Term
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Definition
| An increase in the average price level |
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Term
| What happens to relative prices as inflation occurs? |
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Definition
| Relative prices change during the course of inflation because not all prices change by exactly the same percentage over time. |
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Term
| How is inflation measured in the Consumer Price index? |
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Definition
| Inflation is measured as the weighted average of the percentage changes in prices of a fixed basket of goods, where the weights are equal to the relative importance of the items in the typical consumer's budget |
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Term
| What is meant by the "base year" of a price index? |
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Definition
| The base year value always is equal to 100 |
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Term
| How can the rate of inflation be measured between two years with the CPI? |
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Definition
| The rate of inflation between these two years is the change in the CPI divided by the original value of the CPI. |
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Term
| What are the two basic types of inflation? |
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Definition
A) Demand pull inflation
B) Cost-push inflation |
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Term
What causes demand pull inflation?
Cost-push inflation? |
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Definition
A) When the economy experiences too much demand for a full employment level of GDP
B) When changes in the costs of production or distribution cause the individual supply schedules of business firms to shift upward and to the left |
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Term
| Explain how inflation redistributes income and wealth |
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Definition
| Households that hold their wealth in non-money forms (e.g., rare coins, rare paintings, apartment buildings, real estate) find that the value of their assets rises along with the overall price level, so their wealth is protected during the course of inflation. |
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Term
| Explain how inflation affects nominal and real rates of interest. |
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Definition
| Real rates of interest are calculated as the nominal interest rate minus the inflation rate. Real rates of interest may be positive, zero or negative. If the rate of inflation exceeds the nominal rate of interest, the real rate of interest has a negative value. Inflation also distorts both the amounts and quality of investment spending in the economy, and this has the effect of reducing the rate of economic growth |
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Term
| What factors influence the extent to which the Consumer Price Index accurately measures the rate of inflation experienced by individual households? |
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Definition
| The household’s expenditure weights (the percentage of the budget spent on different items) must be similar to those used in the CPI. The CPI is an index of the prices of a fixed basket of goods. If the quality of the goods included in the basket (and hence in the CPI) is declining over time, the CPI would understate increases in the cost of living. If the quality of products included in the fixed market basket of goods is rising over time, then the CPI would tend to overstate increases in the cost of living |
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Term
| If you were told that the value of the CPI for this year was 130, what would that mean? |
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Definition
| It would mean that prices are 30% higher in this year than in the base year |
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Term
| What factors cause the Consumer Price Index to overstate or understate the inflation rate? |
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Definition
| The inflation rate is overstated because of "substitution bias." This bias results from pricing a fixed market basked of goods in different years. Other biases result from changes in product quality or because any given household may not allocate its income across the fixed market basket of goods in the same way (and hence the "weights" associated with the percentages changes in prices could be different for different households) |
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Term
| Why is a “weighted average” of price changes more appropriate than a “simple average” of price changes if we wish to measure changes in the cost of living? |
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Definition
| A simple average of the percentage changes in product prices would not account for how important the different items are in the consumer’s budget. In a simple example, there is a 800% increase in the price of product D, yet this did not impact of the cost of living of any household that did not purchase product D. This 800%, however, would be included in calculating the “simple” average of the percentage changes in prices. As a result, simple averages of the percentage increases in product prices will not accurately measure changes in the cost of living. |
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Term
| What was the basic conclusion of Classical macroeconomic theory? |
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Definition
| The basic conclusion was that the economy could only be in equilibrium at the full employment level of GDP |
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Term
| What were the “building blocks” or mechanisms of Classical theory that resulted in this conclusion? |
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Definition
| Say’s law; a belief that the interest rate would equate saving and investment; and the belief that flexible wage and prices clear resource and product markets. (supply creates its own demand) |
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Term
| How did Keynes attack the Classical theory? |
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Definition
| By noting that there was no automatic mechanism in a market economy that would cause (profit-maximizing) business firms to want to invest an amount equal to what households would choose to save out of a full employment income. In effect, Keynes argued that it was the level of GDP that would fluctuate to equilibrate saving and investment, and not the rate of interest |
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Term
| How did Keynes conclusions differ from those of the Classical writers? |
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Definition
| Keynesian theory is that the economy can be in equilibrium at any level of GDP and employment, and not just at the full employment level of GDP |
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Term
| An inflationary gap can only occur if Y(e) > Y(f). How can the equilibrium level of GDP exceed the full employment GDP? |
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Definition
| The nominal value of a full employment GDP could exceed the real value of the full employment GDP because of demand-pull inflation. Demand-pull inflation occurs at the full employment level of production where households, business, government and the rest of the world wish to buy more than the full employment level of production. This would be indicated by the fact that some buyers are willing to pay even higher prices for the full employment GDP, and so the nominal value of GDP continues to rise even though real GDP does not. |
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Term
| Calculate the size of the aggregate expenditures multiplier |
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Definition
| The aggregate expenditures multiplier = the reciprocal of the MPS |
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Term
| What is the relationship between the value of the aggregate expenditures multiplier and: (a) the value of the MPC; and (b) the value of the MPS? |
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Definition
| The multiplier is given by either: (a) 1/MPS or (b) by 1/[1-MPC] If the MPC = 9/10, then 1/[1-MPC] = 1/ [1/10] = 10. |
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Term
| What is the relationship between the size of a GDP gap and a recessionary gap? |
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Definition
| The relative values are determined by the value of the aggregate expenditures multiplier. If the GDP gap is 100 and the multiplier is 5, then the recessionary gap = 20 |
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Term
| What was the biggest short-coming of Classical macroeconomic theory that led to its demise and replacement by Keynesian theory? |
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Definition
| The Classical theory could not account for the severity and length of the depression of the 1930s. Either the Classical theory was wrong (Keynes) or the adjustment period was socially intolerable |
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Term
| What types of real-world economic problems could be analyzed by or through the Keynesian model, and what types of problems could not be appropriately analyzed by the Keynesian model? |
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Definition
| The Keynesian model was capable of providing reasonable macroeconomic policy prescriptions if the economy was experiencing either a recessionary gap or an inflationary gap. During the decade of the 1970s, the U.S. economy (and many other economies) experienced rising unemployment and rising inflation at the same time. The Keynesian model was not capable of producing sound macroeconomic policy advice when the economy was simultaneously experiencing both inflation and unemployment. These real world developments led to the replacement of the Keynesian model with the Aggregate Demand – Aggregate Supply |
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Term
| Why are investment expenditures predicted to rise as the rate of interest falls? |
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Definition
| At higher rates of interest, it is more expensive for firms to borrow the money to undertake investment projects. Because these costs rise, fewer investments will be undertaken at higher, compared with lower, rates of interest. |
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Term
| What is meant by the term “autonomous” expenditures? |
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Definition
| Autonomous expenditures include those components of aggregate expenditures that are independent of the current level of GDP. In the Keynesian model, investment expenditures, government expenditures and net exports are assumed to be autonomous and independent of the current level of production. The only component of aggregate expenditures that is not autonomous is consumption expenditures, because consumption expenditures depend on the level of household income (and GDP). |
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Term
| What is the difference between the “investment demand schedule” and the autonomous investment schedule? |
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Definition
| The investment demand schedule shows the amounts of investment spending that would occur at different rates of interest. The autonomous investment schedule shows the same amount of investment spending at each level of GDP |
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Term
| What is the relationship between the aggregate expenditures multiplier and the value of the marginal propensity to save? |
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Definition
| The aggregate expenditures multiplier is calculated as the reciprocal of the marginal propensity to save. If the MPS = 1/6, then the aggregate expenditures multiplier has a value of 6. |
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Term
| What is the purpose of macroeconomic theory? |
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Definition
The two major purposes of
macroeconomic theory are to predict and explain the behavior of important macroeconomic variables |
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Term
| How does the Keynesian model eliminate a) a recessionary gap and b) an inflationary gap? |
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Definition
| To eliminate a recessionary gap, the level of aggregate expenditures (AE) must be increased by an amount equal to the size of the recessionary gap. To eliminate an inflationary gap, the level of aggregate expenditures (AE) must be reduced by the size of the inflationary gap.) |
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Term
| Does macroeconomic theory belong to the world positive economics or normative economics? |
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Definition
| Macroeconomic theory belongs to the world of normative economics, because the purpose of macroeconomic theory is to achieve a real world outcome that is something other than what would automatically occur as a result of market forces alone. |
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Term
| What was the biggest short-coming of Keynesian theory that led to its demise and replacement with the AD—AS model? |
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Definition
| In the Keynesian model the economy cannot experience unemployment and inflation at the same time. The fundamental macroeconomic problem of the decade of the 1970s was the simultaneous existing of both high (and rising) unemployment and high (and rising) inflation.) |
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Term
| What is the AD schedule and how is it derived? |
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Definition
| The AD schedule shows the total of aggregate expenditures (C + I + G + X – M) at each possible domestic price level, all other things equal |
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Term
| Explain the “real balances” (or “wealth”) effect of a change in the price level |
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Definition
| The wealth effect is one of three reasons why the AD schedule is negatively sloped with respect to the price level. A lower price level increases the value of household wealth and increases consumption expenditures at each possible level of GDP and DI. A lower domestic price level will cause a downward movement along the demand schedule. |
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Term
| Explain the “interest rate” effect of a change in the price level. |
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Definition
| The interest rate effect is the second of three reasons why the AD schedule is negatively sloped with respect to the domestic price level. As the domestic price level falls, nominal interest rates decline and investment expenditures increase, all other things equal. This causes the total of aggregate expenditures to rise and the domestic price level falls. |
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Term
| Explain the “foreign trade” effect of a change in the price level |
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Definition
| The foreign trade effect is the third of three reasons why the AD schedule is negatively sloped with respect to the domestic price level, all other things equal. A lower domestic price level will cause exports to rise and imports to fall. Remember, in the “all other things equal” we include foreign price levels as well. So, when the domestic price level falls U.S. goods become more price-attractive to foreign buyers, and exports rise. At the same time, a lower domestic price level will cause domestic buyers to switch from imports to domestically-produced goods. The result is an increase in aggregate expenditures as the domestic price level falls |
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Term
| Explain the “profit effect” of a change in the price level. |
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Definition
| If some costs of production are “fixed” in the short-run, a rise in the domestic price level will cause revenues from increased sales to exceed the additional costs of increasing the level of output. The result will be that profit maximizing firms respond to a rise in the domestic price level by increasing production and the overall level of GDP supplied to the economy. This is one of two explanations of why a rise in the domestic price level will cause business firms to expand real production (real GDP) when the domestic price level rises) |
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Term
| Explain the “cost effect” of a change in the price level. |
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Definition
| The cost effect is the second of two reasons for why business firms will expand production when the domestic price level rises. Firms experience increasing marginal costs of production. Each extra unit of output has a higher marginal cost than the previous unit. When the domestic price level rises, firms are able to sell their output for higher prices and, as a result, can profitable expand production even if marginal costs are rising. |
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Term
| Draw and explain an AS schedule that contains: (a) a “Keynesian” range; (b) an intermediate ranges; and (c) a “Classical” range. What is the significance of each range of these ranges of the AS schedule with respect to the effects of a change in aggregate demand? |
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Definition
| In the Keynesian range the AS schedule is horizontal. In the “intermediate” range, the AS schedule is upward-sloping but not vertical. In the “classical” range, the AS schedule is shown as a vertical line drawn at the point of full employment real GDP. |
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Term
| What factor(s) cause(s) a movement along an AD (or AS) schedule? What factors cause these schedules to shift? |
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Definition
| A change in the domestic price level will cause a movement along an AD or AS schedule. A change in one of the other determinants of AD or AS will cause those schedules to shift. For example, a fall in the rate of interest, reduced tax rates, or increases in government expenditures for the war in Iraq would each cause the AD schedule to shift to the right. An increase in oil prices would cause the AS schedule to shift upward and to the left. |
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Term
Using the AD—AS model, explain the impact on the economy of: (a) a significant rise in oil
prices; and (b) technological change. Also, explain how movements (shifts) in the AD and AS schedules can explain the “business cycle.” |
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Definition
| If oil prices increase, the cost of producing every possible level of GDP increase. In order for profit maximizing firms to produce any given level of real GDP, they must be able to sell it for a higher price. So, an increase in oil prices—because such increases cause the costs of production and distribution to rise—will cause the AS schedule to shift upward and to the left. Technological change lowers production costs and will cause the AS schedule to shift downward and to the right. Over time, as the “non-price” determinants of the AD and AS schedule shift, the level of real GDP and the overall price level fluctuate. Modern macroeconomic theory explains business cycle fluctuations as being caused by shifts in the AD and AS schedules over time. |
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Term
| What impact would the shape of the aggregate supply schedule have on the ability of demand-side, discretionary fiscal policies to change the level of real GDP? |
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Definition
| The flatter is the AS schedule, the greater would be impact of any rightward shift of the AD on real GDP, and the smaller would be the impact on the domestic price level. By way of contrast, the steeper is the AS schedule, the smaller will be the impact of any rightward shift of the AD schedule on real GDP, and the greater will be the impact on the domestic price level. |
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Term
| Suppose the goal of demand-side discretionary fiscal policy is to provide for a full employment level of GDP. What impact does the shape of the AS schedule have on the ability of these fiscal policies to accomplish this goal? |
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Definition
| The steeper is the AS schedule, the greater will the impact on the price level (rather than real GDP) of any change in AD. If the goal of a discretionary fiscal policy is to raise real GDP, then the steeper is the AS schedule, the greater will be the required magnitude of discretionary fiscal policy to achieve any given change in real GDP. |
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Term
| What is “supply side” fiscal policy? What advantages might “supply side” policies have over “demand-side” policies if the economy was in a recession? |
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Definition
| Supply side fiscal policies are those that would cause the AS schedule to shift downward and to the right. For any given AD schedule, such shifts of the AS schedule cause the overall price level to fall and the level of real GDP to rise. This is the type of policy that is advocated by supply side economists to combat the simultaneous problems of inflation and unemployment. |
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Term
Distinguish between discretionary and non-discretionary fiscal policies, and give examples of
each. In what way does the effectiveness of the non-discretionary fiscal policy tools impact the effectiveness of the discretionary aspects of fiscal policy? |
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Definition
| Fiscal policy involves the taxing, spending and borrowing powers of the federal government. Discretionary fiscal policies are those that are taken in response to a particular problem that has been identified. The non-discretionary parts of fiscal policy are the so-called “automatic fiscal stabilizers” that cause tax receipts and transfer payments to change “automatically” and the level of real GDP rises and falls over the course of the business cycle. The automatic fiscal stabilizers require no current legislative action to be taken, because all of these policies have been “legislated in advance” and go to work automatically to cushion disposable income from fluctuations in real GDP |
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Term
| What is the Laffer curve? How was it related to the development of “supply side” economics? |
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Definition
| The Laffer Curve relates federal tax rates to total tax collections. According to Laffer, a reduction in tax rates could either increase or decrease total tax collections. Supply side economists used the Laffer Curve concept to rationalize that by lowering federal income tax rates the U.S. could actually realize an increase in total tax collections. This was one of the major components of “supply-side” economics which was so in vogue in the 1980s |
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Term
| Why is an increase in the rate of interest predicted to reduce investment expenditures (all other things equal)? |
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Definition
| A rise in the rate of interest reduces the present value of the future profits expected to flow in from an investment project, so that fewer investment projects will be calculated as profitable as the rate of interest rises |
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Term
| Why is the tax multiplier smaller in size and opposite in sign to the multiplier for changes in government expenditures? |
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Definition
| A $1 rise in government expenditures increases the demand for goods and services by $1. A $1 decline in tax collections does increase disposable income by $1, but not all of this increase in DI will be spent. Some portion will be saved. As a result, the expansionary effect of a $1 rise in government expenditures is greater than a $1 reduction in tax collections |
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Term
| What impact do the automatic fiscal stabilizers have on the effectiveness of the discretionary fiscal policy tools? |
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Definition
| The more effective are the automatic fiscal stabilizers—the elements of non-discretionary fiscal policy—the less effective will be the tools of discretionary fiscal policy. The reason is that the automatic fiscal stabilizers reduce the value of the multipliers for all of the discretionary fiscal policy tools. |
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Term
| What is the impact of each of the following on the ability of government budget deficits (discretionary fiscal policy) to increase the equilibrium level of real GDP: (a) the effectiveness of the automatic fiscal stabilizers? and (b) the shape of the aggregate supply schedule. |
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Definition
| The more effective are the automatic fiscal stabilizers, the smaller will be the multipliers for each of the discretionary fiscal policies that could create a budget deficit (increases in government expenditures or reductions in tax collections. As a result, the more effective are the components of nondiscretionary fiscal policy, the less effective will be the tools of discretionary fiscal policy. |
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Term
| Describe the concept of “crowding out.” Explain how crowding out can total, partial be or zero (non-existent) |
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Definition
| Crowding out occurs when the U.S. Treasury sells new bonds to finance a government budget deficit. An increase in the supply of bonds causes bond prices to fall and, consequently, rates of interest to rise. The higher rates of interest reduce investment expenditures and so some of the impact of the government budget deficit (caused by either a reduction in taxes, an increase in expenditures, or both) is offset because higher interest rates “crowd out” private investors in the money market. |
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Term
| What is the difference between a budget deficit and the national debt? |
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Definition
| A budget deficit occurs when federal tax receipts are less than federal government expenditures in a given year. To financial an annual budget deficit, the U.S. Treasury must borrow by selling new bonds. The total value of these bonds that the Treasury has sold (and not yet repurchased at any moment in time) is what we call the national debt. |
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Term
| What happens to the size of the national debt as budget deficits and surpluses occur? |
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Definition
| The national debt rises in any year in which there is a budget deficit and falls when the federal government uses an excess of tax receipts over its expenditures to re-purchase bonds that it sold in the past. |
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Term
| How does the federal government pay for budget deficits? |
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Definition
| The U.S. Treasury sells bonds to acquire the funds needed to pay for expenditures that cannot be financed with tax receipts. |
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Term
| During what periods of U.S. history has the national debt grown the most? |
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Definition
| It took from1789 to 1980 for the U.S. government to acquire the first one trillion dollars of national debt. Between 1980 and 1990 the size of the national debt tripled, from one trillion to three trillion dollars. This was the period in which advocates of supply side economics argued that reductions in tax rates would increase federal tax revenues. Tax rate reductions occur during this decade, but tax collections declined rather than increasing. The national debt also increased rapidly following the recession which began in 2007 |
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Term
| What is meant by a “payoff” burden of the national debt, and under what circumstances would such a burden occur? |
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Definition
| The payoff burden is the burden that the debt leaves to future generations of Americans. A payoff burden occurs when future generations of Americans would have to give up some of its claims on our annual GDP and give those claims (dollars) to those outside of the United States. A potential payoff burden only exists with that portion of the national debt held outside the United States |
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Term
| What is meant by an “interest cost” burden of the national debt, and under what conditions would such a burden occur? |
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Definition
| The interest cost burden arises because as the size of the national debt grows, more and more tax dollars have to be used to make interest payments on the national debt. When households and business firms pay taxes to the federal government, they do so with the expectation that the federal government will provide needed and useful government goods and services in return. |
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Term
| Under what conditions would government deficits not shift the AD schedule? |
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Definition
| If “crowding out” was complete (or total), then every dollar of government spending not paid for by tax receipts (but rather by borrowing) would be exactly offset by a $1 decline in investment spending caused by crowding out. So, if crowding out is complete (or total), then the AD schedule would not shift because each $1 increase in government purchases would be offset by a $1 decline in investment expenditures |
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Term
| Will the present or future sizes of the national debt cause the federal government to declare bankruptcy? |
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Definition
| No, the federal government will not go bankrupt as a result of the national debt. There are three reasons why this is the case: (a) the federal government can and does refund the national debt by selling new bonds to pay off old ones as they come due; (b) the federal government has the power to tax to raise the funds needed to pay principle and interest on the national debt; and (c) the federal government can print money to pay for expenditures in excess of tax receipts.) It is possible, however, for the size and growth rate of the U.S. national debt to cause potential bond-holders to prefer other assets. |
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Term
| Why is the distinction between domestically-held and debt held outside the U.S. so important? |
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Definition
| The portion of the national debt held inside the United States does not represent a payoff burden. If the internally-held bonds were all turned into the U.S. Treasury for repayment, one group of Americans (bond holders) would get more dollar claims to buy GDP, while some other group of Americans (e.g., tax payers who had to pay more so the Treasury could repurchase the bonds) would end up with less GDP than otherwise would have occurred. Bonds held outside the United States represent a potential payoff burden, as noted above. |
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