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Study Guide 3

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Department
Economics
Course Code
ECON 2001.01
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All

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H201 Study Guide 3 Chapter 12 – Aggregate Demand and Aggregate Supply Analysis 1. Explain the Wealth Effect, the Interest Rate Effect, and the International Trade Effect Wealth Effect: The effect price level has on consumption P down= W/P up, spending up The Interest Rate Effect: The effect price level has on investment P down= M/P up, interest rates down, spending up The International Trade Effect: The effect price level has on net exports P down= Exports up, imports down, net exports up, spending up 2. Name the three factors that could shift the AD curve 1. Change in expectations of households and firms 2. Change in price level 3. Change in government policy 3. Define Fiscal and Monetary Policy. Explain how Fiscal Policy and Monetary Policy could be used to shift the AD curve to the left or the right. Fiscal Policy: The changes in federal taxes and spending that are meant to attain macroeconomic policy objectives. Ad shifts right is government spending is up and taxes are down Monetary policy: the actions the federal reserve takes to monitor the money supply and interest rates in order to pursue macroeconomic policy objectives M up, M/P up, interest rates down, spending up 4. How do changes in expectations affect the AD curve? If people are more optimistic about their future incomes, instead of just waiting around they are willing to increase their consumption now instead of later. 5. How do changes in Foreign Variables such as exchange rates or the income level in foreign countries affect the AD curve The higher the income level in foreign countries, the better it is for our exports (shift right) If money depreciates in comparison to foreign currencies, exchange rates may change if money is worth less it is also good for our exports 6. What are four reasons which explain the upward sloping Short Run Aggregate Supply Curve? 1. Contracts make some prices and wages sticky 2. Firms are often slow to adjust wages 3. Menu costs make some prices sticky 4. Shortages and bottlenecks occur as economy approaches Yfe 7. Explain the Profit Effect and the Cost Effect Profit effect: When price level goes revenue increases faster than cost Cost effect: As economy approaches full employment level, shortages and bottlenecks occur which makes the slop of the short run aggregate supply curve is increasingly steep 8. How do the Profit Effect and the Cost Effect affect the slope of the Short Run Aggregate Supply Curve? Profit makes graph go up and cost makes it steep Some prices and wages are slow to adjust so price will increase faster 9. Name five factors that shift the Short Run AS curve 1. Size of labor force and capital stock 2. Expectations of future price level 3. Adjustments to workers and firms due to errors in past expectations of price level 4. Technology 5. Unexpected increase in price of important resource 10. Draw the AD-AS graph and indicate a Supply Shock – graphically and in words explain what will happen. Supply shock is when graph shift left or right due to an unexpected event 11.What is meant by “Validating Inflation”? Explain and draw the graph. Validating inflation is when economy is self correcting too slowly, so we shift Ad curve to speed it up by accepting a permanently higher price level and using monetary or fiscal policy 12. What will happen if the AD curve shifts to intersect Short Run AS to the right of the full employment level of Y? Explain and draw the graph Wages will adjust so that AD curves shifts to intersect AS curve at Yfe 13. Why do we draw the Long Run Aggregate Supply Curve as a vertical line? In the long run, it is AS if LRAS is vertical at Yfe 14. Name three factors that determine the long run level of real GDP. 1. Size of labor force 2. technology 3. size of capital stock 15. Does rising productivity growth reduce employment in the long run? No. People are against increasing productivity because they lose their jobs in the short run, but as wealth increases, new industries are created Chapter 11 – Output and Consumption in the Short Run 1. Why did the Classical School believe that the economy would always move to Yfe in the long run? They believe that the short run will always self correct so that AS intersects with AD at Yfe 2. What was the point that John Maynard Keynes was trying to make when he said, “in the long run we are all dead”? That the classical school wasn’t specific about how long the long run was. He though that it was important to know because markets take a very long time to reach equilibrium 3.What are the three leakages that must equal injections if the economy is to be at equilibrium? Savings+ total taxes+ imports = leakages 4. What is Say’s Law? Say’s law is that supply creates its own demand. In the time it take to produce something, people will have earned enough money to afford it. 5. Keynes said that in order to have equilibrium, it is necessary that planned_____ _______ spending equals income. 6. Define endogenous, exogenous, and autonomous Endo- determined within model Exo- determined outside of model Auto- constant within model 7. Leaving out Government spending and net exports, it is always true that savings equals _______investments______? 8. In the graph of the Keynesian model, what is the significance of the 45 degree line? The 45 degree line is the AS curve and equilibrium curve price level is exogenous 9. What are the 7 determinants of consumption spending? 1. Price Level 2. Taxes 3. income 4. credit availability 5. interest rates 6. wealth 7. expectations 10. What are the 6 determinants of investment spending? 1. Taxes 2. Interest rates 3. Technology and innovation 4. Size of capital stock 5. Expectations 6. Cash flow 11. Draw the Investment Demand Curve graph and write the Investment equation. Define “b” and explain it’s significance. What is the implication of b=0? Change in investment in response to change in interest rates I=constant I – bi B is the interest rate sensitivity of investment demand B=0 so I = constant I no matter what 12. What is the relationship between time since 1979 and real consumption? Increased pretty steadily 13. What has caused investment spending since 1979 to occasionally decrease? Occasionally decreases during recessions because people have negative attitudes 14. What has been the trend in real government purchases since 1979? Pretty pronounced increase, flat in 90’s but up overall 15. What happened to net exports between 1994 and 2004? Decreased by 100-150 bil, then increased, then decreased again in 95 and has been down since 16. What are 3 determinants of net exports? 1. Level of real GDP compared to GDP of other countries 2. Price level in U.S. compared to other countries 3. exchange rate in U.S. to other countries 17. What is the effect of a lower price level on the Quantity of Aggregate Demand? Q of AD increases 18. What is the “Engine” of the Keynesian model? Inventories 19. What is the difference between inventory investment and planned inventory investment? Inventory investment: goods not purchased Planned inventory investment: the more cars you have on a lot, the likelier it is that someone will buy one 20. Draw the Keynesian diagram and indicate areas of excess and depleted inventories – explain the movement toward equilibrium. Movement towards equilibrium where planned spending =’s income As above AD is excess AS is below AD is depleted 21. Graph the Consumption Function, write the Consumption equation, and indicate areas of autonomous and induced consumption consumption function is c= constant c- cy 22. Define MPC, APC, MPS, and APS Marginal prosperity to consume: change in C/change in Y: slope of consumption curve Average prosperity to consume c/y MPS marginal prosperity to save: change in s/change in Y slope of savings curve Average prosperity to save s/y 23. On the same graph, graph the consumption function and the implied saving function. 24. Graph equilibrium in the Keynesian model using the savings equals investment approach 25. Define the Paradox of Thrift and illustrate the answer to the paradox graphically if everyone decides to save their money, overall savings would be less. What is good for one person is not necessarily good for economy as a whole 26. What is the relationship between the MPC and equilibrium Y? the higher the MPC the higher the equilib
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