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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

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

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)

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.

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")

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

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


A vote in which citizens accept or reject a proposal such as a law passed by their legislature.


A vote to remove an elected official from office before the official's term expires


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

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"

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.


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?


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 _____________.

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


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?

1.5 percent

Intellectual property laws arise as a result of:


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?


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

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