Chapter 11 & 12

Question 1

What is the Self-Correcting Economy?

Answer 1

3 facts that imply the economy can correct itself without government intervention.

Question 2

What are the 3 facets of the self-correcting economy?

Answer 2

1. Consumption demand is relatively stable
2. Changes in real interest rates stabilize aggregate demand and redirect economic fluctuations (Recession: less investment —-> low interest rates —-> higher consumption and investment (offsets recession) (Expansion —-> high interest rates —-> lower consumption and investment (offsets expansion))
3. Changes in real resource prices will help redirect economic fluctuations (recession: low demand —-> resource prices go down —-> SRAS increases as a result) (Expansion: high demand —-> increase in resource prices —-> leads to SRAS going down)

Question 3

What is the Permanent-Income Hypothesis

Answer 3

People’s consumption depends on their long-run expected permanent income rather than their current income.

Question 4

When will people save and spend?

Answer 4

They will save during expansions (spending only increases slightly)

Spend savings during recessions (spending decreases only slightly)

Question 5

Define Classical Economics

Answer 5

Believes that market and resource prices are flexible and allow the economy to self-correct fairly quickly.

Question 6

Define Keynesian Economics

Answer 6

Believe that market and resource prices are inflexible, and therefore, the market will not be able to quickly correct itself.

Question 7

What are key things regarding the classical view of economy?

Answer 7

Prices are flexible and economy can fix itself very quickly. Say’s Law: supply creates demand (production matters)- People respond to economic calculations (incentives matter)

Question 8

What are key things regarding the Keynesian view of economy?

Answer 8

Prices are inflexible- Economy cannot correct itself (at least not quickly)- Demand Creates Supply- People Respond to “animal spirits”

Question 9

What does it mean for people to respond to animal spirits?

Answer 9

People being influenced by their own psychological hangups (pessimism and optimism regarding the economy)

Question 10

What are the reasons for sticky wages and prices?

Answer 10

1. Trade unions and large corporations enter into long-term contracts.
2. Menu Costs: the costs of changing prices.

As a result of sticky prices, businesses produce the amount demanded.

Question 11

Define Marginal Propensity to Consume

Answer 11

The amount of additional income that is consumed. MPC= Additional Consumption/Additional Income

Question 12

Define Expenditure Multiplier

Answer 12

A change in expenditures will have a greater impact the initial change. M= 1/(1-MPC)

Question 13

What would make the multiplier effective?

Answer 13

It must come from resources that otherwise would have been unemployed.

Question 14

Define Balanced Budget

Answer 14

Government revenues (taxes) is equal to government expenditures. T=G

Question 15

Define Budget Deficit

Answer 15

Government spending is greater than government revenue. T<G

Question 16

Define Budget Surplus

Answer 16

Government revenue is greater than government spending. T>G

Question 17

What are the changes in the size of the deficit or surplus caused by?

Answer 17

1. A reflection of the state of the economy.
2. Discretionary Fiscal Policy

Question 18

Define Fiscal Policy

Answer 18

Deliberate changes in tax policy and or government expenditures designed to affect the budget deficit or surplus.

Question 19

What happens with the expansionary fiscal policy?

Answer 19

Increasing government expenditures and/or reducing taxes.

Question 20

What is the main way the expansionary fiscal policy mitigates recessions?

Answer 20

Designed to bring the economy out of a recession by increasing aggregate demand. Expansionary policy will increase the size of the budget deficit.

Question 21

What happens with restrictive fiscal policy?

Answer 21

Decreasing government expenditures and/or increasing taxes.

Question 22

What is the main way restrictive fiscal policy mitigates problems?

Answer 22

Designed to bring the economy down from an expansion by decreasing aggregate demand. Restrictive policy will reduce the size of the budget deficit.

Question 23

What is the Keynesian view of fiscal policy?

Answer 23

Keynesians believed in the use of counter-cyclical policy, rather than balancing the budget.

Question 24

Define Counter Cyclical Policy

Answer 24

A policy that moves the economy in the opposite direction from the forces of the business cycle.

Question 25

What would happen with the counter-cyclical policy during a recession and expansion respectively?

Answer 25

Recession: expansionary policy. Expansion: restrictive policy.

Question 26

What are the timing problems of fiscal policy?

Answer 26

1. Our ability to forecast is extremely limited. 2. Changes in fiscal policy requires legislative action, which takes a long time. 3. A change in fiscal policy will not have an immediate impact on the economy. (If timed incorrectly, fiscal policy will increase economic instability).

Question 27

Define Automatic Stabilizers

Answer 27

Built in features that automatically promote a budget deficit during a recession and a budget surplus during expansion (even without a change in policy).

Question 28

What are the different types of automatic stabilizers?

Answer 28

Unemployment Compensation- Corporate Tax Profit-Progressive Income Tax