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ECON 104 Final Exam
Terms in this set (95)
What happens when a shift in aggregate demand is offset by a shift in aggregate supply?
1. AD falls
2. GDP falls below potential
3. unemployment rises
4. wage rates fall
5. AS shifts down
Is equilibrium below potential GDP still equilibrium?
No, because of disequilibrium in the labor market.
Keynes' General Theory
wages are inflexible downward b/c people don't like their wages reduced
effect: the AS curve won't shift out enough to restore potential GDP
changes in ___________ are the major source of instability
what is consumption and what is it determined by?
1. how much households spend
2. how much they earn (AKA disposable income)**, household wealth, debt and expectations
consumption = autonomous consumption + induced consumption
C = AC + MPC (DI)
how much you'd spend if you had NO current disposable income
how much you spend because you earn your current disposable income
what are keynes' two assumptions?
1. autonomous consumption is a constant
2. induced consumption is a constant percentage of disposable income (MPC)
Marginal Propensity to Consume (MPC)
the constant percentage that induced consumption is of disposable income
what are the functions that relate consumption and saving?
DI = C + S
MPC + MPS =1
purchases of structures, equipment, and intended changes in inventories
planned investment + unintended changes in inventories
the lower the ______, the higher the number of profitable investment opportunities
real interest rate (cost of borrowing money)
investment is unstable because:
1. The real interest rate is unstable
- this is caused by inflation
2. Investment demand is unstable
- demand is based on expected profitability of investment
investment is modeled as being a ______________ of disposable income
Government activity consists of
purchases, taxes, transfers
- purchases independent of DI
- taxes reduce DI
- transfer payments increase DI
Net exports relationship to disposable income
Exports: not related
Net exports: negative
What are the definition and formula for aggregate expenditures?
1. All expenditures expected at a given level of income
2. = C + IP + G + NE
(same as GDP except for unintended changes in inventories)
if AE < GDP
inventories are accumulating
if AE > GDP
inventories are being drawn down
what drives the economy to equilibrium and when does it occur?
unintended inventory changes; when GDP does not = AE
when inventories are being drawn down, businesses:
when inventories are building up, businesses:
cut back on production
only when _______________, is there no pressure to change GDP
unintended inventory change is 0 (that is, when nothing is happening that businesses don't want to happen)
the economy is in equilibrium when:
1. GDP = AE
2. I = Ip
3. when unintended inventory changes = 0
4. when saving = planned investment
What causes a recession?
a reduction in any component of AE; means that anything that influences any of the AE components can
How do you fix a recession?
Increase aggregate demand through government spending
What is the multiplier?
where a small initial change expands into a big final change (b/c of the circular flow of the economy)
- each time money is spent, it is paid to someone, they spend part and save part and it goes to someone else
what determines the size of the multiplier?
how much of the consumer's DI is spent; their MPC
what is the formula for the multiplier?
1 / (1 - MPC)
OR 1 / MPS
What is the formula for GDP with the injections into the economy on the left and the leakages on the right?
Ip + G + X = S + T + M
What happens to an economy in equilibrium if Ip increases?
1. Injections exceed leakages
- that is, aggregate expenditures exceed aggregate production
2. Inventories are drawn down
3. Firms increase production
4. This increases household income
5. This increases S, T, and M
6. Process continues until leakages rise to balance higher injections
How can the govt. practice expansionary fiscal policy to increase aggregate demand?
Via spending or via taxes or transfers
What are the 3 types of lag in fiscal policy?
Recognition lag, administrative lag, operational lag
it takes time for policy makers to realize that we have entered the downswing of the business cycle (they end before we know they've started)
changes in taxes and spending generally have to be passed by congress (long and difficult process), even if all members of congress agree spending changes are needed, disagree about which programs to change
Appropriated funds are not immediately spent
Even when spent, the multiplier process takes time to work
What is the result of the fiscal policy lags?
by the time an expansionary fiscal policy takes effect, the economy may have recovered by itself, and the expansionary policy pushes the economy into overheating
What are automatic stabilizers?
fiscal policy can be made to work automatically; that is, without any policymaker in government actually doing anything
programs that automatically increase government spending when the economy contracts, and automatically decrease government spending when the economy expands (also avoid lags)
What are the major automatic stabilizers?
taxes, unemployment insurance, and welfare programs
What does making a household budget involve?
balancing income and expenditures
What are the steps in creating the federal budget?
1. The President develops a proposed budget
- (assisted by staff, OMB, Treasury, Council of Economic Advisors, various govt. agencies)
2. The Congress modifies the proposed budget
a. Starts in the House
- Appropriations considers spending
- Ways and Means considers taxes
b. Senate reviews what the House passes
c. Differences go to a conference committee
d. Both Houses then vote on reconciled bills
3. President signs or vetoes each bill in its entirety
- line item veto was declared unconstitutional
4. Federal agencies actually spend money and collect taxes
What are the differences between a household budget and a federal budget?
less people involved, changed much more quickly, smaller, and informal
What are the similarities between a household budget and a federal budget?
1. Both must balance income and expenditures
2. Both have a large "unavoidable" component
3. Both cause headaches, fights, tension, and hard feelings
What is the difference between a govt deficit and surplus?
1. when the gov. spends more than it collects in taxes in a year
2. when the gov. spends less than it collects in taxes in a year
What are the differences between federal debt and household debt?
1. Household debt must someday be repaid
2. Household debt is owed to outsiders
3. Federal debt can be monetized
What is the relationship between the deficit and aggregate demand?
the bigger the deficit, the larger the net increase in aggregate demand
(b/c consumption and DI are reduced by taxes)
What is crowding out?
More government borrowing raises the interest rate
- this decreases private investment
What is the high value of the dollar?
High real interest rate increases foreign demand for dollars
This raises price of dollar in terms of foreign currencies
This raises price of our exports, and this decreases our exports
What is Ricardian equivalence?
Consumers realize that bigger budget deficit now means higher taxes later
- so they decrease consumption now in anticipation of higher taxes later
What is the time difference between deficit and debt?
Deficit happens over a one year period, while debt is accumulated deficits over time
What is the high employment deficit?
how big the deficit would be if we were at the natural rate of unemployment
- should be 0: we should have a balanced budget when the economy is at potential GDP
What is foolish debt for the government?
debt that doesn't help generate a growing economy
What is the Gramm-Rudman Act?
required across-the-board cuts in the budgets of Federal agencies
- it was supposed to eliminate the deficit by 1993
How did the unwritten agreement of the govt to balance the budget go away?
This ended in the 1930's
- The depression was the critical event
- Keynesian economic theory provided the justification
Ideally, we should balance the budget over the business cycle. How?
- run a deficit during contractions
- run a surplus during expansions
What is money?
anything that you can take into a store and exchange for goods and services
What are the two types of money?
Commodity money and Fiat money
What is commodity money?
the money has intrinsic value (can be used for something other than money)
What is fiat money?
money that has little to no intrinsic value (good for nothing except as money)
What is M1?
currency, demand deposits, other checkable deposits, traveler's checks
What is M2?
M1 plus some near-monies, includes savings accounts
How do you graph the money market?
with the quantity of money on the x-axis and the price of money aka the interest rate on the y-axis
What causes a change in the demand for money?
changes in nominal GDP
either an increase in real GDP or an increase in the price level
What determines the equilibrium interest rate on a money graph?
the intersection of downward sloping money demand with fixed money stock (supply of money)
What happens to the money graph if price level rises?
- shifts money demand outward
- increases equilibrium interest rate
- this is the real interest rate effect we looked at earlier
What is fractional reserve banking?
A bank doesn't keep enough money on hand to pay all of its depositors
- percent that it keeps is called the reserve ratio (defined by federal reserve)
What does the FDIC do to prevent runs on the bank and earn depositors trust?
guarantees deposits of up to $250k
How does the balance sheet for the banks work?
Assets are things owned or owed to the bank
- reserves, loans, government securities, real property
Liabilities are things owed by the bank
- deposits: owed to depositors
- net worth: owed to bank owners
By definition, assets = liabilities
- the two sided of the balance sheet must balance
What are reserves?
- money that the bank keeps on hand to meet any immediate liabilities
- like when a depositor wants to withdraw some money
What is the formula for required reserves?
Required reserves = deposits x required reserves ratio
What are excess reserves?
reserves above what is required (Reserves - required reserves = excess reserves)
Why do banks make loans?
- to earn interest on the money they loan
- the interest earned must be balanced against the risk of default
What is the reserve multiplier formula?
Multiplier = 1 / required reserve ratio
What do federal reserve banks do?
issue currency, there are 12; board of governors set reserve requirements
What does the federal open market committee do?
decides about buying and selling gov. securities
What is the monetary base?
currency in circulation plus total bank reserves (doesn't include loans and securities or demand deposits)
What are the tools to control the monetary base?
a. required reserve ratio
b. discount rate (rate @ which member banks can borrow from the fed)
c. open market operations (buying & selling gov. securities)
-- they affect the banks' excess reserves, influencing how many loans banks make, affecting money supply
What are the formulas for the discount and yield of treasury bills?
discount = face value - price
yield = discount / price
what are the formulas for coupon interest, discount, and yield for coupon bonds?
coupon interest = face value x coupon yield
discount = face value - price
yield = (coupon interest + discount) / price
How does expansionary monetary policy work?
1. Fed buys securities
2. This increases monetary base
3. This increases excess reserves
4. This leads banks to make more loans
5. This increases supply of money
6. This lowers interest rate
7. This increases investment
8. This increases aggregate demand
What are the monetary policy prescriptions in a recession and in an overheated economy?
a. In a recession : expansionary monetary policy
b. In an overheated economy : contractionary monetary policy
What is the argument of the monetarists involving monetary policy?
They argue that the rate of growth of the money supply is extremely important
- it should grow at the same rate as the growth of real GDP
What is the equation of exchange?
MV = PQ, heart of classic analysis of monetary policy
M= money supply
V= velocity of money
P= price level
Q= real GDP
2 sides must be equal
What is MV?
total expenditures (the number of dollars times how often each is spent)
What is PQ?
total expenditures (the average price times the number purchased)
What is the relationship between unemployment and inflation?
Inverse; lower inflation means higher unemployment
What does the phillips curve do?
Originally devised by a New Zealand economist (Phillips) to explain relationship between rate of change of wages (wage inflation) and unemployment
What is the natural rate of unemployment?
the unemployment rate when excess demand is zero
- that is, the level of unemployment that would naturally prevail if labor markets were not distorted by excess demand
What is the formula for the average tax rate?
tax paid / income
What is the formula for marginal tax rate?
marginal tax rate = (change in earned income - change in disposable income) / change in earned income
What are the factors that affect growth?
Quantity of labor
* Birth rate and immigration
Quantity of natural resources
* Fixed : given level of technology and price of resource
Quantity of physical capital
* Business investment
* Infrastructure (largely government investment)
Quality of labor
* Human capital investment
* Research and development
* Investment is either from retained earnings (business savings) or from borrowing (private savings)
What is the population bomb?
overpopulation will lead to disaster
Why are all predictors of disasters wrong?
They ignore technological change and they ignore market adjustments (how people respond when the price of something rises)
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