SECTION 4 Review

Module 16

1. An autonomous change in aggregate spending leads to a chain reaction in which the total change in real GDP is equal to the spending multiplier times the initial change in aggregate spending. The size of the spending multiplier, 1/(1 − MPC), depends on the marginal propensity to consume, MPC, the fraction of an additional dollar of disposable income spent on consumption. The larger the MPC, the larger the multiplier and the larger the change in real GDP for any given autonomous change in aggregate spending. The fraction of an additional dollar of disposable income that is saved is called the marginal propensity to save, MPS.

2. The consumption function shows how an individual household’s consumer spending is determined by its current disposable income. Autonomous consumer spending is the amount a household would spend if it had no disposable income. The aggregate consumption function shows the relationship for the entire economy. According to the life-cycle hypothesis, households try to smooth their consumption over their lifetimes. As a result, the aggregate consumption function shifts in response to changes in expected future disposable income and changes in aggregate wealth.

3. Planned investment spending depends negatively on the interest rate and on existing production capacity; it depends positively on expected future real GDP.

4. Firms hold inventories of goods so that they can satisfy consumer demand quickly. Inventory investment is positive when firms add to their inventories, negative when they reduce them. Often, however, changes in inventories are not a deliberate decision but the result of mistakes in forecasts about sales. The result is unplanned inventory investment, which can be either positive or negative. Actual investment spending is the sum of planned investment spending and unplanned inventory investment.

Module 17

5. The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded.

6. The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.

7. The aggregate demand curve shifts because of changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital. Policy makers can also influence aggregate demand. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. Monetary policy is the Fed’s use of changes in the quantity of money or the interest rate to stabilize the economy, which involves shifting the aggregate demand curve.

Module 18

8. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied.

9. The short-run aggregate supply curve is upward slopng because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run.

10. Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve.

11. In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output.

Module 19

12. In the AD–AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output.

13. Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short-run aggregate supply curve (a supply shock). A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves along the short-run aggregate supply curve. A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve. A particularly nasty occurrence is stagflation—inflation and falling aggregate output—which is caused by a negative supply shock.

14. Demand shocks have only short-run effects on aggregate output because the economy is self-correcting in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, in which aggregate output is equal to potential output. In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium. We can use the output gap, the percentage difference between actual aggregate output and potential output, to summarize how the economy responds to recessionary and inflationary gaps. Because the economy tends to be self-correcting in the long run, the output gap always tends toward zero.

Module 20

15. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit, leading to lower long-run growth. Also, poorly timed policies can increase economic instability.

16. Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

17. The government plays a large role in the economy, collecting a large share of GDP in taxes and spending a large share both to purchase goods and services and to make transfer payments, largely for social insurance. Fiscal policy is the government’s tool for stabilizing the economy, although many economists caution that a very active fiscal policy may in fact make the economy less stable due to time lags in policy formulation and implementation.

18. Government purchases of goods and services directly affect aggregate demand, and changes in taxes and government transfers affect aggregate demand indirectly by changing households’ disposable income. Expansionary fiscal policy shifts the aggregate demand curve rightward; contractionary fiscal policy shifts the aggregate demand curve leftward.

Module 21

19. Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. Except in the case of lump-sum taxes, taxes reduce the size of the spending and tax multipliers. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a decrease in real GDP. Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers.

20. The tax multiplier indicates the total change in aggregate spending that results from each $1 increase in tax collections. It is smaller than the spending multiplier because some of the tax collections would have been saved, not spent. Smaller still, with a value of 1, is the balanced budget multiplier, which indicates the total increase in aggregate spending that results from each $1 increase in both government spending and taxes.

21. Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the spending multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.