1. Last Stuff Test Review

2. & Self-Correcting Economy
Short-run vs. long-run
& Self-Correcting Economy

3. What is the difference between the short-run and the long-run in economics?
In the short-run workers wage and other input costs (like raw materials, energy, etc.) are “sticky” and do not adjust to increases in inflation. Over time, however, workers demand and receive raises, causing the per-unit cost of production to increase. As such, the AS curve shifts leftward, restoring the economy to the full-employment level of equilibrium real GDP.

4. If an economy is facing the condition shown on the next slide, what is true about the long-run equilibrium of the economy depicted?
(SR vs. LR analysis – this is an automatic change without Fiscal or Monetary policy actions)

5. AD/AS Inflationary Gap: PL GDPr PLe LRAS SRAS ---------------- AD YFYe
GDPr

6. As wages and other input costs increase, the per-unit cost of production would go up and the SRAS will shift to the left to restore long-run equilibrium. Why? At first, workers don’t realize that their real wages (buying power) have gone down. As such, input costs are “sticky” and businesses can make higher profits. Over time, however, workers demand and receive wage increases (become “flexible”), thus causing the per-unit cost of production to increase, shifting the AS curve leftward, restoring the economy.

7. This is the SR to LR Adjustment for the previous slide
This is the SR to LR Adjustment for the previous slide. Notice it began with an inflationary gap. As input costs rose, the AS shifts leftward, restoring the Full-Employment Equilibrium level of GDPr.

8. Please note:
When there is an INFLATIONARY GAP, the SR to LR adjustment and Self-Correcting Economy situations have the same effect. Input costs will go up and the SRAS shifts leftward to restore full- employment.

9. If an economy is facing the condition shown on the next slide, what is true about the long-run equilibrium of the economy depicted? (SR vs. LR analysis. Again an automatic adjustment withour Monetary or Fiscal policy actions)

10. Recessionary Gap AD/AS PL GDPr PLe Ye YF LRAS SRAS -----------------

11. As wages and other input costs decrease, the per-unit cost of production would go down and the SRAS will shift to the right to restore long-run equilibrium. Why? During recessions, workers will take lower pay (and other input costs like raw materials will go down) causing the per-unit cost of production to decline, thus shifting the AS to the right.

12. This is the SR to LR Adjustment for the previous slide
This is the SR to LR Adjustment for the previous slide. Notice it began with a recessionary gap. As input costs decline, the AS shifts rightward, restoring the Full-Employment Equilibrium level of GDPr.

13. Please note:
When there is an RECESSIONARY GAP, the SR to LR adjustment and Self-Correcting Economy situations have the same effect. Input costs will go DOWN and the SRAS shifts rightward to restore full- employment.

14. Economic Theories

15. Keynesian Economic Theory
The economy is incapable of self-adjusting to the full- employment level of output and government maintenance of AD is critical to stabilize the economy and prevent valuable resources from standing idle. This describes _______________________.
Keynesian Economic Theory

16. By cutting taxes on individuals and businesses, the government will stimulate consumers to work, save, and invest more. In addition, businesses will be able to produce more output so AS will increase, providing more jobs in the economy.
The economic theory described above is known as ____________.
Supply Side Economics

17. Classical Economic Theory
The economy will always self-adjust to the full-employment level of output. Therefore, no government intervention in the economy is needed. This describes _________________.
Classical Economic Theory

18. The Monetarists (They had soul too!)
Which economic theories promoted that if we just increase the money supply by the projected rate of growth of real GDP everything will be alright? This is because Fiscal and Monetary Policies are inept and ineffective. (“I feel good, nananananana” James Brown, the godfather of Soul, may you rest in peace).
The Monetarists (They had soul too!)

19. Rational Expectations Theorists
They propose a monetary rule because the public will counter fiscal/monetary actions by adjusting their investment options to counter these government policies and render those government actions ineffective.
Rational Expectations Theorists

20. Fiscal policy is weak and ineffective due to the “crowding out” effect and monetary policy is ineffective due to the time lags between when monetary policy is implemented and when it actually affects the economy. They propose a Monetary Rule, increasing the money supply by the projected growth rate of real GDP. This describes ________________.
The Monetarists

21. Economic growth

22. Economic Growth & Productivity are characterized by which of the following:
Growth in GDP & Per-Capita GDP.
Economic Freedom, Sound Legal & Economic Institutions.
Respect for Private Property.
Excessive Consumption.
Trade Protectionism.
High interest rates to encourage investment.
Maintenance of capital.
Advanced technology resulting in productivity.
Low-skilled & Minimally Educated Human Capital
Lack of Private Property
Stable Food Supply & Access to technology for workers.

23. Economic Growth & Productivity are characterized by which of the following:
Growth in GDP & Per-Capita GDP. YES
Economic Freedom, Sound Legal & Economic Institutions. YES
Respect for Private Property.
Excessive Consumption NOPE
Trade Protectionism NOPE
High interest rates to encourage investment. NOPE
Maintenance of capital YES
Advanced technology resulting in productivity. YES
Low-skilled & Minimally Educated Human Capital NOPE
Lack of Private Property NOPE
Stable Food Supply & Access to technology for workers. YES

24. PPC shifts rightward LRAS shifts rightward LRPC shifts leftward
In which direction do the following graphs shift in order to show economic growth: 1) PPC or Production Possibilities Curve 2) LRAS or Long-Run Aggregate Supply Curve 3) LRPC or Long-Run Phillips Curve
PPC shifts rightward
LRAS shifts rightward
LRPC shifts leftward

25. Economic Growth Illustrated
Capital Goods 
PPC
PPC1
Consumer Goods

26. Economic Growth Illustrated
LRAS
LRAS1 PL YF YF
GDPR

27. Economic Growth Illustrated
Long-Run Phillips Curve
LRPC1
LRPC % YF YF U%

28. PPC shifts leftward LRAS shifts lefttward LRPC shifts rightward
In which direction do the following graphs shift in order to show economic decline: 1) PPC or Production Possibilities Curve 2) LRAS or Long-Run Aggregate Supply Curve 3) LRPC or Long-Run Phillips Curve
PPC shifts leftward
LRAS shifts lefttward
LRPC shifts rightward

29. Economic Decline Illustrated
Production Possibilities Curve
Capital Goods 
PPC
PPC1
Consumer Goods

30. Economic Decline Illustrated
AD/AS
LRAS1
LRAS PL YF YF
GDPR

31. Economic Decline Illustrated
LRPC
LRPC1 % YF YF U%

32. Policy mix

33. Tips for solving Policy Mix Multiple Choice Questions 1
Tips for solving Policy Mix Multiple Choice Questions 1. Determine what the question is looking for, but then boil that down to simple terms. For example: If you are asked which of the following answers would increase AD, but maintain stable interest rates, you must look for Expansionary Policies and interest rate changes that conflict. Expansionary Fiscal and Monetary Policies will both increase AD, but since they have opposite effects on interest rates, we assume they interest rates remain stable.

34. Tips for solving Policy Mix Multiple Choice Questions (continued) 2
Tips for solving Policy Mix Multiple Choice Questions (continued) When looking at each question keep in mind: a) Expansionary Policies AD and Contractionary Policies AD. b) Lower interest rates encourage borrowing for Investment (IG) since it costs less for loans and higher interest rates discourage borrowing for IG since it costs more for loans. c) Investment or IG involves businesses borrowing money for the purchase of capital goods (plant, equipment, machines, etc.). d) IG is part of AD/GDPr and if it increases, AD/GDPr goes up If IG decreases, then AD/GDPr goes down.

35. Tips for solving Policy Mix Multiple Choice Questions (continued) 3
Tips for solving Policy Mix Multiple Choice Questions (continued) Remember what the tools of Fiscal and Monetary Policy are and how they are used for Expansionary or Contractionary situations.

36. How are the tools of Fiscal and Monetary Policies used to fight recession?
Fiscal Policy: - Increase Government Spending & or Lower Taxes Monetary Policy: - Decrease Reserve Requirement - Decrease Discount Rate - Buy Government Securities

37. How are the tools of Fiscal and Monetary Policies used to fight inflation?
Fiscal Policy: - Decrease Government Spending & or Raise Taxes Monetary Policy: - Increase Reserve Requirement - Increase Discount Rate - Sell Government Securities

38. Policy Mix involves combining Fiscal and Monetary Policy Actions to achieve a goal for the economy. The keys to remember are shown below:
When each is used to fight recession, expansionary policy is used. Both will increase the PL, AD and GDPr, and reduce the u%.
When each is used to fight inflation, contractionary policy is used. Both will decrease the PL, AD, and GDPr and increase the u%.
However, each policy has opposite effects on interest rates:
a. Expansionary Fiscal Policy increases the demand for Loanable Funds and
raises the r%. Expansionary Monetary Policy increases the Money Supply
and lowers the i%. Thus interest rates would have minimal changes.
b. Contractionary Fiscal Policy decreases the demand for Loanable Funds
and lowers the r%. Contractionary Monetary Policy decreases the Money
Supply and raises the i%. Thus interest rates would have minimal changes.

39. Policy Mix Graphs
The next four slides show the four possible Policy Mix Graph Combinations

40. Combination of Expansionary Fiscal Policy & Expansionary Monetary Policy
Both policies will increase Because Expansionary Indeterminate Expansionary Monetary
AD Fiscal Policy lowers taxes as each policy Policy lowers the i%
& or increases govt spending, affects interest
the demand for loanable funds rates differently.
rises, thus increasing r%.
_________________________________________________________________________________________________________
The effect on AD is the same for both policies, so it can be predicted. However, since each policy has different effects on interest rates, the effect on Investment Demand is uncertain.

41. Combination of Contractionary Fiscal Policy & Contractionary Monetary Policy
Both policies will decrease Because Contractionary Indeterminate Contractionary Monetary
AD Fiscal Policy raises taxes as each policy Contractionary Monetary Policy
& or decreases govt spending, affects interest raises the i%
the demand for loanable funds rates differently.
drops, thus decreasing r%.
_________________________________________________________________________________________________________
The effect on AD is the same for both policies, so it can be predicted. However, since each policy has different effects on interest rates, the effect on Investment Demand is uncertain.

42. Combination of Expansionary Fiscal Policy & Contractionary Monetary Policy
Both policies affect Because Expansionary Both policies Contractionary Monetary
AD differently, so AD Fiscal Policy lowers taxes increase interest Policy raises the i%
is indeterminate & or increases govt spending, rates, so Investment
the demand for loanable funds Demand decreases
rises, thus increasing r%.
_________________________________________________________________________________________________________
The effect on AD is different for both policies. Expansionary Fiscal Policy increases AD while Contractionary Monetary Policy decreases AD. As such, AD is indeterminate. However, both policies increases interest rates, so Investment Demand declines.

43. Combination of Contractionary Fiscal Policy & Expansionary Monetary Policy
Both policies affect Because Contractionary Both policies reduce Expansionary Monetary AD differently, so AD Fiscal Policy raises taxes interest rates, so Policy lowers the i%
is indeterminate & or decreases govt spending, Investment Demand
the demand for loanable funds should rise.
drops, thus decreasing r%.
_________________________________________________________________________________________________________
Contractionary Fiscal Policy reduces AD while Expansionary Monetary Policy increases AD so the effect on AD is Indeterminate. However, both policies will reduce interest rates, so Investment Demand will increase.

44. If the government wants to get the economy out of an inflationary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) Contractionary Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary

45. If the government wants to get the economy out of an inflationary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) Contractionary Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary a) Use contractionary fiscal policy and monetary policy actions. In this case, both policies should lower AD and reduce the PL. However, contractionary fiscal policy decreases the demand for Loanable Funds and lower the r%, while contractionary monetary policy decrease the Money Supply and would raise the i%. These changes would offset each other, causing a minimal change in interest rates.

46. If the government wants to get the economy out of a recessionary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary

47. If the government wants to get the economy out of a recessionary gap with minimal change in interest rates, what combination of fiscal and monetary policy actions should it conduct? Fiscal Policy Monetary Policy a) No Change Contractionary b) Expansionary No Change c) Expansionary Contractionary d) Expansionary Expansionary e) Contractionary Expansionary D) Use expansionary fiscal policy and monetary policy actions. In this case, both policies should raise AD and lower unemployment. However, expansionary fiscal policy would increase the demand for Loanable Funds and raise r%, while expansionary monetary policy would increase the Money Supply and lower i%. These changes would offset each other, causing a minimal change in interest rates.

48. If the economy is at full-employment and policymakers want to maintain the price level, but encourage greater investment, which combination of monetary and fiscal policy actions would best achieve that goal?
Fiscal Policy Monetary Policy
a) No Change Contractionary
b) Expansionary No Change
c) Expansionary Contractionary
d) Expansionary Expansionary
e) Contractionary Expansionary

49. Fiscal Policy Monetary Policy a) No Change Contractionary
If the economy is at full-employment and policymakers want to maintain the price level, but encourage greater investment, which combination of monetary and fiscal policy actions would best achieve that goal?
Fiscal Policy Monetary Policy
a) No Change Contractionary
b) Expansionary No Change
c) Expansionary Contractionary
d) Expansionary Expansionary
e) Contractionary Expansionary
The contractionary fiscal policy would reduce the demand for loanable funds by the government, decrease r%. The expansionary monetary policy will increase the money supply, decrease the i%. The reduced interest rates would increase borrowing for investment spending by businesses. The contractionary fiscal policy would decrease AD and the PL, while expansionary monetary policy would increase AD and PL. This would keep the the economy at full-employment and maintain the PL.

50. If the government wants to raise interest rates with a minimal change in AD, what combination of fiscal and monetary policy actions should it conduct?
Fiscal Policy Monetary Policy
a) No Change Contractionary
b) Expansionary No Change
c) Expansionary Contractionary
d) Expansionary Expansionary
e) Contractionary Expansionary
Use expansionary fiscal policy combined with contractionary monetary policy actions. In this case, the expansionary fiscal policy would increase AD, while contractionary monetary policy would lower AD. Thus the policies would offset each other in terms of AD. However, expansionary fiscal policy would raise r% and contractionary monetary policy would raise i%.

51. If the government wants to raise interest rates with a minimal change in AD, what combination of fiscal and monetary policy actions should it conduct?
Fiscal Policy Monetary Policy
a) No Change Contractionary
b) Expansionary No Change
c) Expansionary Contractionary
d) Expansionary Expansionary
e) Contractionary Expansionary
Expansionary Fiscal Policy will increase the demand for Loanable Funds and increase the r%, while Contractionary Monetary Policy will decrease the Money Supply and raise the i%. Also, since Expansionary Fiscal Policy increases AD and Contractionary Monetary Policy decreases AD, there would be minimal change in AD.
Use expansionary fiscal policy combined with contractionary monetary policy actions. In this case, the expansionary fiscal policy would increase AD, while contractionary monetary policy would lower AD. Thus the policies would offset each other in terms of AD. However, expansionary fiscal policy would raise r% and contractionary monetary policy would raise i%.