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Unit 4 Quiz 2 Review

Unit 4 Quiz 2 Review. The Aggregate Market- The Basics. Long Run Aggregate Supply (LRAS). Aggregate- all together (total). Price Level Measure of Inflation. Aggregate Supply (AS). The purpose of this graph is to look at countries. Total supply and demand at full employment. P e.

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Unit 4 Quiz 2 Review

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  1. Unit 4 Quiz 2 Review

  2. The Aggregate Market- The Basics Long Run Aggregate Supply (LRAS) Aggregate- all together (total) Price Level Measure of Inflation Aggregate Supply (AS) The purpose of this graph is to look at countries. Total supply and demand at full employment P e AD= Aggregate Demand AD= GDP= C + I + G + NX Aggregate Demand (AD) Q e G.D.P real employment Qy Qy= Quantity at full employment You may find it amazing how a graph can be interpreted in so many different ways. Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways. The law of demand is the same. There is an inverse relationship- PL up, AD down, PL down AD up The law of supply is the same There is a direct relationship- PL up, AS up, PL down AS down

  3. Conflicting Views Keynesian Views- Top Down (government has a larger view) Classical Views- Bottom Up (we cannot know everything!!) John M. Keynes More Government Macro not Micro Keynesians Multiplier Neo-Keynesians Increase Gov’t Demand-siders spending!!!!!!!! Fiscal Policy F.A. Hayek Neo-Classical Austrian Supply-siders Real Production= real wealth Less Government Equilibrium of market Increase consumer or Investments SAVINGS!!!!! 1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem 1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor. 2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.- savings hurt The paradox of thrift 2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output 3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run Savings-investment equality-anydecrease in output because of savings is offset an increase in the demand for investment This creates a different market – the money market Investment is demand Savings is Supply Interest rates create equilibrium- Monetarist 4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending 5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle Individualism 5. Savings leads to investments, which lead to stronger business, which leads to investments in capital and to more supply and more employment. Stronger econ. in the Long Run 6. The Animal Spirits- believed growth and contraction had much to do with confidence and trust

  4. Summary To Hayek: Only real savings should lower interest rates, not the Fed. Interest rates drop as private savings increase. During recession: We will stay at full employment if prices and wages are allowed to be flexible. Runaway inflation is a wealth destroyer that lowers the standard of living, this must be feared during the boom. Inflation hurts those who have money. To Keynes:--Spending!!!!!!! During a recession: Only prices and wages will stay (prices and wages are sticky) and employment drops. Government spending during a recession will increase employment, GDP, and AD and will not have an impact on price level until full employment is reached. Cyclical unemployment and underproduction is the biggest concern. Free Markets can not be trusted to provide full employment. Economies can suffer from insufficient aggregate demand because people want to acquire liquid assets (stocks, bonds, etc.) rather than real goods.

  5. Aggregate Supply – So what Model is correct? They Both have some valid points LRAS P.L. Classical Phase When in the Classical Phase The economy is operating at full employment Any and all increase in AD will result in an increase in price and in increase in inflation P e Intermediate Phase Keynesian Phase AD AD AD Q y full G.D.P real When in the Intermediate Phase As AD approaches the curve An increase in AD and decrease in unemployment Result in a gradual increase of price and some inflationary pressure When in the Keynesian Phase Output can increase with no change in price. No increase in price level, no inflationary pressure, spare room to grow.

  6. Inflationary and Recessionary Gaps- Steering the Market Potential GDP Economic Activity Inflationary Gap (Full Employment) Recessionary Gap Time (years) The Government can steer the economy in different ways Laws and Regulations- stabilizers Fiscal Policy- changes in government spending or taxation to influence the economy Monetary policy- changes in monetary supply to influence the interest rates that influence economy

  7. Summary Recessionary Gap and what Keynesians think the government should do. Actual GDP < Potential GDP Output is below full employment High unemployment Government wants to limit unemployment by increasing demand Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE Congress Fiscal Policy: Monetary Policy: Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE

  8. Summary Inflationary Gap and what Keynesians think the government should do. Actual GDP > Potential GDP Output is beyond full employment Unemployment very low Prices very high Government wants to limit inflation by reducing demand Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE Congress Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE Fiscal Policy: Monetary Policy:

  9. Fiscal Policy (Demand side) Keynesians and Democrats Keynesian economics President sets the budget, Congress develops programs- they can tax and borrow Commerce clause – etc. Raising Revenue- Tax or Borrow Spending- increase of Decrease (discretionary and nondiscretionary)

  10. Deficit Spending- annually – When the government spends more that it brings in as tax revenue. Deficits make good politics, why? Surplus- when revenue exceeds spending (annually) It is popular to cut taxes and to increase spending. How do we pay for the deficit? Borrowing Debt- Accumulation of Deficits over the years What is the Fiscal Cliff? To balance the budget many Republicans proposed cutting programs and not raising taxes. To balance the budget many Democrats proposed raising taxes and not cutting programs. This was a game of chicken. http://money.msn.com/investment-advice/fiscal-cliff-worst-case-scenarios

  11. Monetary Policy (Demand side) Who- the Federal Reserve What- increasing or decreasing the amount of money in circulation Goal- full employment, stability, and growth Easy Money Supply- increasing money supply and decreasing interest rates Open Market Operations- buy securities Discount Rates- lower discount rate Reserve Requirements- lessen requirements Decrease interest rates Tight Money Supply – decreasing the money supply and increasing interest rates Open Market operations- sell securities Discount Rates- increase discount rates Reserve Requirements- increase requirements

  12. Monetary Policy (Demand side) Leading advocates- Monetarist Milton Friedman showed that people’s annual consumption is a function of their “permanent income,” a term he introduced as a measure of the average income people expect over a few years. Monetarist believe that price level depends on money supply Friedman stated that in the long run, increased monetary growth increases prices but has little or no effect on output. In the short run, he argued, increases in money supply growth cause employment and output to increase, and decreases in money supply growth have the opposite effect. Friedman’s solution to the problems of inflation and short-run fluctuations in employment and real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to increase the money supply at the same rate as real GDP increased, he argued, inflation would disappear. He argued that the Great Depression was caused by the Federal Reserves poor management of money. Most monetarist do not support the idea of using money supply to fix the economy- too much lag To keep unemployment permanently lower, he said, would require not just a higher, but a permanently accelerating inflation rate – increase with rate of increase of real GDP

  13. Milton Friedman’s money-supply rule Growth of the Money Supply < rate of Growth of real GDP= Recession There is not enough money to buy what has been produced this leads to inventory and layoffs Growth of the Money Supply > rate of Growth of real GDP= Inflation There is an abundance of money and not enough goods- prices will rise Growth of Money Supply = rate of Growth of real GDP= equilibrium

  14. Supply-side theory in AS/AD/LRAS AS 1 LRAS 1 LRAS 2 LRAS 3 AS 2 v v v P 1 P 2 AD Q1 Q2 Supply side economics Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness. This increases potential output (Increase abundance, decreases price). Price drops= Increase in demand Supply creates its own demand There are a number of methods Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefits Invest in education Advancements in technology – lowers production cost and creates new markets Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates) Lower corporate tax rates Invest in infrastructure reduce regulations and oversight Remove barriers of entry (licenses, certs. Etc.) Eliminate safety nets and allow for profit and loss

  15. How to fix the economy? According to . . . Fiscal Policy Monetary Policy Supply Side Policy Increase Government Spending Buy Securities from banks or dealers Cut tax on Business Reduce Regulation During a Recession With high unemployment Decrease Taxes Decrease Discount Rate Give business a chance to expand and hire Reduce Reserve requirements No capital gains tax or marginal (progressive income tax) All ideas intended to lower interest rate Sell securities to banks Decrease Government Spending Do nothing the market will take care of itself. Increase Discount Rate During Expansion With high inflation Increase Tax Increase Reserve Requirements All ideas intended to increase interest rates

  16. Progressive Tax

  17. Laffer Curve

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