chapter 11 stuff

What will happen to the position of the SAS curve and/or LAS curve in the following circumstances?

Available factors of production increase.
Answer:  The LAS will shift to the right. The SAS curve will not shift initially.

b. A civil war occurs.
Answer:  The LAS will shift left while the SAS will shift up.

Wages that were fixed become flexible, and aggregate demand increases.
Answer:  The SAS curve will shift up. The LAS curve will not shift.

If an economy is in short-run equilibrium that is below potential, what forces will bring the economy to long-run equilibrium?
Answer:  Underutilization of inputs will cause input prices to fall, causing the short-run aggregate supply curve to shift  down and the price level to fall . This will set the wealth, interest rate, and international effects in motion,  increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output.”




a. The economy begins at potential output, but foreign economies slow dramatically.
Ans:  Increase spending while decreasing taxes (expansionary fiscal policy).

The economy has been operating above potential output and inflationary pressures rise.
Ans:  Decrease spending while increasing taxes (contractionary fiscal policy).

A new technology is invented that significantly raises potential output.
Ans:  Increase spending while decreasing taxes (expansionary fiscal policy).


Choose those factors that might destabilize the economy when the price level falls.

1. Falling asset prices reduce perceived wealth.  CORRECT

3. Banks call in loans as asset values fall.  CORRECT


6. People expect aggregate demand to fall.  CORRECT

Why is countercyclical fiscal policy difficult to implement?
ANS:
 	IT is difficult to assess the condition of the economy at any one time.
It takes a long time to enact new government policies.
Politically it is difficult to raise taxes, even when countercyclical policy is contractionary.

Why is knowing the level of potential output important to designing appropriate fiscal policy?
ANS:  Knowing where the economy is relative to potential output tells you whether to implement expansionary or contractionary policy.

In the late 1990s, a growing number of economists argued that world policy makers were focusing too much on fighting inflation. The economists also argued that the technical level of potential output had risen. Show their argument using the AS/AD model.
ANS:  A large increase in potential output would shift the LAS curve to the right and cause downward pressure on the price level. As the price level shifts down, the SAS curve also shifts down and the output level increases.
Why is macro policy more difficult than the simple model suggests?

Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for.

The model does not take into account the difficulties in implementing fiscal policies.

The model does not take into account the uncertain effectiveness of fiscal policies.
→
The model does not take into account potential negative feedback effects.
ALL THE ABOVE




Distinguish between a laissez-faire economist and an activist economist.

“The central difference between activist and laissez-faire economists is their differing views about whether the economy is self-regulating. Laissez-faire   economists, also known as Classicals   believe the pricing mechanism will bring the economy to an equilibrium of potential output and full employment. Keynsians  , on the other hand, believe that the government sometimes needs to use fiscal policies, such as changing tax levels and government spending, in order to keep the economy from getting stuck above or below potential output and full employment.

Why, in principle, would one expect the AD curve to be vertical?



One expects the AD curve to be vertical because when the price level rises, all prices rise together. That is, since wages have risen as much as prices for consumer goods, no relative prices have changed and therefore people’s decisions to consume should not change either.



What are five factors that cause the AD curve to shift?


(1) Changes in foreign income, (2) changes in expectations, (3) changes in exchange rates, (4) changes in the distribution of income, and (5) changes in governmental aggregate demand policy.


Explain how a rise in the price level affects aggregate quantity demanded with the:
Interest rate effect.



A rise in the price level reduces the value of cash people are holding. To keep the real value constant, they withdraw more from their banks. This reduces the amount banks have to lend, which leads to higher interest rates and lower investment expenditures.

Assuming fixed exchange rates, a rise in the price level makes goods less internationally competitive, decreasing exports.

Foreign holders of money are poorer, which decreases spending.

c) Money wealth effect.



The money people hold in cash is worth less, which decreases spending.







What will likely happen to the slope or position of the AD curve in the following circumstances?

a) The exchange rate changes from fixed to flexible.



Steeper.


b) A fall in the price level doesn’t make people feel richer.



Steeper.


The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the money wealth effect not holding true.

A fall in the price level creates expectations of a further-falling price level.



Steeper.


The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to reduce their present expenditures in the hope of getting more for their money in the future.

d. Income is redistributed from rich people to poor people.



Shift to the right.




Assuming that poor people spend a higher percentage of their income than rich people (as suggested by the data), the AD curve will shift to the right.

e) Autonomous exports increase by 20.



Shift to the right by a multiple of 20.




f) Government spending decreases by 10.




Shift to the left by a multiple of 10.

What dynamic feedback effects can offset the interest rate, international, and money wealth effects?

Instructions: Select all that apply.

If the price level falls, expectations of falling aggregate demand

If the price level falls, lower asset prices

If the price level falls, expectations of government intervention

If the price level falls, an increase in spending

What are two factors that cause the SAS curve to shift?

Instructions: Select all that apply.

Changes in productivity

Changes in input prices

Why is the LAS curve vertical?



Because output is independent of the price level.


The LAS curve is vertical because potential output depends on the capacity for production, not the price level. In the long run, output is independent of the price level.
A;  Larger fluctuations.


If planned expenditures are below actual production, what will happen to income? Explain the process by which this happens.

Ans:  If planned expenditures are below actual production, income will decline . When planned expenditures are below actual production, firms will see that their inventories are building up  faster than they’d like. In response, they   cut production. As production falls , so does income. Consumption  falls by a fraction of the decline in income, leading to a further  decline in planned expenditures. This process continues until planned expenditures equal actual production.

Are inventories building up at levels of output above or below equilibrium output? Explain your answer.

Ans:  At levels of output above equilibrium inventories are building up because planned expenditures are below actual production. People are buying  less than what is produced.


What happens to equilibrium income when the marginal propensity to expend rises?

The AE curve becomes steeper when the marginal propensity to expend increases. Equilibrium income rises.

What happens to the aggregate expenditures curve when autonomous expenditures fall?
Ans:  Aggregate expenditures will shifts down by the decline in aggregate expenditures.

The marginal propensity to expend is .66 and autonomous expenditures have just fallen by $20.
a) What will likely happen to equilibrium income?

Equilibrium income decreases by $  60


Explanation:
If the mpe is .66, the value of the multiplier is 3. A decrease in autonomous expenditures of $20 will likely result in a decrease in income of $60.

If withdrawals were instantaneously translated into expenditures, what would be the multiplier’s size? What would be the level of autonomous expenditures?
Answer:  The multiplier would be infinity. Autonomous expenditures would no longer exist. The multiplier model would break down.

What forces could cause shocks to aggregate expenditures?

Consumer sentiment.

Business optimism.

Foreign income.

Government policy.

A change in people’s marginal propensities to consume and save.

Why does cutting taxes by $100 have a smaller effect on GDP than increasing expenditures by $100?
ANS:  People don’t spend the entire amount of the tax cut, so less enters the spending stream.

Why is the circular flow diagram of the economy an only partially correct conception of the multiplier model?
ANS:  It does not include leakages of savings to investment that cause the diagram to pulsate as the economy continually overshoots equilibrium in response to shocks to the economy.

How do mechanistic models differ from interpretive models?

A mechanistic model states the equilibrium independent of where the economy has been or where people want it to be. A mechanistic model is used as a direct guide for policy prescriptions. An interpretive model is used as a guide that highlights dynamic interdependencies and suggests the possible response of aggregate output to various policy initiatives.

How does the multiplier-accelerator model magnify changes in demand?
ANS:  Changes in investment depend on changes in income, not just the level of income. This new interconnection accelerates the fall in demand and can possibly make the second shift larger than the first.