Economics Test 3

Front 1

Classical Economics

Back 1

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

Front 2

Keynesian Economics

Back 2

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

Front 3

Reason for sticky wages and prices

Back 3

Trade unions and large corporations enter into long-term contracts.
Menu costs: The costs of changing prices

Front 4

as a result of sticky prices, businesses produce

Back 4

the amount demanded

Front 5

Marginal propensity to consume (MPC):

Back 5

The amount of additional income that is consumed

Front 6

MPC=
marginal propensity to consumer

Back 6

additional consumption / additional
income

Front 7

The Expenditure Multiplier (M

Back 7

A change in expenditures will have a greater impact than the initial change

Front 8

M=
expenditure multiplier

Back 8

1/1-mpc

Front 9

: For the multiplier to be effective it must come from

Back 9

resources that otherwise would have been unemployed*

Front 10

balanced budget

Back 10

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

Front 11

budget deficit

Back 11

government spending is greater than government revenues
T < G

Front 12

budget surplus

Back 12

government revenue is greater than government spending

Front 13

Changes in the size of the deficit or surplus can have two main sources:

Back 13

A reflection of the state of the economy
Discretionary Fiscal Policy

Front 14

fiscal policy

Back 14

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

Front 15

expansionary fiscal policy

Back 15

Increasing government expenditures and/or
Reducing tax rates
shifts AD right
increases the size of the deficit

Front 16

expansionary fiscal policy was designed to

Back 16

to bring the economy out of a recession by increasing aggregate demand

Front 17

restrictive fiscal policy

Back 17

Decreasing government expenditures and/or
Raising tax rates
reduce the size of the budget deficit
shifts AD left

Front 18

restrictive fiscal policy was designed to

Back 18

bring the economy down from an expansion by decreasing aggregate demand.

Front 19

Keynesians believed in the use of ------------, rather than ---------

Back 19

counter-cyclical policy

balancing the budget

Front 20

counter-cyclical policy

Back 20

a policy that moves the economy in the opposite direction from the forces of the business cycle.
recession: expansionary policy

expansion: restrictive policy

Front 21

Effectiveness of fiscal policy is reduced by the following timing problems:

Back 21

Our ability to forecast is extremely limited
Change in fiscal policy requires legislative action, which takes a long time
A change in fiscal policy will not have an immediate impact on the economy

Front 22

If timed incorrectly, fiscal policy will -------- (rather than ---------) economic instability

Back 22

increase
rather

Front 23

Automatic stabilizers:

Back 23

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

Front 24

3 automatic stabilizers

Back 24

Unemployment compensation
The corporate profit tax
The progressive income tax

Front 25

kenyensian vs classical economist

Back 25

Keynesian Economist: expansionary fiscal policy during a recession will stimulate Aggregate Demand (AD) and pull us out of a recession
Classical Economist: possibly, but maybe not….

Front 26

Crowding-out:

Back 26

Crowding-out:a reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing

Front 27

the crowding out process

Back 27

Government conducts expansionary fiscal policy to bring economy out of a recession.
This increases the budget deficit (which must be financed through borrowing).
Government borrowing increases the demand for loanable funds (and, thus, the interest rate).
Increase in interest rate causes consumption and investment to decrease. It also causes capital inflow to increase.
This causes the dollar to appreciate, which causes net exports to decline (fiscal policy fails to bring economy out of a recession).

Front 28

New Classical Economists do not believe that budget deficits will

Back 28

stimulate additional consumption and aggregate demand Because people will save for the expected future tax increase.
(remember the permanent income hypothesis)

Front 29

Ricardian equivalence

Back 29

belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people will know that higher future taxes are coming

Front 30

Paradox of Thrift

Back 30

: When many people drastically increase their savings and reduce consumption, total savings may decrease

Front 31

Keynesian Economist: Its alright to allow the government to run budget deficits during

Back 31

recessions, because they will run a budget surplus during expansions to pay for the deficit and so the country will not amass a lot of debt.

Front 32

Politicians have a tendency to overuse

Back 32

expansionary policy (even when its not called for).

….especially around election time (remember chapter 6)

Front 33

Most macroeconomists, both Keynesian and Classical, believe:

Back 33

Proper timing is crucial and hard to achieve.
Automatic stabilizers help redirect the economy.
Fiscal policy is less potent than originally thought.

Front 34

High taxes retard growth because

Back 34

1.High tax rates discourage work effort and productivity
2. High tax rates reduce capital formation
3. High tax rates encourage people to purchase goods that are less desired, just because they are tax deductible

Front 35

Supply-side economics:

Back 35

The belief that changes in the marginal tax rate will exert important effects on aggregate supply

Front 36

what are the 3 components of supply-side economics

Back 36

A lower marginal tax rate will give people the incentive to work more.
If the lower marginal rate is believed to be long-term than it will shift both SRAS and LRAS.
Supply side economics is a long-run, growth oriented strategy, not a short-run stabilization tool.

Front 37

3 functions of money

Back 37

1.medium of exchange
2.a store of value
3.a unit of account

Front 38

medium of exchange

Back 38

used to buy goods and services

It is more efficient to use money than to barter goods.

Front 39

fiat money

Back 39

money that has no instinsic value

Front 40

a store of value

Back 40

: An asset that will allow people to transfer purchasing power from one period to the next

Front 41

liquid asset

Back 41

asset that can be easily and quickly converted to purchasing power

Front 42

a unit of account

Back 42

a unit of measurement used by most people to post prices and keep track of revenues and costs.

Front 43

value of money is determined by

Back 43

demand relative to supply

Front 44

M1

Back 44

currency + checkable deposits + travelers checks

M1 is the more liquid form of money

Front 45

M2

Back 45

M1 + savings deposits + time deposits (less than $100,000) + money market mutual funds

is a broader definition of money (less liquid)

Front 46

savings account

Back 46

: interest bearing holding account at a bank

Front 47

time deposits

Back 47

: Financial accounts with a minimum time requirement (CD)

Front 48

money marketable mutal funds

Back 48

interest earning accounts that pool depositors funds and invest them in highly liquid short-term securities.

Front 49

central bank

Back 49

: An institution that regulates the banking system and controls the money supply

The central bank in the U.S. is called the Federal Reserve System (the Fed)
Carries out regulatory policies
Conducts monetary policy

Front 50

bank reserves

Back 50

Vault cash + the deposits of banks with the Fed

Front 51

fractional reserve banking

Back 51

A system that permits banks to hold reserves of less than 100% against depositors.

Front 52

required reserves

Back 52

The minimum amount of reserves that a bank is required by law to keep on hand to back up its deposits.

Front 53

Federal Deposit Insurance Corporation (FDIC

Back 53

a federal corporation that insures deposits up to $250,000.

Front 54

Required reserve ratio

Back 54

percentage of deposits that banks are required to hold as reserves.

Front 55

excess reserves

Back 55

actual reserves that exceed the legal requirement

Front 56

excess reserves

Back 56

actual reserves that exceed the legal requirement

Front 57

potentional deposit expansion (money) multiplier

Back 57

The maximum potential increase in the money supply as a ratio of new reserves injected into the banking system

Front 58

money multiplier

Back 58

inverse of required reserve ratio

Front 59

The lower the required reserve ratio

Back 59

the more money supply will expand

Front 60

The higher the required reserve ratio

Back 60

the less money supply will expand

Front 61

New currency reserves will NOT

Back 61

expand money supply by as much as the potential multiplier indicates for 2 reasons:

Front 62

The effect of the deposit multiplier will be reduced if:

Back 62

Some people decide to hold currency rather than deposit it in the bank
Banks fail to use all of the new excess reserves to extend loans

Front 63

The Federal reserve system is instructed by congress to conduct monetary policy in a manner that promotes:

Back 63

Full employment
Price stability

Front 64

Federal Open Market Committee (FOMC)

Back 64

determines the feds policy with respect to the purchase and sale of government bonds

Front 65

open market operations

Back 65

the buying and selling of bonds on the open market by the Fed.

Front 66

open market operations

Back 66

When the Fed buys bonds it increases the money supply.

When the Fed sells bonds it decreases the money supply.

Front 67

Reserve requirements

Back 67

Lower reserve requirements will increase the money supply.

An increase in reserve requirements will reduce the supply of money.

Front 68

3. Extension of loans:

Back 68

When the fed extends more loans, money supply increases.

When the fed extends less loans, money supply decreases

Front 69

the discount rate

Back 69

The interest rate the Fed charges banking institutions to borrow funds

Front 70

federal funds rate

Back 70

The interest rate that commercial banks charge each other.

Front 71

Interest paid on excess bank reserves:

Back 71

Reducing the interest paid on excess reserves increases the money supply

Increasing the interest paid on excess reserves reduces the money supply

Front 72

how does the fed control eh money supply

Back 72

1. open market operations
2.reserve requirements
3.extension of loans
4.interest paid on excess bank reserves

Front 73

fed expansionary policy

Back 73

purchase gov bonds
lower reserve requirements
extend more loans
reduce the interest paid on excess reserves

Front 74

fed restrictive policy

Back 74

sell government bonds
raise reserve requirements
extend less loans
increase the interest paid on excess reserves

Front 75

Money demand curve

Back 75

indicates the inverse relationship between the interest rate and the quantity of money people want to hold.
downward sloping because as the interest rate increases, people will hold less money.

Front 76

the money supply curve

Back 76

The amount of money in the economy, determined by the Fed.


The money supply curve is vertical because it is determined by Fed policy and does not depend on the interest rate

Front 77

Equilibrium occurs where MD =

Back 77

= MS (money demand intersects the money supply).

Front 78

Expansionary monetary policy

Back 78

A shift in monetary policy designed to stimulate aggregate demand

Front 79

Increase in money supply

Back 79

shift money supply to the right.

Front 80

Lower interest rate causes

Back 80

Consumption and investment to increase
Net exports to increase
Asset prices to increase

Front 81

The effect of expansionary policy in the long run:

Back 81

Economy is in recession
Economy is in long-run equilibrium

Front 82

Restrictive monetary policy

Back 82

A shift in monetary policy designed to restrict aggregate demand

Front 83

Decrease in money supply

Back 83

shift money supply to the left.

Front 84

How restrictive policy decreases aggregate demand.

higher interest rate causes

Back 84

Consumption and investment to decrease
Net exports to decrease
Asset prices to decrease

Front 85

The effect of restrictive policy in the long run:

Back 85

Economy is in expansion (boom).
Economy is in long-run equilibrium.

Front 86

Velocity of Money (V):

Back 86

The average number of times a dollar is used to purchase final goods and services during a year.

Front 87

The quantity theory of money

Back 87

a change in the money supply will cause a proportional change in the price level

Front 88

Equation of exchange

Back 88

PY = MV

Front 89

The quantity theory of money in terms of growth rates:

Back 89

rate of inflation + growth rate of real output = Growth rate of money supply + growth rate of velocity

Front 90

In the long-run, rapidly increasing the money supply will:

Back 90

1. Cause inflation
2. NOT reduce unemployment
3. NOT increase output

Front 91

There is no short-run increase in output, only

Back 91

long-run inflation

Front 92

There is no short-run increase in output, only long-run inflation

This occurs because expected future inflation causes:

Back 92

Consumers to demand more now
Producers to supply less now
People to factor inflation into their long-term contracts

Front 93

Summary of effects of expansionary monetary policy
Unanticipated increase in money supply

Back 93

short run:Real GDP rises
Unemployment falls
Price level rises
long run:Only price level rises

Front 94

Summary of effects of expansionary monetary policy
Anticipated increase in money supply

Back 94

short run: only price level rises
long run: only price level rises