Last Stuff Quiz Review

& Self-Correcting Economy Short-run vs. long-run & Self-Correcting Economy

What is the difference between the short-run and the long-run in economics? In the short-run workers wage and other input costs (like raw materials, energy, etc.) are “sticky” and do not adjust to increases in inflation. Over time, however, workers demand and receive raises, causing the per-unit cost of production to increase. As such, the AS curve shifts leftward, restoring the economy to the full-employment level of equilibrium real GDP.

If an economy is facing the condition shown on the next slide, what is true about the long-run equilibrium of the economy depicted? (SR vs. LR analysis)

Inflationary Gap: AD/AS PL LRAS SRAS PLe AD YF Ye GDPr

As wages and other input costs increase, the per-unit cost of production would go up and the SRAS will shift to the left to restore long-run equilibrium. Why? At first, workers don’t realize that their real wages (buying power) have gone down. As such, input costs are “sticky” and businesses can make higher profits. Over time, however, workers demand and receive wage increases (become “flexible”), thus causing the per-unit cost of production to increase, shifting the AS curve leftward, restoring the economy.

This is the SR to LR Adjustment for the previous slide This is the SR to LR Adjustment for the previous slide. Notice it began with an inflationary gap. As input costs rose, the AS shifts leftward, restoring the Full-Employment Equilibrium level of GDPr.

Please note: When there is an INFLATIONARY GAP, the SR to LR adjustment and Self-Correcting Economy situations have the same effect. Input costs will go up and the SRAS shifts leftward to restore full-employment.

If an economy is facing the condition shown on the next slide, what is true about the long-run equilibrium of the economy depicted? (SR vs. LR analysis)

Recessionary Gap AD/AS LRAS PL SRAS PLe AD Ye YF GDPR

As wages and other input costs decrease, the per-unit cost of production would go down and the SRAS will shift to the right to restore long-run equilibrium. Why? During recessions, workers will take lower pay (and other input costs like raw materials will go down) causing the per-unit cost of production to decline, thus shifting the AS to the right.

This is the SR to LR Adjustment for the previous slide This is the SR to LR Adjustment for the previous slide. Notice it began with a recessionary gap. As input costs decline, the AS shifts rightward, restoring the Full-Employment Equilibrium level of GDPr.

Please note: When there is an RECESSIONARY GAP, the SR to LR adjustment and Self-Correcting Economy situations have the same effect. Input costs will go DOWN and the SRAS shifts rightward to restore full-employment.

Economic Theories

Keynesian Economic Theory The economy is incapable of self-adjusting to the full- employment level of output and government maintenance of AD is critical to stabilize the economy and prevent valuable resources from standing idle. This describes _______________________. Keynesian Economic Theory

By cutting taxes on individuals and businesses, the government will stimulate consumers to work, save, and invest more. In addition, businesses will be able to produce more output so AS will increase, providing more jobs in the economy. The economic theory described above is known as ____________. Supply Side Economics

Classical Economic Theory The economy will always self-adjust to the full-employment level of output. Therefore, no government intervention in the economy is needed. This describes _________________. Classical Economic Theory

The Monetarists (They had soul too!) Which economic theories promoted that if we just increase the money supply by the projected rate of growth of real GDP everything will be allright? This is because Fiscal and Monetary Policies are inept and ineffective. (“I feel good, nananananana” James Brown, the godfather of Soul, may you rest in peace). The Monetarists (They had soul too!)

Rational Expectations Theorists They propose a monetary rule because the public will counter fiscal/monetary actions by adjusting their investment options to counter these government policies and render those government actions ineffective. Rational Expectations Theorists

Fiscal policy is weak and ineffective due to the “crowding out” effect and monetary policy is ineffective due to the time lags between when monetary policy is implemented and when it actually affects the economy. They propose a Monetary Rule, increasing the money supply by the projected growth rate of real GDP. This describes ________________. The Monetarists

Economic growth

Economic Growth & Productivity are characterized by which of the following: Growth in GDP & Per-Capita GDP. Economic Freedom, Sound Legal & Economic Institutions. Respect for Private Property. Excessive Consumption. Trade Protectionism. High interest rates to encourage investment. Maintenance of capital. Advanced technology resulting in productivity. Low-skilled & Minimally Educated Human Capital Lack of Private Property Stable Food Supply & Access to technology for workers.

Economic Growth & Productivity are characterized by which of the following: Growth in GDP & Per-Capita GDP. YES Economic Freedom, Sound Legal & Economic Institutions. YES Respect for Private Property. Excessive Consumption. NOPE Trade Protectionism. NOPE High interest rates to encourage investment. NOPE Maintenance of capital. YES Advanced technology resulting in productivity. YES Low-skilled & Minimally Educated Human Capital NOPE Lack of Private Property NOPE Stable Food Supply & Access to technology for workers. YES

PPC shifts rightward LRAS shifts rightward LRPC shifts leftward In which direction do the following graphs shift in order to show economic growth: 1) PPC or Production Possibilities Curve 2) LRAS or Long-Run Aggregate Supply Curve 3) LRPC or Long-Run Phillips Curve PPC shifts rightward LRAS shifts rightward LRPC shifts leftward

Economic Growth Illustrated Capital Goods  PPC PPC1 Consumer Goods

Economic Growth Illustrated LRAS LRAS1 PL YF YF GDPR

Economic Growth Illustrated Long-Run Phillips Curve LRPC1 LRPC % YF YF U%

PPC shifts leftward LRAS shifts lefttward LRPC shifts rightward In which direction do the following graphs shift in order to show economic decline: 1) PPC or Production Possibilities Curve 2) LRAS or Long-Run Aggregate Supply Curve 3) LRPC or Long-Run Phillips Curve PPC shifts leftward LRAS shifts lefttward LRPC shifts rightward

Economic Decline Illustrated Production Possibilities Curve Capital Goods  PPC PPC1 Consumer Goods

Economic Decline Illustrated AD/AS LRAS1 LRAS PL YF YF GDPR

Economic Decline Illustrated LRPC LRPC1 % YF YF U%

Policy mix

Policy Mix involves combining Fiscal and Monetary Policy Actions to achieve a goal for the economy. The keys to remember are shown below: When each is used to fight recession, expansionary policy is used. Both will increase the PL, AD and GDPr, and reduce the u%. When each is used to fight inflation, contractionary policy is used. Both will decrease the PL, AD, and GDPr and increase the u%. However, each policy has opposite effects on interest rates: a. Expansionary Fiscal Policy increases the demand for Loanable Funds and raises the r%. Expansionary Monetary Policy increases the Money Supply and lowers the i%. Thus interest rates would have minimal changes. b. Contractionary Fiscal Policy decreases the demand for Loanable Funds and lowers the r%. Contractionary Fiscal Policy decreases the Money Supply and raises the i%. Thus interest rates would have minimal changes.

Policy Mix Graphs The next four slides show the four possible Policy Mix Graph Combinations

Combination of Expansionary Fiscal Policy & Expansionary Monetary Policy Both policies will increase Because Expansionary Indeterminate Expansionary Monetary AD Fiscal Policy lowers taxes as each policy Policy lowers the i% & or increases govt spending, affects interest the demand for loanable funds rates differently. rises, thus increasing r%. _________________________________________________________________________________________________________ The effect on AD is the same for both policies, so it can be predicted. However, since each policy has different effects on interest rates, the effect on Investment Demand is uncertain.

Combination of Contractionary Fiscal Policy & Contractionary Monetary Policy Both policies will decrease Because Contractionary Indeterminate Contractionary Monetary AD Fiscal Policy raises taxes as each policy Contractionary Monetary Policy & or decreases govt spending, affects interest raises the i% the demand for loanable funds rates differently. drops, thus decreasing r%. _________________________________________________________________________________________________________ The effect on AD is the same for both policies, so it can be predicted. However, since each policy has different effects on interest rates, the effect on Investment Demand is uncertain.

Combination of Expansionary Fiscal Policy & Contractionary Monetary Policy Both policies affect Because Expansionary Both policies Contractionary Monetary AD differently, so AD Fiscal Policy lowers taxes increase interest Policy raises the i% is indeterminate & or increases govt spending, rates, so Investment the demand for loanable funds Demand decreases rises, thus increasing r%. _________________________________________________________________________________________________________ The effect on AD is different for both policies. Expansionary Fiscal Policy increases AD while Contractionary Monetary Policy decreases AD. As such, AD is indeterminate. However, both policies increases interest rates, so Investment Demand declines.

Combination of Contractionary Fiscal Policy & Expansionary Monetary Policy Both policies affect Because Contractionary Both policies reduce Expansionary Monetary AD differently, so AD Fiscal Policy raises taxes interest rates, so Policy lowers the i% is indeterminate & or decreases govt spending, Investment Demand the demand for loanable funds should rise. drops, thus decreasing r%. _________________________________________________________________________________________________________ Contractionary Fiscal Policy reduces AD while Expansionary Monetary Policy increases AD so the effect on AD is Indeterminate. However, both policies will reduce interest rates, so Investment Demand will increase.

If the government wants to get the economy out of an inflationary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) Contractionary Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary

If the government wants to get the economy out of an inflationary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) Contractionary Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary a) Use contractionary fiscal policy and monetary policy actions. In this case, both policies should lower AD and reduce the PL. However, contractionary fiscal policy decreases the demand for Loanable Funds and lower the r%, while contractionary monetary policy decrease the Money Supply and would raise the i%. These changes would offset each other, causing a minimal change in interest rates.

If the government wants to get the economy out of a recessionary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary

If the government wants to get the economy out of a recessionary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary D) Use expansionary fiscal policy and monetary policy actions. In this case, both policies should raise AD and lower unemployment. However, expansionary fiscal policy would increase the demand for Loanable Funds and raise r%, while expansionary monetary policy would increase the Money Supply and lower i%. These changes would offset each other, causing a minimal change in interest rates.

If the economy is at full-employment and policymakers want to maintain the price level, but encourage greater investment, which combination of monetary and fiscal policy actions would best achieve that goal? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary

Fiscal Policy Monetary Policy a) No Change Contractionary If the economy is at full-employment and policymakers want to maintain the price level, but encourage greater investment, which combination of monetary and fiscal policy actions would best achieve that goal? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary The contractionary fiscal policy would reduce the demand for loanable funds by the government, decrease r%. The expansionary monetary policy will increase the money supply, decrease the i%. The reduced interest rates would increase borrowing for investment spending by businesses. The contractionary fiscal policy would decrease AD and the PL, while expansionary monetary policy would increase AD and PL. This would keep the the economy at full-employment and maintain the PL.

If the government wants to raise interest rates with a minimal change in AD, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary Use expansionary fiscal policy combined with contractionary monetary policy actions. In this case, the expansionary fiscal policy would increase AD, while contractionary monetary policy would lower AD. Thus the policies would offset each other in terms of AD. However, expansionary fiscal policy would raise r% and contractionary monetary policy would raise i%.

If the government wants to raise interest rates with a minimal change in AD, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary Expansionary Fiscal Policy will increase the demand for Loanable Funds and increase the r%, while Contractionary Monetary Policy will decrease the Money Supply and raise the i%. Also, since Expansionary Fiscal Policy increases AD and Contractionary Monetary Policy decreases AD, there would be minimal change in AD. Use expansionary fiscal policy combined with contractionary monetary policy actions. In this case, the expansionary fiscal policy would increase AD, while contractionary monetary policy would lower AD. Thus the policies would offset each other in terms of AD. However, expansionary fiscal policy would raise r% and contractionary monetary policy would raise i%.