Unit 4 Short-run economic fluctuations: Business cycles
1. Short-run economic fluctuations are irregular and unpredictable. Most macroeconomic variables move together in some specific patterns. As output falls, employment falls.
2. The aggregate-demand (AD) curve plots the quantity of the aggregate output (total value of all goods and services) demanded for different price levels. The AD curve is downward sloping because of the wealth effect, interest rate effect and exchange rate effect.
3. The long-run aggregate-supply (LRAS) curve specifies the total quantity of goods and services supplied for different price levels. The LRAS curve is vertical because an economy s output depends only on real factors: capital, labour, human capital, land and technology. The output produced is the natural rate output.
4. The short-run aggregate-supply (SRAS) curve is upward sloping, which can be explained by the misperception theory, sticky wage theory or sticky price theory.
5. The output of an economy is given in the equation: Output = Natural rate output + a (actual price level expected price level), where a is a positive constant indicating how much the economy s output responds to a surprise in the price level.
6. When the expected price level falls, the SRAS curve shifts downwards (or outwards).
7. In the money market, the money demand curve plots the quantity of money that the public wants to hold at different interest rates. It is downward sloping because of liquidity preference. The money supply curve is vertical. The intersection of the money demand and supply curves gives the money market equilibrium, in particular, the equilibrium interest rate.
8. A higher price level shifts the money demand curve outwards.
9. When the central bank follows an expansionary monetary policy, it increases the money supply. The policy shifts the aggregate demand curve outwards, resulting in a short-run expansion in output and a higher price level.
10. When the government follows an expansionary fiscal policy, it either increases government purchases of goods and services or decreases net taxes (net taxes = taxes transfers).
11. When the government increases government purchases of goods and services by $X, through the multiplier process, the total increase in the aggregate demand is $X × [1/(1 MPC)], where MPC is the marginal propensity to consume. 1/(1 MPC ) is the value of the multiplier.
12. When the government decreases net taxes by $X, through the multiplier process, the total increase in the aggregate demand is $X × [MPC /(1 MPC)], where MPC is the marginal propensity to consume. MPC / (1 MPC) is the value of the multiplier.
13. When income increases, people want to hold more money. The money demand increases; thus the interest rate rises in the money market. With a higher interest rate, investment spending decreases. The effect of (expansionary fiscal policy --> higher aggregate demand --> higher income --> higher money demand --> higher interest rate --> lower investment spending --> lower income) is known as the crowding-out effect. The net change in the income, as a result of the multiplier effect and the crowding-out effect, must be positive.
14. The chief argument for the active policy orientation is that the economy is constantly subject to economic shocks. Animal spirits introduce ups and downs into the economy. The government should, as the argument goes, use an active stabilisation policy to counteract the shocks brought about by animal spirits .
15. The arguments against the use of active stabilisation policies include:
a. Both monetary and fiscal policies work with time lags.
b. The magnitude of policy impact is uncertain.
c. The use of active economic policies may be politically motivated.
d. The automatic stabiliser makes the use of active stabilization policies redundant.
e. Expansionary stabilisation policies do not have long-run effects on output and employment but create a long-run consequence of higher inflation.
16. According to Phillips original paper, statistical figures show that the higher the inflation rate, the lower the unemployment rate, and vice versa. Some economists tried to generalise the curve, calling it the Phillips curve and say that there is a tradeoff between the inflation rate and the unemployment rate, which the government can exploit.
17. The short-run Phillips curve is downward sloping and shows a tradeoff between inflation and unemployment. The long-run Phillips curve is vertical " there is no tradeoff between inflation and unemployment. The unemployment rate indicated by the vertical long-run Phillips curve is known as the natural rate of unemployment.
18. The (short-run) Phillips curve can be summarised by the following equation: Unemployment rate = u* a × (actual inflation expected inflation), where a is a positive constant measuring how unemployment changes with surprise inflation .
19. When people s expected inflation rate rises, the short-run Phillips curve shifts upwards.
20. The tradeoff between inflation and unemployment indicated by the Phillips curve is possible only in the short run. In the long run, people will not be fooled and there is no tradeoff. In addition, the short-run gain in output (and lower unemployment) at the expense of higher inf lation has a cost of a higher long-run inflation rate. To make the long-run inflation rate lower (i.e., to disinflate), the cost may be very large.
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