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64 Cards in this Set
- Front
- Back
Classical economic theory states what?
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Nominal variables such as the money supply and price level do not influence real variable such as output and unemployment.
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When is the classical economic theory accurate?
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In the long run, not the short run.
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What is used to analyze short run economic fluctuations?
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The model of aggregate demand and aggregate supply.
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According to the model of aggregate demand and aggregate supply...
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the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.
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What are the three reasons the aggregate demand curve slopes downward?
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1. The wealth effect
2. The interest-rate effect 3. The exchange-rate effect |
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What is the wealth effect?
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A lower price level raises the real value of households' money holdings, which stimulates consumer spending.
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What is the interest-rate effect?
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-A lower price level reduces the quantity of money households demand.
-As households try to convert money into interest-bearing assets, interest rates fall. -This stimulates investment spending. |
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What is the exchange-rate effect?
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-A lower price level reduces interest rates
-The dollar depreciates in the market for foreign-currency exchange -Thus stimulating net exports |
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What events or policies increase aggregate demand?
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Ones that raise:
-consumption -investment -government purchases -net exports -(GDP) |
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How is the long run aggregate supply curve shaped? Why?
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-vertical
-long run quantity of supply does not depend on overall price levels |
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What affects long run aggregate supply?
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the economy's:
-labor -capital -natural resources -technology |
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What shape is the aggregate demand curve?
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downward sloping
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What three theories attempt to explain the upward sloping short-run aggregate supply curve?
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1. Sticky-wage theory
2. Sticky-price theory 3. Misperceptions theory |
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What is the sticky-wage theory?
What does it attempt to explain? |
1. -An unexpected fall in the price level temporarily raises real wages
-this induces firms to reduce employment and production 2. The upward slope of the short-run aggregate supply curve. |
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What is the sticky-price theory?
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1. -An unexpected fall in the price level leaves some firms with prices that are temporarily too high
-This reduces their sales and causes them to cut back production. |
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What is the misperceptions theory?
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-An unexplained fall in the price level leads suppliers to mistakenly believe their relative prices have fallen
-This induces them to reduce production. |
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What do all three theories on the upward slope of aggregate supply imply?
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Output deviates from its natural rate when the actual price level deviates from the price level that people expected.
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What events alter an economy's ability to produce output?
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-labor
-capital -resources -technology |
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What two things shift the short-run aggregate supply curve?
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1. Events that alter the economy's ability to produce output
2. The expected price level |
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What are two possible cause of economic fluctuations?
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-A shift in aggregate demand.
-A shift in aggregate supply. |
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What happens when the aggregate demand curve shifts to the left? How does this affect the aggregate supply curve in the short run? Why?
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-output and prices fall in the short-run.
-The aggregate supply curve shifts to the right -a change in the expected price level causes wages, prices, and perceptions to adjust. |
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What effect has the short-run aggregate supply curve shifting to the left? What is this called?
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-Falling output and rising prices.
-Stagflation |
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Who developed the theory of liquidity preference?
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Keynes
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What is the theory of liquidity preference?
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The interest rate adjusts to balance the supply and demand for money.
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How does an increase in the overall price level affect the money demand and interest rates?
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it raises money demand and increases the interest rate that brings the money market into equilibrium.
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What does the interest rate represent?
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The cost of borrowing
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What does a rising interest rate cause?
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A reduction in investment and the quantity of goods and services demanded
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What does the downward sloping aggregate demand curve express?
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The negative relationship between the price level and the quantity of output.
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What are two ways that policy makers can influence aggregate demand?
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Fiscal and Monetary policy
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What is the effect of an increase in the money supply on the interest rate, investment spending, and aggregate demand?
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-Reduction of the equilibrium interest rate for any given price level.
-Lower interest rate stimulates investment spending. -Aggregate demand curve shifts to the right. |
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What is the cause of a lower interest rate?
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an increase in investment spending
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What is the effect of a decrease in the money supply on interest rates and demand?
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-Increase in the equilibrium interest rate for any given price level
-Shifts aggregate demand curve to the left. |
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What are two ways the government can use fiscal policy?
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-Government spending
-Taxes |
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What is the effect of an increase in government purchases on aggregate demand?
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Aggregate demand curve shifts to the right
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What is the effect of an increase in taxes on aggregate demand?
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Aggregate demand curve shifts to the left
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What is the effect of a decrease in government purchases on aggregate demand?
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Aggregate demand curve shifts to the left
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What is the effect of a decrease in taxes on aggregate demand?
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Aggregate demand curve shifts to the right
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What amplifies the effects of fiscal policy on aggregate demand?
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The multiplier effect
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What dampens the effects of fiscal policy on aggregate demand?
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The crowding-out effect
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What two things cause fiscal policy to not have an exact impact on aggregate demand?
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1. The multiplier effect
2. The crowding-out effect |
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What are the beliefs of advocates of active stabilization policy?
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-changes in attitudes of households and firms shift aggregate demand
-if the gov't does not respond the result is undesirable and unnecessary fluctuations in output and employment |
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WHat are the beliefs of critics of active stabilization policy?
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Monetary and fiscal policy work with such long lags that attempts to stabilize the economy often end up in destabilization.
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What is the multiplier effect?
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The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
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What is the crowding out effect?
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The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
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What is an automatic stabilizer?
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a change in fiscal policy that stimulates aggregate demand when the economy goes into a recession without policy makers having to take deliberate action
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What is the most important automatic stabilizer? Why?
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-The tax system
-Taxes collected in a recession fall because they are almost all tied to economic activity |
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What does the Phillips curve describe?
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A negative relationship between inflation and unemployment.
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What does an expansion of aggregate demand by policy makers cause in regards to the Phillips curve?
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Higher inflation and lower unemployment.
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When does the trade-off between inflation and unemployment in the Phillips curve hold true?
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Only in the short-run
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What does the Phillips curve look like in the long run and at what rate? Why?
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-It is vertical at the natural rate of unemployment.
-In the long run expected inflation adjusts to actual inflation causing the short-run Phillips curve to shift. |
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What are three causes of shifts in the short-run Phillips curve?
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1. Expected inflation adjusting to actual inflation
2. Shocks in aggregate supply 3. Policies that cause changes in aggregate demand. |
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What does an adverse supply shock cause in regards to the Phillips curve? Which way does it shift?
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-A less favorable trade-off between inflation and unemployment.
-It shifts to the right. |
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What happens when the fed contracts growth in the money supply in regards to the short-run Phillips curve?
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Lower inflation and higher unemployment.
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What effect does an increase in aggregate demand have on the Phillips curve?
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Higher inflation rate and lower unemployment.
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What effect does a decrease in aggregate demand have on the Phillips curve?
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Lower inflation and higher unemployment
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What are the labels for the X and Y axes of aggregate demand and aggregate supply?
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X - Quantity of Output
Y - Price Level |
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What are the labels for the X and Y axes of the Phillips curve?
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X - Unemployment rate
Y - Inflation rate |
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Why is it called the "natural" rate of unemployment?
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It is beyond the influence of monetary policy
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What is the natural rate of unemployment?
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The rate of unemployment at which the economy gravitates to in the long run
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What is the equation for the Phillips curve?
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Unemployment rate = Natural rate of unemployment - (actual inflation - expected inflation)
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How does a higher expected inflation rate shift the Phillips curve?
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It shifts to the right.
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What is the sacrifice ratio?
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the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point
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What is the theory of rational expectations?
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the theory that people optimally use all the information they have, including information about government policies, when forecasting the future.
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How do advocates of active monetary and fiscal policy view the economy?
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Inherently unstable
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