with high unemployment.Q1 Q2 Q4 Q3 Q1 Real Domestic Output (a) Effects of an Increase in AD in AD Real Domestic Output (b) Effects of a Decrease 5. Prices downwardly inflexible and new temporary equilibrium where PL1 intersects AD3 (point f) iii.
Budget deficit worsens (Borrow and Spend) 2. Capital Outflow 4. Exchange rates may fall Expansionary Advantages 1. IR may fall 2. Hurts country’s ability 1. Risks recession may rise 2. IR may rise Fiscal Policy Expansionary continue 1. Exchange rate 1. May cause short run decrease political problems 4. Increases UE 1. Economy may grow 3. Trade deficit may 4. Growth may 2. Decreases UE 3. May help solve SR political problems . Trade deficit may increase Contractionary 2. Inflation may worsen 2. Helps fight inflation 3. Slows growth 3.Option Disadvantages Monetary Policy 1. Capital outflow 5.
May allow a better monetary/fiscal mix 3. Risks recession 1. May help fight 2. Increases UE Contractionary 1.to borrow in the future 3. Trade deficit may 4. Interest rates may fall . Upward pressure on interest rates inflation 2. May help cause SR decrease political problems 4. Trade deficit may increase 4. Decreases UE 3. Slows growth 3.
Comparison of Classical and Keynesian Policies Problem Keynesian Policy Classical Policy Cause: Inflation is a monetary problem Avoid inflation by relying on strict monetary rule-use contractionary monetary policy Be careful about expanding output too high and causing inflation Push inflation to zero by strict monetary rule .
possibly consider a temporary income policy Some small amount of inflation may be good for economy.Cause: Inflation is a combination institutional and monetary problem Use contractionary monetary and fiscal policy Supplement above policy with policies to change wage and price-setting institutions. and it is not worth trying to push inflation to zero if it involves significant unemployment. Inflation: .
and too few incentives for growth Remove government impediments to growth. too high tax rates. go back to laissez-faire policy Cause: An institutional and AD problem Use expansionary monetary and fiscal policy Supplement above policy with policies to establish incentive for growth Slow Growth: .Cause: Growth rates reflect people’s desires. probable cause of slow growth is too much regulation.
Unemployment: Fiscal Policy Advocates of fiscal policy solutions believe that the government’s decisions about spending and taxing can influence the equilibrium of the nation’s GDP. causing inflation If UE were very high. This stabilization is achieved in part through the manipulation of the public budget-government spending and tax collections.for the expressed purpose of increasing output and employment or reducing the rate of inflation. use expansionary monetary and fiscal policy. however. government policies should focus on LR Cause: Institutional and AD problem Use expansionary monetary and fiscal policy. a fundamental function of the government’sspending and taxing policy is to stabilize the economy.Recessionary Cause: Earlier government policies were too expansionary. More specifically. . Generally.
Expansionary fiscal policy includes: · · · Increased government spending Lower taxes A combination of the two If the budget is balanced. It stimulates . Supply-side policies include all policies targeted toward production in the business sector (e. they have very different distributional impacts. Critics of fiscal policy measures argue that this expansion of the government “crowds out” expansion by private firms by competing for investment funds used to finance spending. In this regard. While all of these scenarios might have the same expansionary impact on the economy as a whole. the Federal government is also concerned with the provision of public goods and services and the redistribution of income. That is.g.g. or by reducing income taxes for the wealthy. by serving as employer of last resort for low-skilled. the government could engage in an expansionary policy by increasing the dollars going toward education. One policy helps the middle class (the primary recipients of education). and a slow growth in GDP. and one helps the wealthy (tax breaks) Fiscal policy can be targeted toward either the supply or the demand side of the economy. expansionary fiscal policy is effective when the economy needs stimulation. changing incentives for investment). Expansionary Fiscal Policy Increased government spending or decreased taxes are used when the growth of the economy is “too slow”. an expansionary fiscal policy will increase the deficit as government spending is increased.In addition to its role in stabilizing the economy. one helps the poor (low-skilled and unemployed). unemployed workers. high levels of unemployment. Assuming that the crowding out effects are minimal. the economy is faced with a recession. the specific types of spending and taxing policies are important. Demand-side policies include all policies targeted toward spending by consumers (e. altering employment opportunities or taxes on consumption). For example.
Agreement about Macroeconomic Policy Both Keynesians and Classicals generally agree that: 1. Expansionary monetary and fiscal policies have short-run simulative . This surplus slows economic growth and production. stimulates production and reduces unemployment. Work from Buck Trust Seminar. it will further reduce economic growth and exacerbate unemployment. contractionary fiscal policies are most effective when the economy faces excess demand for workers by firms or for goods by consumers. which. Provided by Kristen Lubenow. That is. in turn. Lowell H. expansionary fiscal policies can expand the economy with little impact on price levels. By decreasing spending (of consumers or firms). If it is undertaken when the economy is in a recession. If prices are rising because of non-labor cost push factors and the economy is sluggish. contractionary fiscal policies will increase the sluggishness of the economy and will have little impact on price levels. production is slowed and the demand for workers decreases. a contractionary fiscal policy would move the government toward a budget surplus. Contractionary fiscal policy is effective when the economy contains (demand-side) inflationary pressures. 1997. Contractionary fiscal policy includes: · · · Decreased government spending Increased taxes A combination of the two If the budget is balanced at the outset. These pressures underlie inflationary pressures and GDP growth that is “too rapid”. If it is undertaken when demand-pull inflationary pressures are present or when the economy is at full employment.S. Contrary Fiscal Policy Decreasing government spending or increasing taxes is used when growth in the economy is overheated.spending (of consumers or firms). it will overheat the economy and create increased rates of inflation. If prices are rising because of non-labor cost-push factors and the economy is sluggish.
You had to look at the state of the economy to decide whether a deficit was good or bad. 5. which was the policy of the US government. 4. According to Keynesian economics. Doing so increases inflation. prosperity. 2. deficits were NOT necessarily bad. governing the monetary and fiscal policies a country follows. Expansionary monetary and fiscal policies have potential long-run inflation effects 3. The big difference in policy regimes bore and after WWII was the introduction of Keynesian economics and its use of discretionary fiscal policy. Keynesians were blamed for the deficit. Before WWII. That was changed to Keynesian economics. 7. one must run deficits and increase the money supply. Traditional macro policies offer trade-offs. Expansionary monetary policy places downward pressure on the exchange rate. Expansionary monetary and fiscal policies tend to increase the trade deficit. Supply Side Economics in a Few Words Policy regime: The general set of rules.effects on income. 6. Classical economics dictated that government budget deficits were bad and that. and low unemployment—without deficits. whether explicit or implicit. but grew. To expand the economy. they should be avoided. Supply-side policies offer hope of expanding potential output and hence having it all—growth. . but when the government changed hands in the 1980’s. Monetary policy is politically easier to implement than fiscal policy. which prescribed deficits to stimulate the economy and achieve higher levels of output. the deficit did not disappear. except in wartime. and Classical supply-side economic policy came in. Expansionary fiscal policy has an ambiguous effect on the exchange rate.
There is a natural rate of unemployment that controls the rate of growth. . not tax revenues. but because of the incentive effects of lower tax rates on supply. 2. output will increase. As they do all these things. that growth decreases the budget deficit and creates jobs.SUPPLY-SIDE policies expand potential output by creating supply-side incentives by lowering tax rates or by modifying the composition of government spending and taxes to stimulate the economy. (The aggregate supply curve and hence potential income will shift out). changes in the money supply—in the bank’s ability to make loans—result directly in changes in expenditure. Rather. there is an important difference. and to invest. Since supply creates its own demand. to save. IMPORTANT DIFFERENCE: It looks as though the Supply-Side argument for cutting taxes is much like the Keynesian argument for fiscal policy in which cutting taxes stimulates the economy via the multiplier effect. Because they expand potential output. Monetarism: 3 Tenets 1. The economy will expand because of greater incentives to work. AD will also increase. they allow the economy to grow. ****CLAIM: A decrease in taxes directly shifts the AD curve. Changes in the supply of money DO NOT affect the economy via their effect on Interest Rates and Investment. However. people will have greater incentive to work. The supply-side argument goes as follows: If the government cuts tax rates. not because of expectations of increased demand. The supply-side explanation of how the tax cut would stimulate the economy is by microeconomic incentives. It focuses on TAX RATES.
Hence. When they read that the authorities are increasing M. . they make monetarist theory come true. Changes in M affect P. but because the level of output is “fixed” by the natural rate of UE. attempts to accelerate growth through spending will only “crowd out” private activity. geared to the economy’s natural rate of UE. they spend their incomes more quickly to “beat” the coming price rise. If the economy lagged for any reason. Anti-Monetarists contest all these tenets: 1. Rather. they are more often caused than cured by government intervention. A steady increase in M. Strategies: 1. Rational Expectations link M and MV 1) This theory asserts that all individuals are guided by common sense predictions about the future. An increase in M leads to an increase in MV. booms and busts will be transient—indeed. too. This rate would not vary (2-4%). Changes in expenditure (MV) may result in bursts of activity. but will not budge that fundamental controlling force. given the prevailing wage. the steady rate would hold it back. the steady increase in M would stimulate growth to its natural rate. They deny that the Fed controls the money supply as the monetarists state. The system will return to its natural path. they expect P to rise. 3. they suggest that the demand for money (for transactions needs) forces the Fed to change the money base. As intuitive monetarists.The natural rate of UE refers to the willingness of individuals to work. Therefore. its effects will be felt in changes in P. These natural changes are the only source of rising or falling prices. is best for the economy. If circumstances tended to push the economy ahead faster than the fixed rate of growth of M. Therefore. Where money matters most is in its effect on the price level.
determine P. . One of the pivotal features of current macro theory research of the assumption that rationality also applies to the way that economic participants think about the future as well as the present. there is widespread agreement among the many leading macro researchers that the rational expectations hypothesis extends our understanding of the behavior of the macro economy. The bases for inflation are such changes in supply shocks and changes in wages. not M. We think of firms that rationally maximize profits when they choose today’s output and consumers who rationally maximize utility when they choose how much of what goods to consume.2. These expectations incorporate individuals’ understanding about how the economy operates. Tend to favor a discretionary monetary policy that will try to fit the supply of money to changing needs. There are two key elements to the hypothesis: 1. Individuals base their forecasts or expectations about the future values of economic variables on all the available information past and present. including the operation of monetary and fiscal policy. They deny a natural rate of UE or the uselessness of intervention. and assert that costs. 3. In particular. 2. Rational Expectations and the New Classical Model You already know that economists assume that economic participants act as though they were rational and calculating.
Realistic? · Assumes that people are able to accurately forecast government policymaking when it often seems the government is unable to do so itself.In essence. but you can’t fool all the people all the time. the rational expectation hypothesis assumes that Lincoln was correct when he stated. people learn how to predict both changes in policies and the policies themselves. As a result. unless the effects of demand-management policies come as complete surprises to the public. Therefore. longterm business contracts and numerous other obstacles all keep wages and prices for adjusting immediately to changes in AD and AS. “It is true that you may fool all the people some of the time. certain laws and regulations. you can even fool some of the people all the time. · Assumes people understand economics and react according to changes in policy. policy goals cannot be achieved. Consumers and investors will then behave in ways that prevent predictable policies from having any real effect. Information about government policies is unavoidably expensive and imprecise. Union contracts. It takes time for private investment and households to: a) Recognize that policies and situations have changed b) Implement plans to reflect new circumstances . many people remain “rationally ignorant”. · Assumes wages and prices are totally flexible and adjust instantly to changes in the market. even in the short-run.” The theory of rational expectations suggests that after policy makers pursue either expansionary or contractionary policies a few times.
also shifts the AD curve out. supply leads demand and potential income is increased. and impact lags. . producers will increase output because of that increased expected demand. In the supply-side explanation. AS is the best estimate of potential income. In the supply side view. which means the tax rate cut increases potential income too. demand leads supply and potential income is unaffected. administrative. The differences are important because the supply-side explanation has specific policy implications. The supply-side explanation states that a deficit financed by a tax cut will not be inflationary. If. (For SupplySide: Society can have a free lunch). The result will be either shortages or inflation. which further increases AD. the tax cut shifts the AD but not AS because AS cannot increase beyond potential income. The Classical Explanation: A reduction in taxes for businesses moves AS out and since supply creates its own demand. The Keynesian (Demand-Side) explanation if a tax cut’s effect is the multiplier process: In it. IF the level of potential income is greater than the actual level of income. All of these reasons cause critics of this version of the new classical theory. The Keynesian Explanation: Cuts in taxes increase income and expected AD. however the economy is initially at potential income.c) Have their new plans take effect Government policies face parallel recognition.