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Economic fluctuations model
Dynamic aggregate demand and aggregate supply model
Static models & dynamic models
Static models describe the economy at a point in time, while dynamic models describes how the economy evolves over time.
3 Relationships in the Economics Fluctuations Model
-The IS curve
-The MP curve
-AS curves
-The MP curve
-AS curves
IS Curve
, which represents the relationship between aggregate spending (=real GDP) and the real interest rate
MP Curve
represents how monetary policymakers react to inflation changing real interest rates. The IS and MP Curves together yield the aggregate demand (AD) curve
AS curves (short run and long run)
represent how inflation changes are real GDP deviates from its long-run trend (potential output). Taylor calls the short-run aggregate supply curve the inflation-adjustment (IA) curve.
Classical dichotomy
the theoretical separation of real and nominal variables, which implies that nominal variables do not affect real variables
Money neutrality
the property that a change in the money supply does not influence real variables
Key Difference Between Short Run & Long Run in Econ. Fluct. Model
Short run: wages & prices do not fully adjust (sticky inflation assumption s othat nominal variables like money supply and nominal interest rates can affect real variables, like real interest rates and real GDP. Classical dichotomty breaks down and money ins not neutral
Inflation in the short run
Slow to adjust. Sticky.
IS Curve in the Market for Good and Services
Represents Equilibrium
When does equilibrium occur?
When Real GDP (Y) equals planned aggregate spending: Y= C + I + G+ X or Y=PAE
Disposable income (Y-T) in IS Curve
The amount of income households have at their disposal after paying taxes and receiving any transfers from the government, like unemployment benefits or Social Security. T is net taxes. As disposable income increases so does consumption spending.
Real interest rate (R) in IS Curve
As the real interest rate increases, consumer spending falls since the cost of borrowing is higher.
Consumption Function
C=f (Y-T, r)
Planned Investment in IS Curve
Investment consists of business fixed investment (businesses' purchases of capital, new equipment and construction of structures), residential fixed investment (household purchases of new homes), and inventory investment
What happens to planned investment when the real interest rate increases in the IS Curve?
The cost of borrowing is higher, so firms will purchase less capital and households will purchase fewer new homes. I=I(r)
Expected revenue from selling the product made with the capital (IS Curve)
More expected revenue, higher expected rate of return, more investment at any given real interest rate.
Price of Capital (IS Curve)
The higher the price of capital, the lower the expected rate of return, and the less investment at any given real interest rate.
The Cost of using the capital (IS Curve)
The more costly it is to use the capital, the lower the expected real rate of return, and the less investment at any given real interest rate.
Government Spending (IS Curve)
-Government spending is exogenously determined and bears no systematic relationship to the other variables in the model -Same thing about net taxes (T)
-If G and/or T changes, then the IS curve shifts since spending has changed at any given real interest rate -Government sometimes responds to recessions or expansions, but we will look at this on case-by-case basis
-If G and/or T changes, then the IS curve shifts since spending has changed at any given real interest rate -Government sometimes responds to recessions or expansions, but we will look at this on case-by-case basis
Money neutrality
the proposition that changes in money have no real effect on the economy in the long-run and only affect other nominal variables
Suppose that an economy is currently not in short-run equilibirum (spending balance) and production is greater than planned aggregate expenditures (Y>PAE). In this case, there would be an unexpected ___________ in inventories, which would provide a signal to firms to _______________ production.
Increase; decrease
The IS curve describes the _________ relationship between ___________ and _______________.
negative; real interest rate; real GDP
If the real interest rate rises in the IS curve, then...
there is an upward movement along the IS curve
If net taxes decrease then the IS curve...
shifts right!
Monetary Policy (MP) Curve
Describes how the Federal Reserve reacts to inflation r=r(pi). The monetary policy reaction function or monetary policy rules says that the Fed Reserve increases the real interest rate when inflation increases, and decreases the real interest rate when inflation decreases.
1977 Amendment to the 1913 Federal Reserve Act
Established two key objects for monetary policy: maximum employment and stable prices
Stable prices
interpreted to mean a low and stable inflation rate
Maximum employment
interpreted to mean keeping the economy lose to potential output.
What is the main policy tool that the Federal Reserve uses?
The Federal Funds Rate
What is the federal funds rate?
The overnight interest rate on loans between commercial banks
What happens if the market federal funds rate goes about the target rate?
The Federal Reserve buys government bonds, which increases reserves in the commercial banking system and lowers the federal funds rate.
What happens if the market federal funds rate goes below the target rate?
The Federal Reserve sell government bonds, which decreases reserves and increases the federal funds rate.
What principle does the Fed use in order to raise real interest rates when inflation increases?
The Taylor Principle
The Taylor Principle
When inflation increases by 1 percentage point, the Fed must increase nominal interest rates by more than 1 percentage point to increase the real interest rate
What does the Federal Reserve do when inflation falls by one percentage point?
The Federal Reserve must lower nominal interest rates by more than one percentage point to decrease real interest rates.
The Aggregate Demand Curve
Intersections of the IS and MP curves. Chain of reasoning: Increase in inflation --> increase in real interest rates ---> C lower, I lower, X lower --> decrease in Y
The AD curves shifts right (left) if the IS curve shifts right (left)
-Exogenous increase in C (due to increased wealther, more optimistic expectations of the future, reduced uncertainty, greater availability of credit, or lower taxes, T)
-Exogenous increase in I (due to higher expected real rates of return)
-Exogenous increase in G
-Exogenous increase in X (=Ex-IM)
-Exogenous increase in I (due to higher expected real rates of return)
-Exogenous increase in G
-Exogenous increase in X (=Ex-IM)
Why does the short-run Aggregate Supply (SRAS) or inflation-adjustment (IA) curve not depend on the current level of GDP (i.e. the SRAS or IA is horizontal in the short-run)?
Because inflation is sticky in the short-run.
What happens to the Long-run Aggregate Supply (LRAS) curve in the long-run?
The LRAS curve is vertical at potential output in the long run because the economy will return to potential output.
What happens to the SRAS and LRAS curves if the economy is above potential output or below potnetial output?
The SRAS will shift up or down. If the economy is above potential output, inflation increases. If the economy is below potential output, then inflation decreases.
What are price shocks?
Sudden increases (or decreases) in oil prices, agricultural prices, or other commodity prices
What do price shocks do to the SRAS (IA) curve?
An exogenous shift. For example, higher oil or other commody prices shifts up the SRAS curve (negative price shocks). Lower price shifts down the SRAS curve (positive price shocks).
Explain the slope of the AD Curve.
A change in inflation causes the real interest rate to change, which results in a change in spending and real GDP. The Fed reacts to inflation.
What effect would a decrease in the real rate of interest due to a decrease in the inflation rate have on the AD curve?
Cause a movement along the AD curve.
What effect would a decrease in the rate of inflation have upon the AD curve?
Cause a movement along hte AD curve.
What effect would an increase in government purchases ahve upon the AD curve?
Cause the AD curve to shift to the right.
What effect would a decision by the Fed to decrease the nominal interest rate have upon the AD curve?
Cause it to shift to the right.
Suppose that there is an adverse price shock, such as a dramatic increase in the price of oil. Using the economic fluctuations model, what is the effect in the short-run?
The effect on net exports is ambiguous.
Suppose that there is an adverse price shock, such as a dramatic increase in the price of oil. Using the economic fluctuations model, what happens in the short-run?
The effect on net exports is ambiguous!
Using the economic fluctuations model, what would be the impact of change from an incomte tax to a consumption tax (that both bring in the same amount of tax revenue each year) on the investment spending in the short run?
It would be unaffected.
Using the economic fluctuations model, what would be the impact of change from an income tax to a consumption tax (that both bring in the same amount of tax revenue each year) on the investment spending in the long run?
It would go up.
Using the economic fluctuations model, what would be the impact of change from an income tax to a consumption tax (that both bring in the same amount of tax revenue each year) on the inflation rate in the long run?
It would go down.
Who developed the Paradox of Thrift?
John Maynard Keynes.
Paradox of Thrift
(aka Paradox of Saving or Saving Paradox) The paradox is that while saying is beneficial in the long run (more capital accumulation and higher labor productivity), in the short run, higher savings lead to decreases in AD and recession.
Stabilization Policy
Policy enacted by governments and central banks to keep economic growth stable, along with inflation and unemployment
Main two tools of stabilization policy
Fiscal policy (government spending, transfer spending, & taxes) and monetary policy (federal funds rate, aka open market operations, discount rate *lender of last resort, reserve requirements)
Since monetary policy, in particular, has a long impact lag, how long will it take for changes in interest rates today to substantially impact the economy?
12-18 months in the future
Monetary policy has a longer _________ lag while fiscal policy typically has a longer _______ lag.
Impact; implementation
The aim of countercyclical fiscal policy
shift the aggregate demand curve so that real GDP equals potential GDP
Great Recession
December 2007 until June 2009
How did the monetary policy during the Great Depression of the 1930s made things much worse.?
-The fed failed to act as a lender of last resoirt and 1/3 of US banks failed (9,000 failures) in three waves of banking panics. -Bank failures led to large reductions in the money supply, causing deflation, and high real interest rates, which reduced spending and output.
-Fed didn't distinguish between nominal and real interest rates. They thought they were being expansionary with near zero nominal interest rates.
-Fed didn't distinguish between nominal and real interest rates. They thought they were being expansionary with near zero nominal interest rates.
Similarities between Great Depression and Great Recession
-Both periods preceded by home construction boom (8% of GDP in mid-1920s and 6.2% peak in 2005)
-Both periods preceded by financial innovation (Mutual funds and margin buying in the 1920s; mortgage-backed securities and no money down mortgages in 2000s)
-Both periods preceded by diminished government regulations and lax enforcement of existing rules (1920s and 2000s dominated by belief in the "free market")
-Both periods preceded by financial innovation (Mutual funds and margin buying in the 1920s; mortgage-backed securities and no money down mortgages in 2000s)
-Both periods preceded by diminished government regulations and lax enforcement of existing rules (1920s and 2000s dominated by belief in the "free market")
Financial markets and financial institutions perform two critical tasks for the economy
Allocating savings and managing risk
Rapid financial "innovation"
-Large increase in # of adjustable-rate mortgages
-Negative amortization loans, "Liars" loans, Loans in excess of the value of your home and more!
-Mortgage-backed securities and collateralized-debt obligations (CDOs)
-Credit default swaps (CDSs) and other derivatives
-Negative amortization loans, "Liars" loans, Loans in excess of the value of your home and more!
-Mortgage-backed securities and collateralized-debt obligations (CDOs)
-Credit default swaps (CDSs) and other derivatives
Collateralized debt obligation (CDO)
turbo-charged version of a mortgage-backed security. Made up of a pool of individual mortgage loans or, more commonly, a pool of mortgage-backed securities
Sources of Federal Revenue
40% Payroll Taxes, 9% Corporate Income Taxes, 41% Individual Income Taxes, & 10% Other
Federal Expenditures
Net Interest 6%, Social Security 20%, Income Security 18%, Medicare/Medicaid/Health 24%, National Defense 20%, Other 12%
What's the "other 12%"?
Road/Bridges/Infrastructure, wages/benefits of all federal employees, foreign aid, and border security, national institute of health and the national science foundation, the food and drug administration, the enivronmental protection agency, federal financial aid to students, & farm subsidies
Referendum
A vote in which citizens accept or reject a proposal such as a law passed by their legislature.
Recall
A vote to remove an elected official from office before the official's term expires
Initiative
A measure put on the ballot by a petition of citizens. A proposition is an initiative that has qualfiied for a ballot and recevied a # (ie Prop 13)
Prop 13
-Tax on residential and commercial real estate "shall not exceed one percent (1%) of the full cash value of such property"
-Property taxes based on 1975 assessed values and restricted to annual incrase to 2 percent per year. It prohibited reassessment to a new base-year value except for a change in ownership or completion of new construction
-Businesses have been the big winner, getting about 63% of the tax savings since 1978
-Required a 2/3rd majority in both legislative houses for future increases of any state tax rates or amounts of revenue collected, including income tax rates. It also required a 2/3rds vote majority in local elections for local governments wishing to increase special taxes.
-A supermajority for spending increases had been introduced in 1933 and extended to all spending in the 1960s
-Property taxes based on 1975 assessed values and restricted to annual incrase to 2 percent per year. It prohibited reassessment to a new base-year value except for a change in ownership or completion of new construction
-Businesses have been the big winner, getting about 63% of the tax savings since 1978
-Required a 2/3rd majority in both legislative houses for future increases of any state tax rates or amounts of revenue collected, including income tax rates. It also required a 2/3rds vote majority in local elections for local governments wishing to increase special taxes.
-A supermajority for spending increases had been introduced in 1933 and extended to all spending in the 1960s
More on Prop 13
-After Prop 13, California became the only state which needed a supermajority for both spending and tax changes.
-Led to "tyranny of the minority" and what game-theorists call "hostage taking"
-Led to "tyranny of the minority" and what game-theorists call "hostage taking"
In the spending allocation model, what best explains what will happen if the government purchases share of GDP falls?
The investment, consumption, and/or net export share of GDP will rise.
Suppose the exchange rate in the year 2010 was 1 euro per dollar, and in 2011 the exchange rate increased to 2 euros per dollar. If the price of a German sweater was 50 euros in both years, the new dollar price in 2011 would be ____ and imports of German sweaters would ____.
$25, increase
A higher real interest rate in the spending allocation model
causes the exchange rate to increase, which results in a decline in the share of net exports.
What best explains what is meant by the term "crowding out"?
An increase in government purchases causes interest rates to rise and results in a decline in investment expenditures.
Which of the following would cause the national saving rate to increase for any given interest rate?
C. An exogenous decline in the government share of GDP.
Consider the following linear spending allocation model:
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.20
X/Y* = 0-r
What is the equilibrium real interest rate (r) in this economy? Note that r = 0.06, for example, is a real interest rate of 6 percent.
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.20
X/Y* = 0-r
What is the equilibrium real interest rate (r) in this economy? Note that r = 0.06, for example, is a real interest rate of 6 percent.
5%
Consider the following linear spending allocation model once again:
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.20
X/Y* = 0-r
What is the investment share in equilibrium?
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.20
X/Y* = 0-r
What is the investment share in equilibrium?
0.11
Consider the following linear spending allocation model once again, but with one change. Now the government spending share is 0.25 instead of 0.20.
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.25
X/Y* = 0-r
As a result of this change, the real interest rate is now _______ percent and the investment share has _____________ to _____________.
C/Y* = 0.75 - 0.2r
I/Y* = 0.15 - 0.8r
G/Y* = 0.25
X/Y* = 0-r
As a result of this change, the real interest rate is now _______ percent and the investment share has _____________ to _____________.
7.5 percent, decreased, 0.09
Assume that the government budget was balanced when the government spending share was 0.20, but that taxes did not change when the government spending share increased to 0.25. The linear, numerical, spending allocation model in the questions above is consistent with:
both crowding out and the twin deficits.
Using the savings and investment diagram from Chapter 7, we can illustrate the increased government spending share as:
a leftward shift in the national savings rate function.
The natural unemployment rate is the unemployment rate
when real and potential GDP are equal.
Structural unemployment occurs because
people have insufficient skills.
If more women decide to enter the labor market,
the labor force participation rate will immediately increase.
During a recession, people may drop out of the labor force because they are unable to find a job. All else the same, this causes
the unemployment rate to decrease.
Greater labor force participation for households at higher real wage rates is one reason that
the supply of labor curve is upward-sloping.
If prices rise faster than nominal wages,
real wages will decrease.
The minimum-wage, insider-outsider, and the efficiency-wage explanations all seek to explain
why the real wage is above the perfectly competitive equilibrium real wage.
According to the job-search explanation of unemployment,
the equilibrium amount of employment constantly fluctuates.
Suppose that 180 million people are in the labor force and 162 million people are employed. In this economy, the unemployment rate is
10 PERCENT
Higher unemployment caused by higher unemployment compensation can be explained by
the job-search theory
Technological advances generally result in
increased life expectancy
Growth in real GDP per capita for the world economy was greatest during
20th century
Nonrivalry means that
the use of a good by one individual does not preclude its use by another individual.
Which of the following is a reason why the coefficient corresponding to the growth rate of capital per hour of work is one-third in the Solow growth accounting formula in the textbook?
capital income is approximately one-third of aggregate income.
Suppose that the capital stock grows at the same rate as worker hours and there is positive technological progress. This would cause
an upward shift in the per-worker-hour production function.
An undeveloped economy produces goods and services which rely heavily on natural resources. It is described by the following production function:
Y = TK1/4Z1/2L1/4
where Y is real GDP, T is technology, K is physical capital, Z is natural resources, and L is aggregate hours of work.
If there is no growth in labor productivity, and both the capital stock (K) and natural resources (Z) are constant, with population and labor hours growing at 2 percent per year, what is the growth rate of technological progress in this economy?
Y = TK1/4Z1/2L1/4
where Y is real GDP, T is technology, K is physical capital, Z is natural resources, and L is aggregate hours of work.
If there is no growth in labor productivity, and both the capital stock (K) and natural resources (Z) are constant, with population and labor hours growing at 2 percent per year, what is the growth rate of technological progress in this economy?
1.5 percent
Intellectual property laws arise as a result of:
nonexcludability
According to material presented in lecture, all of the following are potentially fundamental causes of economic growth except:
human capital
Because of diminishing returns, an economy can continue to increase real GDP per hour worked only if
there is technological change
Which of the following functions of money would be violated if inflation were extremely high?
store of value
M1 includes
traveler's checks. currency. checking account deposits.
The Federal Open Market Committee consists of the seven members of the ________, the president of the Federal Reserve Bank of New York, and ________.
Federal Reserve's Board of Governors; four presidents from the other 11 Federal Reserve banks
The main tool that the Federal Reserve uses to conduct monetary policy is
open market operations
To increase the money supply, the Federal Reserve could
conduct an open market purchase of Treasury securities.
Using the quantity equation, if the velocity of money grows at 5 percent, the money supply grows at 10 percent, and real GDP grows at 4 percent, then the inflation rate will be
11 percent
According to the quantity theory of money, the inflation rate equals
the growth rate of the money supply minus the growth rate of real output.
Most hyperinflations are the result of
large budget deficits and seigniorage.
Suppose that an economy is currently not in short-run equilibrium (spending balance) and Y<PAE. In this case, there would be an unexpected _________ in inventories, which would provide a signal to firms to _________ production.
decrease; increase
In order for the aggregate demand (AD) curve to be downward-sloping,
there has to be an inverse relationship between the real interest rate and real GDP and a positive relationship between inflation and the real interest rate.
The positive correlation between real interest rates and inflation is best explained by examining
the behavior of central banks.
`When the Fed wants to raise nominal interest rates, it
sells government bonds
Suppose an economy existed in which investment, net exports, and consumption were not sensitive to changes in interest rates. For this economy, the AD curve would
be vertical
When inflation increases,
there is an upward movement along the aggregate demand curve.
The FOMC can change the real interest rate in the short run if:
inflation is slow to adjust
Which of the following would cause the AD curve to shift to the right?
Increase in government purchases
An increase in the target inflation rate will
cause a rightward shift of the AD curve.
The inflation adjustment line is used to
describe how firms and workers act to set prices and wages in the economy.
The IA (SRAS) line will move down if
real GDP falls below potential GDP.
If the economy is in a recession, it is likely that
the aggregate demand curve intersects the inflation adjustment line at a level of real GDP that is less than potential GDP.
If real GDP is below potential GDP,
long-run equilibrium will be achieved once inflation has stopped declining.
Which of the following would lead to a lower inflation rate in the long run?
A permanent decrease in consumer confidence.
The short-run effect of an oil price increase is
an upward shift of the inflation adjustment line.
The long-run effect of an increase in oil prices is a
downward movement of the inflation adjustment line until the rate of inflation returns to the baseline rate at potential output.
In which decade did the U.S. economy experience stagflation?
1970s
Starting from potential output, if consumer confidence permanently increases and consumers decide to spend more, then this will generate a(n) _____ gap and inflation will eventually _____.
expansionary; increase
Suppose that there is an exogenous fall in consumption spending, using the economic fluctuations model, net exports should ________ in the short run and _________ in the long run.
increase; increase
Collateralized-debt obligations (CDOs) are:
a type of mortgage-backed security.
According to the Taylor Rule,
interest rates were kept too low from 2001 to 2006.
By 2010, real housing prices in the United States
were still well above long-run historical levels.
For the bank, leverage is
the ratio of total liabilities to net worth.
In the economic fluctuations model with risk, an increase in the risk premium, associated with a financial crisis, is represented by:
an upward shift in the MP curve.
This year, net interest on the debt is:
a smaller part of federal expenditures than national defense.
If there is an increase in the risk premium, then
the AD curve shifts left
Deflation is costly since it:
increases real interest rates.
Compared to other advanced economies,
the United States spends more per capita on health care, but also ranks well below many other countries in terms of life expectancy.
Primary and secondary public education in California
were once among the best in the United States, but have gotten relatively worse in recent decades.
A referendum
is a vote in which the citizens accept or reject a proposal such as a law passed by their legislature.
Proposition 13 did NOT
required a two-thirds (supermajority) vote for any spending increases
The largest expenditure category for California state government is:
K-12 Education
According to the material from lecture, fiscal and monetary policy responses during the Great Recession
prevented the Great Recession from turning into another Great Depression
The fastest growing component of federal expenditures over the next fifty years is expected to be
Medicare and Medicaid
All of the following are similarities between the Great Depression and the Great Recession except:
Both periods were preceded by overly expansionary monetary policy.
State spending in California, relative to personal income,
peaked around 1980, and is lower now than at any other time in the past thirty years.
A negative externality exists if
the marginal social cost of producing a good or service exceeds the marginal private cost
Why does a monopoly cause a deadweight loss?
because it doesn't produce some output for which marginal benefit exceeds marginal cost
In the supply and demand model, the equilibrium price for a good is
an endogeneous variable
If production involves increasing opportunity costs, then moving nearer to the horizontal axis on a production possibilities curve diagram will increase the opportunity cost of:
producing the good on the horizontal axis
When economists explain the relationship between the price of hotdogs and the # that consumers will buy, the ceteris paribus assumption implies that
factors other than the price and quantity of hotdogs purchased are constant
If cross-price elasticity between two goods is positive, then it is most likely that the two goods are
substitutes
If quantity supplied is less than quantity demanded in a perfectly competitive market, then
the market price will rise until equilibrium is achieved
Adverse selection in employment is more likely to occur when
people's abilities are difficult for potential employers to observe
Suppose that Milton buys collision insurance for his car and then drives it recklessly. This is an example of
moral hazard
What are the characteristics of private goods?
-Consumption of them can generate pos and neg externalities
-Rival/excludable
-Rival/excludable
The income effect of an increase in the price of salmon
refers to the effect of a consumer's purchasing power which causes the consumer to buy less salmon, holding all other factors constant
In economics, the accumulated skills and training that workers have is known as
human capital
A plague causes the deaths of a large proportion of the working-age population in the country of Alpha. As a result, the real wage in Alpha ____ and employment in Alpha ___________.
Increases; decreases
Governments contribute to increase labor productivity by
-Establishing well-defined property rights
-Maintaining political stability
-Allowing the free/open exchange of ideas
-Maintaining the legal system
-Maintaining political stability
-Allowing the free/open exchange of ideas
-Maintaining the legal system
A shady bench on a hot day in a public part is an exmaple of a good that is
rivalrous and nonexcludable
Globalization and skill-biased technological changes have contributed to
increasing wage inequality
If frictional rate of unemployment equals 3 %, the structural rate of unemployment equals 4%, and the cyclical rate of unemployment equals 2 percent, then the natural rate of unemployment equals
7%
If domestic saving is greater than domestic investment, then a country will have
a trade surplus
I'm still confused about the different effects of risk and risk premium on the MP, AD, and IS curves. For example, if there is an increase in risk premium, what happens to the IS and MP curves?
If risk increases, then it is more expensive to borrow since commercial banks will require a higher interest rate in order to lend money (since they believe that borrowers are less credit worthy). The increase in the risk premium raises real interest rates, and this is shown as an upward movement of the MP curve that is independent of the inflation rate. So, only the MP curve shifts up due to greater risk.
Would an increase in the nominal interest rate cause the AD curve to shift to the left?
if the reason the Fed increases interest rates is due to an increase in inflation, then it's just an upward movement along an AD curve. If the Fed raises real interest rates at any given level of inflation, then the AD curve shifts left. As I mentioned in class, this is the hardest part of the model. Under normal circumstances, the Fed reacts endogenously to inflation. If that's the case, then that's what the AD curve shows, so it's just a movement along the AD curve. The Fed, however, can also respond exogenously by changing interest rates for a reason other than a change in inflation. If that's the case, then the AD curve shifts.
If there's a change from an income tax to a consumption tax (that both bring in the same amount of tax revenue each year), why does the investment spending go up in the long run but is unaffected in the short run? What's the difference between the long run and the short run?
if consumption falls, the IS curve and AD curves shift left. In the short run, inflation is constant (the SRAS or IA curve is flat). Since inflation doesn't change in the short run, the Fed doesn't change real interest rates so that investment doesn't change. In the long-run, however, the recessionary gap means that SRAS shifts down until the economy is back at potential output but at a lower inflation rate. As a result of the lower inflation rate, the Fed sets a lower real interest rate, which causes investment spending to rise in the long-run.