Aggregate Demand &
Aggregate Supply
Aggregate Supply
What are the three components of aggregate demand (AD) that come from private sector spending?
Consumption (C), Government Spending (G), Investment (I), and Net Exports (Xn).
C + I + G + Xn
What is the difference between expansionary and contractionary fiscal policy?
Expansionary fiscal policy increases AD through higher government spending or tax cuts, while contractionary fiscal policy decreases AD through spending cuts or tax increases.
What are the three types of unemployment?
Frictional (temporary job transitions), Structural (skills mismatch), and Cyclical (due to economic downturns).
What is inflation, and how is it measured?
Inflation is a rise in the general price level of goods and services, measured by the Consumer Price Index (CPI) or GDP Deflator.
Who controls monetary policy in the U.S?
The Federal Reserve (Fed).
What are two factors that can shift aggregate supply (AS) in the short run?
Changes in resource prices, changes in productivity, changes in business taxes/subsidies, or supply shocks.
What is the formula for the spending multiplier, and what does it measure?
The formula is 1 / (1 - MPC), where MPC is the marginal propensity to consume. It measures how much total GDP changes in response to an initial spending change.
What does the natural rate of unemployment (NRU) represent?
The NRU represents the sum of frictional and structural unemployment when the economy is at full employment.
How do unexpected inflation and expected inflation affect wages differently?
Expected inflation is built into wages, while unexpected inflation reduces real wages, hurting workers on fixed incomes.
What are the three tools of monetary policy?
Open market operations (buying/selling bonds), reserve requirements, and the discount rate.
How does a negative demand shock affect price levels and real GDP in the short run?
A negative demand shock decreases AD, leading to lower price levels and lower real GDP, causing a recession.
If the MPC = 0.8, what is the spending multiplier, and what would be the total impact on GDP if the government increases spending by $500 billion
The spending multiplier = 1 / (1 - 0.8) = 5
The total GDP impact = $500 billion × 5 = $2.5 trillion.
If the unemployment rate is above the natural rate, what kind of output gap exists?
A recessionary gap, meaning actual GDP is below potential GDP.
What is the quantity theory of money, and what equation represents it?
The theory states that inflation is caused by changes in the money supply. The equation is MV = PQ (Money Supply × Velocity = Price Level × Output).
What happens when the Federal Reserve buys bonds in an open market operation?
The money supply increases, interest rates decrease, and aggregate demand rises.
What happens in the long run if the economy is in a recessionary gap with no government intervention?
Wages and resource prices will fall, shifting SRAS to the right, restoring full employment output (LRAS) without inflation.
How does the tax multiplier differ from the spending multiplier, and why is it smaller?
The tax multiplier is MPC / (1 - MPC) and is smaller because tax changes only affect disposable income, not direct spending.
If unemployment is below the natural rate, what problem might arise in the economy?
Inflation may increase because businesses must compete for scarce workers, driving up wages and prices.
What is demand-pull inflation, and what causes it?
Demand-pull inflation occurs when aggregate demand increases too quickly, causing prices to rise. It can be caused by expansionary fiscal or monetary policy.
How does raising the reserve requirement affect banks and the economy?
Raising the reserve requirement reduces the money banks can lend, decreasing the money supply and slowing economic growth.
Explain the difference between the wealth effect, interest rate effect, and net exports on aggregate demand.
The wealth effect states that higher price levels reduce purchasing power, lowering consumption. The interest rate effect states that higher prices lead to higher interest rates, reducing investment. Net exports show that higher prices make domestic goods more expensive, reducing exports and increasing imports.
Explain the crowding-out effect and how it can reduce the effectiveness of expansionary fiscal policy.
When the government increases spending, it often borrows money, raising interest rates. Higher interest rates reduce private investment spending, offsetting the fiscal policy’s impact on AD. Hence, slowing down economic growth.
How do sticky wages contribute to unemployment in the short run?
Sticky wages prevent wages from falling during recessions, leading to prolonged unemployment as firms cannot afford to hire workers at high wage levels.
What is cost-push inflation, and how is it different from demand-pull inflation?
Cost-push inflation occurs when higher production costs (rising wages or raw material costs) force businesses to raise prices. Unlike demand-pull inflation, it originates from the supply side of the economy.
How does an increase in the money supply affect nominal interest rates in the short run?
An increase in the money supply lowers nominal interest rates because there is more money available for banks to lend, making borrowing cheaper and encouraging investment and consumption.