question
What is money? What are the three functions that money can provide? In the US, what is considered money? What is not considered money?
answer
- Money is the means of payment. It functions as a medium of exchange, a unit of account, and a store value. Today, money consists of currency and deposits. A credit card is not considered money.
question
The official measures of money: M1 and M2 and their components
answer
M1 consists of currency and traveler's checks plus checking deposits owned by individuals and businesses. M1 does NOT include currency held by banks, and it does not include currency and checking deposits owned by the US government. M2 consists of M1 plus time deposits, saving deposits, and money market mutual funds and other deposits.
question
Depository institutions - types, functions and benefits provided. What are the 3 types of assets, their components and their characteristics, in which a commercial bank puts the funds it receives from depositors?
answer
- Depository institutions: financial firm that takes deposits from households and firms. These deposits are components of M1 and M2.
- Commercial banks, S&Ls, saving banks, credit unions, and money market mutual funds are depository institutions whose deposits are money.
- Depository institutions provide four main economic services: they create liquidity, minimize the cost of obtaining funds, minimize the cost of monitoring borrowers, and pool risks.
- Commercial banks, S&Ls, saving banks, credit unions, and money market mutual funds are depository institutions whose deposits are money.
- Depository institutions provide four main economic services: they create liquidity, minimize the cost of obtaining funds, minimize the cost of monitoring borrowers, and pool risks.
question
What are the bank's reserves? What is the federal funds rate?
answer
- Bank reserves are a commercial banks' holdings of deposits in accounts with a central bank.
- Federal funds rate are loans to other banks earn interest and the interest rate on these loans is called the federal funds rate and the fed sets a target for this interest rate to influence the economy.
- Federal funds rate are loans to other banks earn interest and the interest rate on these loans is called the federal funds rate and the fed sets a target for this interest rate to influence the economy.
question
The Federal Reserve System (FED), its structure and its goals.
answer
- The Federal Reserve System is the central bank of the United States.
- The FED influences the quantity of money by setting the required reserve ratio, making last resort loans, and by conducting open market operations.
- When the FED buys securities in an open market operation, the monetary base increases; when the FED sells securities, the monetary base decreases.
- The FED influences the quantity of money by setting the required reserve ratio, making last resort loans, and by conducting open market operations.
- When the FED buys securities in an open market operation, the monetary base increases; when the FED sells securities, the monetary base decreases.
question
The Fed's balance sheet, what are its assets and what are its liabilities? What are the three policy tools that the Fed can use to influence the quantity of money and interest rates?
answer
- The fed influences the economy through the size and composition of its balance sheet-the assets that the Fed owns and the liabilities that it owes.
- Two main assets: US government securities and mortgage backed securities.
- The feds two liabilities: currency and reserves of depository institutions.
- The Fed influences the quantity of money and interest rates by adjusting the quantity of reserves available to the banks and the reserves the banks must hold. To do this, the Fed manipulates three tools: open market operations, last resort loans, required reserve ratio.
- Two main assets: US government securities and mortgage backed securities.
- The feds two liabilities: currency and reserves of depository institutions.
- The Fed influences the quantity of money and interest rates by adjusting the quantity of reserves available to the banks and the reserves the banks must hold. To do this, the Fed manipulates three tools: open market operations, last resort loans, required reserve ratio.
question
Understand Figure 8.2 that illustrates one of the methods the Fed employs to increase bank reserves. What is the discount rate? What is the required reserve ratio?
answer
- Figure 8.2: When the Fed buys securities in the open market, it creates bank reserves. The Fed's assets and liabilities increase, and the Bank of America exchanges securities for reserves. The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with.
question
The mechanism of creating money by the banks. Understand Fig. 8.3.
answer
Figure 8.3: The Federal Reserve increases the monetary base, which increases bank reserves and creates excess reserves. Banks lend the excess reserves, which creates new deposits. The quantity of money increases. New deposits are used to make payments. Some of the new money remains on deposit at banks and some leaves the banks in a currency drain. The increase in bank deposits increases banks' desired reserves. But the banks still have excess reserves, though less than before. The process repeats until excess reserves have been eliminated.
question
The definition and characteristics of: the monetary base, desired reserves, desired reserve ratio.
answer
- The monetary base is the sum of currency and the reserves of depository institutions. The Fed's assets are the siroccos of the monetary base. The Fed's liabilities are the uses of the monetary base as currency and bank reserves.
- A banks desired reserves are the reserves that it plans to hold. The quantity of the desired reserves depends on the level of deposits and is determined by the desired reserve ratio.
- The desired reserve ratio is the ratio of reserves to deposits that the banks plan to hold.
- A banks desired reserves are the reserves that it plans to hold. The quantity of the desired reserves depends on the level of deposits and is determined by the desired reserve ratio.
- The desired reserve ratio is the ratio of reserves to deposits that the banks plan to hold.
question
The definition and characteristics of: required reserves, excess reserves.
answer
- The banks required reserves is the minimum quantity of reserves that a bank must hold.
- The required reserve ratio is the minimum percentage of deposits that depository institutions are required to hold as reserves.
- A bank's excess reserves are its actual reserves minus its desired reserves. When a bank has excess reserves, it makes loans and creates deposits.
- The required reserve ratio is the minimum percentage of deposits that depository institutions are required to hold as reserves.
- A bank's excess reserves are its actual reserves minus its desired reserves. When a bank has excess reserves, it makes loans and creates deposits.
question
The definition and characteristics of: desired currency holdings, currency drain ratio and money multiplier.
answer
- The proportions of money held as currency and bank deposits-the ratio of currency to deposits-depend on how households and firms choose to make payments: Whether they plan to use currency or debit cards and checks. Choices about how to make payments change slowly so the ratio of desired currency to deposits also changes slowly, and at any given time this ratio is fixed.
- We call the leakage of bank reserves into currency the currency drain, and we call the ratio of currency to deposits the currency drain ratio.
- The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.
- We call the leakage of bank reserves into currency the currency drain, and we call the ratio of currency to deposits the currency drain ratio.
- The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.
question
The money market - factors that influence the quantity of money held.
answer
- The quantity of money demanded is the amount of money that people plan to hold.
- The quantity of real money equals the quantity of nominal money divided by the price level.
- The quantity of real money demanded depends on the nominal interest rate, real GDP, and financial innovation.
- The nominal interest rate makes the quantity of money demanded equal the quantity supplied.
- When the Fed increases the quantity of money, the nominal interest rate falls (the short-run effect).
- In the long run, when the Fed increases the quantity of money, the price level rises and the nominal interest rate returns to its initial level.
- The quantity of real money equals the quantity of nominal money divided by the price level.
- The quantity of real money demanded depends on the nominal interest rate, real GDP, and financial innovation.
- The nominal interest rate makes the quantity of money demanded equal the quantity supplied.
- When the Fed increases the quantity of money, the nominal interest rate falls (the short-run effect).
- In the long run, when the Fed increases the quantity of money, the price level rises and the nominal interest rate returns to its initial level.
question
The money demand - definition, characteristics and shifts. Understand
Figures 8.4 and 8.5.
Figures 8.4 and 8.5.
answer
- The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.
- Figure 8.4: The demand for money curve, MD, shows the relationship between the quantity of real money that people plan to hold and the nominal interest rate, other things remaining the same. The interest rate is the opportunity cost of holding money. A change in the interest rate brings a movement along the demand for money curve.
- Figure 8.5: A decrease in real GDP decreases the demand of money. The demand for money curve shifts leftward from MD0 to MD1. An increase in real GPD increases the demand for money. The demand for money curve shifts rightward from MD0 to MD2. Financial innovation generally decreases the demand for money.
- Figure 8.4: The demand for money curve, MD, shows the relationship between the quantity of real money that people plan to hold and the nominal interest rate, other things remaining the same. The interest rate is the opportunity cost of holding money. A change in the interest rate brings a movement along the demand for money curve.
- Figure 8.5: A decrease in real GDP decreases the demand of money. The demand for money curve shifts leftward from MD0 to MD1. An increase in real GPD increases the demand for money. The demand for money curve shifts rightward from MD0 to MD2. Financial innovation generally decreases the demand for money.
question
The money market equilibrium, short-run and long-run. Understand Figures 8.6 and 8.7.
answer
- Short-run Equilibrium: the quantity of money supplied is determined by the actions of the banks and the FED. As the FED adjust the quantity of money the interest rate changes.
- Figure 8.6: Money market equilibrium occurs when the quantity of money demanded equals the quantity supplied. In the short run, real GDP determines the demand for money curve, MD, and the FED determines the quantity of real money supplied and the supply of money curve, MS. The interest rate adjusts to achieve equilibrium.
- Long-run equilibrium: When the inflation rate equals the expected (or forecasted) inflation rate and when real GDP equals potential GDP, the money market, the loanable funds market, the goods market, and the labor market are in long-run equilibrium - the economy is in long run equilibrium.
- Figure 8.7: An increase in the quantity of money increases the supply of money. The supply of money curve shifts from MS0 to MS1 and the interest rate falls. A decrease in the quantity of money decreases the supply of money. The supply of money curve shifts from MS0 to MS2 and the interest rate rises.
- Figure 8.6: Money market equilibrium occurs when the quantity of money demanded equals the quantity supplied. In the short run, real GDP determines the demand for money curve, MD, and the FED determines the quantity of real money supplied and the supply of money curve, MS. The interest rate adjusts to achieve equilibrium.
- Long-run equilibrium: When the inflation rate equals the expected (or forecasted) inflation rate and when real GDP equals potential GDP, the money market, the loanable funds market, the goods market, and the labor market are in long-run equilibrium - the economy is in long run equilibrium.
- Figure 8.7: An increase in the quantity of money increases the supply of money. The supply of money curve shifts from MS0 to MS1 and the interest rate falls. A decrease in the quantity of money decreases the supply of money. The supply of money curve shifts from MS0 to MS2 and the interest rate rises.
question
The quantity theory of money - definition. The velocity of circulation definition. The equation of exchange in regular and growth rate form. What do they tell us about the rate of velocity change and the inflation rate in the long run?
answer
- The quantity theory of money is the proposition that money growth and inflation move up and down together in the long run.
- The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation, V, is determined by the equation: V= PY/M.
- The equation of exchange tells us how M, V, P, and Y are connected. The equation is MV=PY.
- We can also express the equation of exchange in growth rates, in which form it states that money growth rate + rate of velocity change = inflation rate + real GDP growth rate. Solving this equation for the inflation rate gives inflation rate= money growth rate + rate of velocity change - real GDP growth rate.
- In the long run, the rate of velocity change is not influenced by the money growth rate. More strongly, in the long run, the rate of velocity change is approximately zero.
- The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. The velocity of circulation, V, is determined by the equation: V= PY/M.
- The equation of exchange tells us how M, V, P, and Y are connected. The equation is MV=PY.
- We can also express the equation of exchange in growth rates, in which form it states that money growth rate + rate of velocity change = inflation rate + real GDP growth rate. Solving this equation for the inflation rate gives inflation rate= money growth rate + rate of velocity change - real GDP growth rate.
- In the long run, the rate of velocity change is not influenced by the money growth rate. More strongly, in the long run, the rate of velocity change is approximately zero.
question
Inflation - definition and short run and long run distinctions
answer
- Inflation: A persistently rising price level.
- The short-run phillips curve shows the tradeoff between inflation and unemployment when the expected inflation rate and the natural unemployment rate are constant.
- The long-run phillips curve, which is vertical, shows that when the actual inflation rate equals the expected inflation rate, the unemployment rate equals the natural employment rate.
- The short-run phillips curve shows the tradeoff between inflation and unemployment when the expected inflation rate and the natural unemployment rate are constant.
- The long-run phillips curve, which is vertical, shows that when the actual inflation rate equals the expected inflation rate, the unemployment rate equals the natural employment rate.
question
What is a demand-pull inflation and what are the factors that can provoke it? What is the demand-pull inflation process? Sources and responses.
answer
- Demand pull inflation is an inflation that starts because aggregate demand increases.
- Demand pull inflation is triggered by an increase in aggregate demand and fueled by ongoing money growth. Real GDP cycles above full employment.
- The only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.
- Demand pull inflation is triggered by an increase in aggregate demand and fueled by ongoing money growth. Real GDP cycles above full employment.
- The only way in which aggregate demand can persistently increase is if the quantity of money persistently increases.
question
Understand Figure 12.3 - A demand-pull rise in the price level
answer
Figure 12.3: in part (a), the aggregate demand curve is AD0, the short run aggregate supply curve is SAS0, and the long-run aggregate supply curve is LAS. The price level is 110, and real GDP is $16 trillion, which equals potential GDP. Aggregate demand increases to AD1. The price level rises to 113, and real GDP increases to $16.5 trillion. In part (b), starting from the above full-employment equilibrium, the money wage rate begins to rise and the short-run aggregate supply curve shifts leftward toward SAS1. The price level rises further, and real GDP returns to potential GDP.
question
What is the demand pull inflation spiral? Understand Figure 12.4
answer
Figure 12.4: Repeated increases in AD create a demand-pull inflation spiral. Each time the quantity of money increases, aggregate demand increases and the aggregate demand curve shifts rightward from AD0 to AD1 to AD2, and so on. Each time real GDP increases above potential GDP, the money wage rate rises and the short run aggregate supply curve shifts leftward from SAS0 to SAS1 to SAS2, and so on. The price level rises from 110 to 113 to 121, and so on. There is a demand pull inflation spiral. Real GDP fluctuates between $16 trillion and $16.5 trillion.
question
What is a cost-push inflation and what are the factors that can provoke it? What is the cost-push inflation process? Sources and responses. Understand Figure 12.5.
answer
- An inflation that is kicked off by an increase in costs is called a cost-push inflation. The two main sources of cost increases are 1. an increase in the money wage rate and 2. an increase in the money prices of raw materials.
- Figure 12.5: (a) initial cost push. Initially, the aggregate demand curve is AD0, the short-run aggregate supply curve is SAS0, and the long run aggregate supply curve is LAS. A decrease in aggregate supply (for example, resulting from a rise in the world price of oil) shifts the short-run aggregate supply curve to SAS1. The economy moves to the point where the short-run aggregate supply curve is SAS1 intersects the aggregate demand curve AD0. The price level rises to 117, and real GDP decreases to $15.5 trillion. (b) The Fed responds. In part (b), if the fed responds by increasing aggregate demand to restore full employment, the aggregate demand curve shifts rightward to AD1. The economy returns to full employment, but the price level rises further to 121.
- Figure 12.5: (a) initial cost push. Initially, the aggregate demand curve is AD0, the short-run aggregate supply curve is SAS0, and the long run aggregate supply curve is LAS. A decrease in aggregate supply (for example, resulting from a rise in the world price of oil) shifts the short-run aggregate supply curve to SAS1. The economy moves to the point where the short-run aggregate supply curve is SAS1 intersects the aggregate demand curve AD0. The price level rises to 117, and real GDP decreases to $15.5 trillion. (b) The Fed responds. In part (b), if the fed responds by increasing aggregate demand to restore full employment, the aggregate demand curve shifts rightward to AD1. The economy returns to full employment, but the price level rises further to 121.
question
What is the cost-push inflation spiral? Understand Figure 12.6.
answer
Figure 12.6: Oil producers and the Fed feed a cost push inflation spiral. Each time a cost increases occurs, the short-run aggregate supply curve shifts leftward from SAS0 to SAS1 to SAS2, and so on. Each time real GDP decreases below potential GDP, the Fed increases the quantity of money and the aggregate demand curve shifts rightward from AD0 to AD1 to AD2, and so on. The price level rises from 110 to 117, 121, 129, 133, and so on. There is a cost-push inflation spiral. Real GDP fluctuates between $16 trillion and $15.5 trillion.
question
Expected inflation: anticipated and unanticipated changes in aggregate demand and their effects. Rational expectations, forecasting inflation and its link with the business cycle.
answer
- If inflation is expected, the fluctuations in real GDP that accompany demand-pull and cost-push inflation that you've just studied don't occur. Instead, inflation proceeds as it does in the long run, with real GDP equal to potential GDP and unemployment at its natural rate.
- Anticipated changes in aggregate demand: the money wage rate rises and the short-run aggregate supply curve shifts leftward.
- Rational expectations: best forecast available is one that is based on all relevant information.
- Forecasting: To anticipate inflation, people must forecast it. A rational expectation is not necessarily a correct forecast. It is simply the best forecast with the information available. These often turn our wrong, but on other forecast that could have been made with the available information could do any better.
- Business cycle: when the inflation forecast is correct, the economy operates at full employment. If aggregate demand grows faster than expected, real GDP rises above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demand pull inflation. If aggregate demand grows more slowly than expected, real GDP falls below potential GDP and the inflation rate slows.
- Anticipated changes in aggregate demand: the money wage rate rises and the short-run aggregate supply curve shifts leftward.
- Rational expectations: best forecast available is one that is based on all relevant information.
- Forecasting: To anticipate inflation, people must forecast it. A rational expectation is not necessarily a correct forecast. It is simply the best forecast with the information available. These often turn our wrong, but on other forecast that could have been made with the available information could do any better.
- Business cycle: when the inflation forecast is correct, the economy operates at full employment. If aggregate demand grows faster than expected, real GDP rises above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demand pull inflation. If aggregate demand grows more slowly than expected, real GDP falls below potential GDP and the inflation rate slows.
question
Understand Figure 12.7. - Expected inflation.
answer
- Figure 12.7: Potential real GDP is $16 trillion. Last year, aggregate demand was AD0 and the short run aggregate supply curve was SAS0. The actual price level was the same as the expected price level: 110. This year, aggregate demand is expected to increase to AD1 and the price level is expected to rise from 110 to 121. As a result, the money wage rate rises and the short-run aggregate supply curve shifts to SAS1. If aggregate demand actually increases as expected, the actual aggregate demand curve AD1 is the same as the expected aggregate demand curve. Real GDP is $16 trillion, and the actual price level rises to 121. The inflation is expected. Next year, the process continues with aggregate demand increasing as expected to AD2 and the money wage rate rising to shift the short-run aggregate supply curve to SAS2. Again, real GDP remains at $16 trillion, and the price level rises, as expected, to 133.
question
Deflation - definition, factors, consequences and a potential "cure"
answer
- Deflation is a falling price level or negative inflation rate.
- Deflation is caused by a money growth rate that is too low to accommodate the growth of potential GDP and changes in the velocity of circulation.
- Unanticipated deflation brings stagnation.
- Deflation can be ended by increasing the money growth rate to a rate that accommodates the growth of potential GDP and changes in the velocity of circulation.
- Deflation is caused by a money growth rate that is too low to accommodate the growth of potential GDP and changes in the velocity of circulation.
- Unanticipated deflation brings stagnation.
- Deflation can be ended by increasing the money growth rate to a rate that accommodates the growth of potential GDP and changes in the velocity of circulation.
question
What is the Short-Run Phillips Curve and what are its features? Understand Figure 12.8.
answer
- The short-run phillips curve shows the tradeoff between inflation and unemployment when the expected inflation rate and the natural unemployment rate are constant.
- Figure 12.8: The short-run phillips curve, SRPC, is the relationship between inflation and unemployment at a given expected inflation rate and a given natural unemployment rate. Here, the expected inflation rate is 10 percent a year and the natural unemployment rate is 6% at point A. A change in the actual inflation rate brings movement along the short-run phillips curve from A to B or from A to C.
- Figure 12.8: The short-run phillips curve, SRPC, is the relationship between inflation and unemployment at a given expected inflation rate and a given natural unemployment rate. Here, the expected inflation rate is 10 percent a year and the natural unemployment rate is 6% at point A. A change in the actual inflation rate brings movement along the short-run phillips curve from A to B or from A to C.
question
What is the Long-Run Phillips Curve and what are its features?
answer
- The long-run phillips curve, which is vertical, shows that when the actual inflation rate equals the expected inflation rate, the unemployment rate equals the natural unemployment rate.
question
How do changes in expected inflation and changes in the natural unemployment rate translate into shifts of the two Phillips Curves? Understand Figure 12.9
answer
Figure 12.9: Decrease in expected inflation shifts short-run phillips curve downward. Increase in natural unemployment rate shifts long-run phillips curve and short-run phillips curve rightward. In part (a), a fall in expected inflation shifts the SRPC downward from SRPC0 to SRPC1. The LRPC does not shift. In part (b), a change in the natural unemployment rate shifts both the short-run and long-run phillips curves.
question
The Keynesian model - main features.
answer
Example: All the firms are like your grocery store. They set their prices and sell the quantities their customers are willing to buy. If they persistently sell more than they plan to and keep running out of inventory, they eventually raise their prices. And if they persistently sell less than they plan to and have inventories piling up, they eventually cut their prices. But on any given day, their prices are fixed and the quantities they sell depend on demand, not supply. Because each firm's prices are fixed, for the economy as a whole 1. the price level is fixed and 2. aggregate demand determines real GDP.
question
Definition and components of aggregate expenditure (AE). The 2-way link between AE and GDP.
answer
- The AE curve is the relationship between aggregate planned expenditure and real GDP, other things remaining the same.
- AE is equal to the sum of planned levels of consumption expenditure, investment, government expenditure on goods and services, and exports minus imports.
- 2 way link between aggregate expenditure and Real GDP: 1. an increase in real GDP increases aggregate expenditure. 2. an increase in aggregate expenditure increases real GDP.
- AE is equal to the sum of planned levels of consumption expenditure, investment, government expenditure on goods and services, and exports minus imports.
- 2 way link between aggregate expenditure and Real GDP: 1. an increase in real GDP increases aggregate expenditure. 2. an increase in aggregate expenditure increases real GDP.
question
The consumption and savings functions—definitions, factors that influence them, relationship with GDP, features, and characteristics. Understand Figure 11.1.
answer
- Consumption function: relationship between expenditure and disposable income, other things remaining the same.
- Relationship with GDP: Disposable income is aggregate income minus taxes plus transfer payments. Aggregate demand equals real GDP, so disposable income depends on real GDP.
- Several factors influence consumption expenditure and saving plans. The more important ones are: disposable income, real interest rate, wealth, and expected future income.
- Saving function: relationship between saving and disposable income, other things remaining the same.
- Characteristics: when consumption expenditure exceeds disposable income, saving is negative, called dissaving.
- Households can only spend their disposable income on consumption or save it, so planned consumption expenditure plus planned saving always equals disposable income.
- Relationship with GDP: Disposable income is aggregate income minus taxes plus transfer payments. Aggregate demand equals real GDP, so disposable income depends on real GDP.
- Several factors influence consumption expenditure and saving plans. The more important ones are: disposable income, real interest rate, wealth, and expected future income.
- Saving function: relationship between saving and disposable income, other things remaining the same.
- Characteristics: when consumption expenditure exceeds disposable income, saving is negative, called dissaving.
- Households can only spend their disposable income on consumption or save it, so planned consumption expenditure plus planned saving always equals disposable income.
question
What are the marginal propensities to consume and to save? How do we define them and calculate them? What is the relationship between them and the slopes of the consumption and saving functions, respectively? For a visual representation, explore Figure 11.2.
answer
- The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption. It is calculated as the change in consumption expenditure, divided by the change in disposable income. The formula is MPC= DeltaC/DeltaYD.
- The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved. It is calculated as the change in saving divided by the change in disposable income. The formula is MPS=DeltaS/DeltaYD.
- Figure 11.2: The marginal propensity to consome, MPC, is equal to the change in consumption expenditure divided by the change in disposable income, other things remaining the same. It is measured by the slope of the consumption function. In part (a), the MPC is 0.75. The marginal propensity to save, MPS, is equal to the change in saving divided by the change in disposable income, other things remaining the same. It is measured by the slope of the saving function. In part (b), the MPS is 0.25.
- The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved. It is calculated as the change in saving divided by the change in disposable income. The formula is MPS=DeltaS/DeltaYD.
- Figure 11.2: The marginal propensity to consome, MPC, is equal to the change in consumption expenditure divided by the change in disposable income, other things remaining the same. It is measured by the slope of the consumption function. In part (a), the MPC is 0.75. The marginal propensity to save, MPS, is equal to the change in saving divided by the change in disposable income, other things remaining the same. It is measured by the slope of the saving function. In part (b), the MPS is 0.25.
question
The import function - definition, relationship with real GDP. What is the marginal propensity to import?
answer
- Imports depend on real GDP, and the import function is M= mY.
- The relationship between imports and real GDP is determined by the marginal propensity to import, which is the fraction of an increase in real GDP that is spent on imports. It is calculated as the change in imports divided by the change in real GDP, other things remaining the same.
- The relationship between imports and real GDP is determined by the marginal propensity to import, which is the fraction of an increase in real GDP that is spent on imports. It is calculated as the change in imports divided by the change in real GDP, other things remaining the same.
question
Aggregate planned expenditure and the AE curve - definition, construction, representation. Relationship between actual expenditure, planned expenditure and real GDP.
answer
- Aggregate planned expenditure depends on real GDP. Aggregate planned expenditure is not always equal to actual aggregate expenditure therefore it is not always equal to real GDP.
- To calculate aggregate planned expenditure at a given real GDP, we add the expenditure components together.
- Actual aggregate expenditure is always equal to the real GDP.
- If aggregate planned expenditure exceeds real GDP, firms sell more than they planned to sell and end up with inventories being too low.
- To calculate aggregate planned expenditure at a given real GDP, we add the expenditure components together.
- Actual aggregate expenditure is always equal to the real GDP.
- If aggregate planned expenditure exceeds real GDP, firms sell more than they planned to sell and end up with inventories being too low.
question
Understand Figure 11.3 (Aggregate planned expenditure: the AE curve)
answer
Aggregate planned expenditure is the sum of planed consumption expenditure, investment, government expenditure on goods and services, and exports minus imports. For example, in row C of the table, when real GDP is $14 trillion, planned consumption expenditure is $3.5 trillion, planned exports are $2.0 trillion, and planned imports are $2.8 trillion. SO when real GDP is $14 trillion, aggregate planned expenditure is $15 trillion (9.8+2.5+3.5+2.0-2.8). The schedule shows that aggregate planned expenditure increases as real GDP increases. This relationship is graphed as the aggregate expenditure curve AE. The components of aggregate expenditure that increase with real GDP are consumption expenditure and imports. The other components-investment, government expenditure, and exports- do not vary with real GDP.
question
What are the autonomous and induced expenditures, respectively?
answer
- Induced expenditure is consumption expenditure minus imports, which varies with real GDP.
- The sum of investment, government expenditure, and exports which does not vary with real GDP, is called autonomous expenditure.
- The sum of investment, government expenditure, and exports which does not vary with real GDP, is called autonomous expenditure.
question
Equilibrium expenditure - definition and illustration. Convergence to equilibrium.
answer
- Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.
- Level of aggregate expenditure and real GDP at which spending plans are fulfilled.
- At a given price level, equilibrium expenditure determines real GDP.
- Convergence: when aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence toward equilibrium expenditure occurs.
- Level of aggregate expenditure and real GDP at which spending plans are fulfilled.
- At a given price level, equilibrium expenditure determines real GDP.
- Convergence: when aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence toward equilibrium expenditure occurs.
question
Understand Figure 11.4.
answer
The table shows expenditure plans at different levels of real GDP. When real GDP is $16 trillion, aggregate planned expenditure equals real GDP. Part (A) of the figure illustrates equilibrium expenditure, which occurs when aggregate planned expenditure equals real GDP at the intersection of the 45 degrees line and the AE curve. Part (B) of the figure sows the forces that bring about equilibrium expenditure. When aggregate planned expenditure exceeds real GDP, inventories decrease- for example, at point B in both parts of the figure. So, firms increase production, and real GDP increases. When aggregate planned expenditure is less than real GDP, inventories increase-for example, at point F in both parts of the figure. So, firms cut production, and real GDP decreases. When aggregate planned expenditure equals real GDP, there are no unplanned inventory changes and real GDP remains constant at equilibrium expenditure.
question
The multiplier—definition, calculation, and use. The size of the multiplier and the link with the slope of the AE curve. The influence of imports and income taxes on the size of the multiplier.
answer
- The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.
- Calculation: multiplier= change in equilibrium expenditure divided by the change in autonomous expenditure.
- Multiplier effect: equilibrium expenditure increases by more than the increase in autonomous expenditure. The multiplier is greater than 1.
- Imports and income taxes make the AE curve less steep and reduce the value of the multiplier.
- Calculation: multiplier= change in equilibrium expenditure divided by the change in autonomous expenditure.
- Multiplier effect: equilibrium expenditure increases by more than the increase in autonomous expenditure. The multiplier is greater than 1.
- Imports and income taxes make the AE curve less steep and reduce the value of the multiplier.
question
The link between aggregate expenditure (AE) and the aggregate demand (AD). Understand Figures 11.8 and 11.9. How changes of AD translate into different multiplier effects in the short run and in the
long-run. Understand Figures 11.10 and 11.11.
long-run. Understand Figures 11.10 and 11.11.
answer
- Link: when the price level changes, aggregate planned expenditure changes and the quantity of real GDP demanded changes. The aggregate demand curve slopes downward because: 1. The wealth effect: the higher the price level, the smaller is the purchasing power of wealth
2. Substitution effect: a rise in the price level today makes current goods and services more expensive relative to future goods and services and results in a delay in purchases.
- When any influence on aggregate planned expenditure other than the price level changes, both the aggregate expenditure curve and the aggregate demand curve shift. Example: an increase in investment or exports increase both the aggregate planned expenditure and aggregate demand and shifts both the AE curve and the AD curve.
- Multiplier effect: the larger the multiplier, the largest is the shift in the aggregate demand curve that results from a given change in autonomous expenditure.
2. Substitution effect: a rise in the price level today makes current goods and services more expensive relative to future goods and services and results in a delay in purchases.
- When any influence on aggregate planned expenditure other than the price level changes, both the aggregate expenditure curve and the aggregate demand curve shift. Example: an increase in investment or exports increase both the aggregate planned expenditure and aggregate demand and shifts both the AE curve and the AD curve.
- Multiplier effect: the larger the multiplier, the largest is the shift in the aggregate demand curve that results from a given change in autonomous expenditure.
question
The business cycles—definitions, patterns impulses and mechanisms. The mainstream business cycle theory - definition and mechanism. Understand Figure 12.1
answer
- The mainstream business cycle theory explains the business cycle as fluctuations of real GDP around potential GDP and as arising from a steady expansion of potential GDP combined with an expansion of aggregate demand at a fluctuating rate.
- Real business cycle theory explains the business cycle as fluctuations of potential GDP, which arise from fluctuations in the influence of technological change on productivity growth.
- Figure 12.1: In a business cycle expansion, potential GDP increases and the LAS curve shifts rightward from LAS0 to LAS1. A greater than expected increase in aggregate demand brings inflation. If the aggregate demand curve shifts to AD1, the economy remains at full employment. If the aggregate demand curve shifts to AD2, a recessionary gap raises. If the aggregate demand curve shifts to AD3, an inflationary gap arises.
- Real business cycle theory explains the business cycle as fluctuations of potential GDP, which arise from fluctuations in the influence of technological change on productivity growth.
- Figure 12.1: In a business cycle expansion, potential GDP increases and the LAS curve shifts rightward from LAS0 to LAS1. A greater than expected increase in aggregate demand brings inflation. If the aggregate demand curve shifts to AD1, the economy remains at full employment. If the aggregate demand curve shifts to AD2, a recessionary gap raises. If the aggregate demand curve shifts to AD3, an inflationary gap arises.
question
Aggregate demand vs. aggregate supplies theories of business cycles
answer
The AS-AD model explains the forces that determine real GDP and the price level in the short-run. The model also enables us to see the big picture or grand vision of the different schools of macroeconomic thought concerning the sources of aggregate fluctuations. The Keynesian aggregate expenditure model provides an account of the factors that determine aggregate demand and make it fluctuate. An alternative real business cycle theory puts all the emphasis on fluctuations in long-run aggregate supply. According to this theory, money changes aggregate demand and the price level but leaves the real economy untouched. The events of 2008 and 2009 will provide a powerful test of this theory.
question
The money wage rigidity
answer
- According to Keynes, money wage rigidity is a downward inflexibility of money wages, resulting in involuntary unemployment of labor, workers are considered unemployed because at a given wage rate supply of labor exceeds demand for labor.
- Money wage would not hcnage sufficiently in the short run to keep the economy at full employment
- Causes: money illusion, wage fixation through contracts, minimum wage laws, efficiency wages.
- Money wage would not hcnage sufficiently in the short run to keep the economy at full employment
- Causes: money illusion, wage fixation through contracts, minimum wage laws, efficiency wages.
question
The Keynesian Cycle theory
answer
- In Keynesian cycle theory, fluctuations in investment driven by fluctuations in business confidence-summarized by the phrase "animal spirits"- are the main source of fluctuations in aggregate demand.
- Reasoned that news or rumors of future tax changes, interest rate changes, advances in technology, global economic and political events affect expectations and investments (animal spirits)
- A rise in 'animal spirits' increases aggregate demand and with flexible wages, brings an expansion and rise in price level.
- A fall in 'animal spirits' decerases aggregate demand.
- Assumes that the money wage rate is rigid and doesn't explain that rigidity.
- Reasoned that news or rumors of future tax changes, interest rate changes, advances in technology, global economic and political events affect expectations and investments (animal spirits)
- A rise in 'animal spirits' increases aggregate demand and with flexible wages, brings an expansion and rise in price level.
- A fall in 'animal spirits' decerases aggregate demand.
- Assumes that the money wage rate is rigid and doesn't explain that rigidity.
question
The Monetarist Cycle theory
answer
- In monetarist cycle theory, fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main source of fluctuations in aggregate demand.
- Slowdowns in money growth bring recession (decreases aggregate demand), but a fall in money wages eventually brings expansion and restores full employment.
- Speedups in money expansion bring expansion (increases aggregate demand) but a rise in money wages lowers real GDP and restores full employment.
- Assumes that the money wage rate is rigid and doesn't explain that rigidity.
- Slowdowns in money growth bring recession (decreases aggregate demand), but a fall in money wages eventually brings expansion and restores full employment.
- Speedups in money expansion bring expansion (increases aggregate demand) but a rise in money wages lowers real GDP and restores full employment.
- Assumes that the money wage rate is rigid and doesn't explain that rigidity.
question
The New Classical Cycle Theory (or the Rational Expectations theory)
answer
- Also called the Rational Expectations theory
- In new classical cycle theory, the rational expectation of the price level, which is determined by potential GDP and expected aggregate demand, determines the money wage rate and the position of the SAS curve. In this theory, only unexpected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.
- A rational expectation is a forecast that is based on all the available relevant information.
- Rational expectations theories are based on the view that money wages are determined by a ration expectation of price level.
- The impulse is the rational expectations theories is an unanticipated change in aggregate demand (larger anticipated increase in aggregated demand brings expansion)
- In new classical cycle theory, the rational expectation of the price level, which is determined by potential GDP and expected aggregate demand, determines the money wage rate and the position of the SAS curve. In this theory, only unexpected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.
- A rational expectation is a forecast that is based on all the available relevant information.
- Rational expectations theories are based on the view that money wages are determined by a ration expectation of price level.
- The impulse is the rational expectations theories is an unanticipated change in aggregate demand (larger anticipated increase in aggregated demand brings expansion)
question
The New Keynesian Cycle Theory
answer
- The new Keynesian cycle theory emphasizes the fact that today's money wage rates were negotiated at many past dates, which means that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. In this theory, both unexpected and currently expected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.
- Combined RBC and with imperfect competition
- Four elements that are central to the new synthesis: inter-temporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs)
- Monetary policy can affect real output in the short-run, but there is no long-run trade- off: money is not neutral in the short-run but it is in the long-run.
- Combined RBC and with imperfect competition
- Four elements that are central to the new synthesis: inter-temporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs)
- Monetary policy can affect real output in the short-run, but there is no long-run trade- off: money is not neutral in the short-run but it is in the long-run.
question
The Real Business Cycle Theories (RBC): impulse and mechanism
answer
- The newest theory of the business cycle, known as the real business cycle theory (or RBC theory), regards random fluctuations in productivity as the main source of economic fluctuations.
- Impulse in RBC theory is the growth rate of productivity
- Rapid technological progress: productivity growth increases quickly.
- Slow progress: productivity grows more moderately.
- Intertemporal substitution is very important.
- Impulse in RBC theory is the growth rate of productivity
- Rapid technological progress: productivity growth increases quickly.
- Slow progress: productivity grows more moderately.
- Intertemporal substitution is very important.
question
RBC, the loanable funds market and the labor market. Understand
Figure 12.2
Figure 12.2
answer
- Recession: labor productivity increased, as did the real wage, because employment and aggregate hours fell more than GDP and unemployment rose.
- Rise in real wages reduced short-term aggregate supply.
- Figure 12.2: (a) Loanable funds and interest rate; in part (a), the supply of loanable funds SLF and the initial demand for loanable funds DLF0 determine the real interest rate at 6 percent a year. In part (b) Labor wage and rate; the intitial demand for labor LD0 and the supply of labor LS0 determine the real wage rate at $35 an hour and unemployment at 200 billion hours. A technological change temporarily decreases productivity, and both the demand for loanable funds and the demand for labor decrease. The two demand curves shift leftward to DLF1 and LD1. In part (a), the real interest rate falls to 4 percent a year. In part (b), the fall in the real interest rate decrease the supply of labor (the when to work decision) and the supply of labor curve shifts leftward to LS1. Employment decreases to 195 billion hours, and the real wage rate falls to $34.50 an hour. A recision is underway.
- Rise in real wages reduced short-term aggregate supply.
- Figure 12.2: (a) Loanable funds and interest rate; in part (a), the supply of loanable funds SLF and the initial demand for loanable funds DLF0 determine the real interest rate at 6 percent a year. In part (b) Labor wage and rate; the intitial demand for labor LD0 and the supply of labor LS0 determine the real wage rate at $35 an hour and unemployment at 200 billion hours. A technological change temporarily decreases productivity, and both the demand for loanable funds and the demand for labor decrease. The two demand curves shift leftward to DLF1 and LD1. In part (a), the real interest rate falls to 4 percent a year. In part (b), the fall in the real interest rate decrease the supply of labor (the when to work decision) and the supply of labor curve shifts leftward to LS1. Employment decreases to 195 billion hours, and the real wage rate falls to $34.50 an hour. A recision is underway.
question
Criticism and defense of the RBC theory
answer
- The three main criticism of RBC theory are that
1. The money wage rate is sticky, and to assume otherwise is at odds with a clear fact.
2. Intertemporal substitituion is too weak a fore to account for large fluctuations in labor supply and employment with small real wage rate changes.
3. Producitivitys hocks are as likely to be caused by changes in aggregate demand as by technological change.
- The defenders of the RBC theory claim that the theory explains the macroeconomic facts about the business cycle and is consistent with the fact about economic growth. Defenders also claim that RBC theory is consistent with a wide rang of microeconomic evidence about labor supply decisions, labor demand and investment demand decisions, and information on the distribution of income between labor and capital.
1. The money wage rate is sticky, and to assume otherwise is at odds with a clear fact.
2. Intertemporal substitituion is too weak a fore to account for large fluctuations in labor supply and employment with small real wage rate changes.
3. Producitivitys hocks are as likely to be caused by changes in aggregate demand as by technological change.
- The defenders of the RBC theory claim that the theory explains the macroeconomic facts about the business cycle and is consistent with the fact about economic growth. Defenders also claim that RBC theory is consistent with a wide rang of microeconomic evidence about labor supply decisions, labor demand and investment demand decisions, and information on the distribution of income between labor and capital.
question
The federal budget- purposes, mechanism, historical perspective, surplus and deficit, budget balance and debt
answer
- The federal budget is an annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support them. The federal budget has two purposes: to finance federal government programs and activities and to achieve macroeconomic objectives.
- The first purpose of the federal budget was its only purpose before the Great Depression of the 1930s. The second purpose arose as a reaction to the Great Depression and the rise of the ideas of economist John Keynes.
- Surplus or deficit: The governments budget balance is equal to receipts minus outlays. (budget balance = receipts - outlays). If receipts exceed outlays, the government has a budget surplus. If outlays exceed receipts, the government has a budget deficit. If receipts equal outlays, the government has a balanced budget.
- Deficit and debt: when federal government runs a deficit, it borrows pay for this. The government borrows by selling treasury bills, notes and bonds. Government debt is the value of outstanding treasury securities- thus the sum of past government deficits minus the sum of past surpluses.
- Tax revenues can exceed, equal or fall short of outlays- the budget can be in surplus, balanced, or in deficit.
- Budget deficits create government debt.
- The first purpose of the federal budget was its only purpose before the Great Depression of the 1930s. The second purpose arose as a reaction to the Great Depression and the rise of the ideas of economist John Keynes.
- Surplus or deficit: The governments budget balance is equal to receipts minus outlays. (budget balance = receipts - outlays). If receipts exceed outlays, the government has a budget surplus. If outlays exceed receipts, the government has a budget deficit. If receipts equal outlays, the government has a balanced budget.
- Deficit and debt: when federal government runs a deficit, it borrows pay for this. The government borrows by selling treasury bills, notes and bonds. Government debt is the value of outstanding treasury securities- thus the sum of past government deficits minus the sum of past surpluses.
- Tax revenues can exceed, equal or fall short of outlays- the budget can be in surplus, balanced, or in deficit.
- Budget deficits create government debt.
question
Supply-side effects of fiscal policy -taxes on expenditure, labor income, and capital income. Their effects on real wages, employment, real interest rates, saving and investment respectively. Understand Figures 13.5 and 13.6.
answer
- Fiscal policy has supply-side effects because taxes weaken the incentive to work and decrease employment and potential GDP.
- The US labor market tax wedge is large, but it is small compared to those of other industrialized countries.
- Fiscal policy has supply-side effects because taxes weaken the incentive to save and invest, which lowers the growth rate of real GDP.
- The Gaffer curve shows the relationship between the tax rate and the amount of tax revenue collected.
- Figure 13.5: In part (a), with no income tax, the real wage rate is $30 an hour and employment is 250 billion hours. In part (b), potential GDP is $16 trillion. As income tax shifts the supply of labor curve forward to LS + tax. The before-tax wage rate rises to $35 an hour, the after-tax wage rate falls to $20 an hour, and the quantity of labor employed decreases to 200 billion hours. With less labor, potential GDP decreases.
- Figure 13.6: The demand for loanable funds and investment demand curve is DLF, and the supply of loanable funds and saving supply curve is SLF. With no income tax, the real interest rate is 3 percent a year and investment is $2 trillion. An income tax shifts the supply curve leftward to SLF + tax. The interest rate rises to 4 percent a year, the after-tax interest rate falls to 1 percent a year, and investment decreases to $1.8 trillion. With less investment, the real GDP growth rate decreases.
- The US labor market tax wedge is large, but it is small compared to those of other industrialized countries.
- Fiscal policy has supply-side effects because taxes weaken the incentive to save and invest, which lowers the growth rate of real GDP.
- The Gaffer curve shows the relationship between the tax rate and the amount of tax revenue collected.
- Figure 13.5: In part (a), with no income tax, the real wage rate is $30 an hour and employment is 250 billion hours. In part (b), potential GDP is $16 trillion. As income tax shifts the supply of labor curve forward to LS + tax. The before-tax wage rate rises to $35 an hour, the after-tax wage rate falls to $20 an hour, and the quantity of labor employed decreases to 200 billion hours. With less labor, potential GDP decreases.
- Figure 13.6: The demand for loanable funds and investment demand curve is DLF, and the supply of loanable funds and saving supply curve is SLF. With no income tax, the real interest rate is 3 percent a year and investment is $2 trillion. An income tax shifts the supply curve leftward to SLF + tax. The interest rate rises to 4 percent a year, the after-tax interest rate falls to 1 percent a year, and investment decreases to $1.8 trillion. With less investment, the real GDP growth rate decreases.
question
Tax revenues and the Laffer curve. Understand Figure 13.7.
answer
- The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve. The curve is named so because Arthur B. Laffer, drew such a curve on a table napkin and launched the idea that tax cuts could increase tax revenue.
- Figure 13.7: A Laffer curve shows the relationship between the tax rate and tax revenues. For tax rates below T, an increase in the tax rate increases tax revenues. At the tax rate T, tax revenue is maximized. For tax rates above T*, an increase in the tax rate decreases tax revenue.
- Figure 13.7: A Laffer curve shows the relationship between the tax rate and tax revenues. For tax rates below T, an increase in the tax rate increases tax revenues. At the tax rate T, tax revenue is maximized. For tax rates above T*, an increase in the tax rate decreases tax revenue.
question
Generational effects of fiscal policy
answer
- Generational accounting measures the lifetime tax burden and benefits of each generation.
- A major study estimated the US fiscal imbalance to be $68 trillion- 4 times the value of one year's production.
- Future generations will pay for 17 percent of the benefits of the current generation.
- About 48 percent of the US government debt is held by the rest of the world.
- A major study estimated the US fiscal imbalance to be $68 trillion- 4 times the value of one year's production.
- Future generations will pay for 17 percent of the benefits of the current generation.
- About 48 percent of the US government debt is held by the rest of the world.
question
Fiscal stimulus - definition. Automatic vs discretionary fiscal policy.
answer
- Fiscal policy can be automatic or discretionary. Automatic fiscal policy might moderate the business cycle by stimulating demand in recession and restraining demand in a boom. Discretionary fiscal stimulus influences aggregate demand and aggregate supply. Discretionary changes in government expenditure or taxes have multiplier effects of uncertain magnitude but the tax multiplier is likely the larger one.
- Fiscal stimulus policies are hampered by uncertainty about the multipliers and by time lags (law-making lags and the difficulty of correctly diagnosing and forecasting the state of the economy).
- Fiscal stimulus policies are hampered by uncertainty about the multipliers and by time lags (law-making lags and the difficulty of correctly diagnosing and forecasting the state of the economy).
question
5.1 automatic stimulus; cyclical and structural budget balances
answer
- Automatic stimulus: Because government receipts fall and outlays increase in a recession, the budget provides automatic stimulus that helps to shrink the recessionary gap. Similarly, because receipts rise and outlays decrease in a boom, the budget provides automatic restraint to shrink an inflationary gap.
- Cyclical and Structural budget balances: To identify the government budget deficit that raises from the business cycle, we distinguish between the structural surplus or deficit, which is the budget balance that would occur if the economy were at full employment, and the cyclical surplus or deficit, which is the actual surplus or deficit minus the structural surplus or deficit.
- Cyclical and Structural budget balances: To identify the government budget deficit that raises from the business cycle, we distinguish between the structural surplus or deficit, which is the budget balance that would occur if the economy were at full employment, and the cyclical surplus or deficit, which is the actual surplus or deficit minus the structural surplus or deficit.
question
5.2 government expenditure multiplier, tax multiplier (Understand Figure 13.11)
answer
- The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. Because government expenditure is a component of aggregate expenditure, an increase in government spending increases aggregate expenditure and real GDP.
- The tax multiplier is the quantitative effect of a change in taxes on real GDP. The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure. The tax multiplier effect on aggregate demand depends on these two opposing effects and is probably quite small.
- Figure 13.11: Potential GDP is $17 trillion, real GDP is $16 trillion, and there is a $1 trillion recessionary gap. An increase in government expenditure and a tax cut increase aggregate expenditure by deltaE. The multiplier increases consumption expenditure. The AD curve shifts rightward to AD1, the price level rises to 115, real GDP increases to $17 trillion, and the recessionary gap is eliminated.
- The tax multiplier is the quantitative effect of a change in taxes on real GDP. The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure. The tax multiplier effect on aggregate demand depends on these two opposing effects and is probably quite small.
- Figure 13.11: Potential GDP is $17 trillion, real GDP is $16 trillion, and there is a $1 trillion recessionary gap. An increase in government expenditure and a tax cut increase aggregate expenditure by deltaE. The multiplier increases consumption expenditure. The AD curve shifts rightward to AD1, the price level rises to 115, real GDP increases to $17 trillion, and the recessionary gap is eliminated.
question
5.3 limitations of the discretionary fiscal policies, time lags
answer
- Discretionary fiscal stimulus actions are also seriously hampered by three time lags: recognition lag, law-making lag, and impact lag.
- Recognition lag: the recognition lag is the time it takes to figure out that fiscal policy actions are needed. This process involves assessing the current state of the economy and forecasting its future state.
- Law-making lag: the law making lag is the time it takes congress to pass the laws needed to change taxes or spending.
- Impact lag: the impact lag is the time it takes from passing a tax or spending change to its effects on real GDP being felt.
- Recognition lag: the recognition lag is the time it takes to figure out that fiscal policy actions are needed. This process involves assessing the current state of the economy and forecasting its future state.
- Law-making lag: the law making lag is the time it takes congress to pass the laws needed to change taxes or spending.
- Impact lag: the impact lag is the time it takes from passing a tax or spending change to its effects on real GDP being felt.
question
Monetary policy objectives and Fed's goals
answer
- The Federal Reserve Act requires the Fed to use monetary policy to achieve maximum employment, stable prices, and moderate long-term interest rates.
- The goal of stable prices delivers maximum employment and low interest rates in the long run but can conflict with the other goals in the short run.
- The Fed translates the goal of stable prices as an inflation rate of between 1 and 2 percent per year.
- The FOMC has the responsibility for the conduct of monetary policy, but the Fed reports to the public and to congress.
- The goal of stable prices delivers maximum employment and low interest rates in the long run but can conflict with the other goals in the short run.
- The Fed translates the goal of stable prices as an inflation rate of between 1 and 2 percent per year.
- The FOMC has the responsibility for the conduct of monetary policy, but the Fed reports to the public and to congress.
question
Monetary policy instruments and decision-making strategies used by the Fed
answer
- The Fed's monetary policy instrument is the federal funds rate.
- The Fed sets the federal funds rate target and announces change to eight dates each year.
- To decide on the appropriate level of the federal funds rate target, the Fed monitors the inflation rate, the unemployment rate, and real GDP.
- A rise in the interest rate is indicated when inflation is above 2 percent, unemployment is below the natural rate, and real GDP is above potential GDP.
- A fall in the interest rate is indicated when inflation is below 1 percent, unemployment is above the natural rate, and real GDP is below potential GDP.
- The Fed hits its federal funds rate target by using open market operations.
- By buying or selling government securities in the open market, the Fed is able to change bank reserves and change the federal funds rate.
- The Fed sets the federal funds rate target and announces change to eight dates each year.
- To decide on the appropriate level of the federal funds rate target, the Fed monitors the inflation rate, the unemployment rate, and real GDP.
- A rise in the interest rate is indicated when inflation is above 2 percent, unemployment is below the natural rate, and real GDP is above potential GDP.
- A fall in the interest rate is indicated when inflation is below 1 percent, unemployment is above the natural rate, and real GDP is below potential GDP.
- The Fed hits its federal funds rate target by using open market operations.
- By buying or selling government securities in the open market, the Fed is able to change bank reserves and change the federal funds rate.
question
Monetary policy transmission - the effects of changes in the federal funds rate on other interest rates (short-term bill rate, long-term bond rate). Understand Figure 14.4.
answer
- A change in the federal funds rate changes other interest rates, the exchange rate, the quantity of money and loans, aggregate demand, and eventually real GDP and the price level.
- Changes in the federal funds rate change real GDP about one year later and change the inflation rate with an even longer time lag.
- Changes in the federal funds rate change real GDP about one year later and change the inflation rate with an even longer time lag.
question
The influence of monetary policy on real GDP and the price level.
answer
Real GDP decreases when price level rises.
question
How does the Fed fight recession and how does it fight inflation. Understand Figures 14.6 and 14.7.
answer
- Figure 14.6: In part (a), the FOMC lowers the federal funds rate target from 5% to 4%. The New York Fed buys securities in an open market operation and increases the supply of reserves from RS0 to RS1 to hit the new federal funds rate target. In part (b), the supply of money increases from MS0 to MS1, the short-term interest rate falls, and the quantity of money demanded increases. The short-term interest rate and the federal funds rate change by similar amounts. In part (c), the increase in the quantity of money increases the supply of bank loans. The supply of loanable funds increases and shifts the supply curve from SLF0 to SLF1. The real interest rate falls and investment increases. In part (d), the increase in investment increases aggregate planned expenditure. The aggregate demand curve shifts to AD0 + deltaE and eventually it shifts rightward to AD1. Real GDP increases to potential GDP, and the price level rises.
- Figure 14.7: In part (a), the FOMC raises the federal funds rate from 5 percent to 6 percent. The New York Fed sells securities in an open market operation to decrease the supply of reserves from RS0 to RS1 and hit the new federal funds rate target. In part (b), the supply of money decreases from MS0 to MS1, the short-term interest rate rises, and the quantity of money demanded decreases. The short-term interest rate and the federal funds rate change by similar amounts. In part (c), the decrease in the quantity of money decreases the supply of bank loans. The supply of loanable funds decreases and the supply curve shifts from SLF0 to SLF1. The real interest rate rises and investment decreases. In part (d), the decrease in investment decreases aggregate planned expenditure. Aggregate demand decreases and the AD curve shifts leftward from AD0 to AD1. Real GDP decreases to potential GDP, and the price level falls.
- Figure 14.7: In part (a), the FOMC raises the federal funds rate from 5 percent to 6 percent. The New York Fed sells securities in an open market operation to decrease the supply of reserves from RS0 to RS1 and hit the new federal funds rate target. In part (b), the supply of money decreases from MS0 to MS1, the short-term interest rate rises, and the quantity of money demanded decreases. The short-term interest rate and the federal funds rate change by similar amounts. In part (c), the decrease in the quantity of money decreases the supply of bank loans. The supply of loanable funds decreases and the supply curve shifts from SLF0 to SLF1. The real interest rate rises and investment decreases. In part (d), the decrease in investment decreases aggregate planned expenditure. Aggregate demand decreases and the AD curve shifts leftward from AD0 to AD1. Real GDP decreases to potential GDP, and the price level falls.
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