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demand-GDP
inventory investment
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assumption in short run
- price is fixed
- ie. firms are willing to supply any amount of goods
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Consumption is a function of...
disposable income
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Why are G&T exogenous?
Governments do not behave with the same regularity as consumers or firms.
Macroeconomists must think about the implications of alternative spending and tax decisions of the government.
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Difference btw GDP and total demand for goods
Inventory investment; because it is not consumed it is not part of the demand
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*Components in GDP, eg. C and IM may offset each other and result in no net change in GDP
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Autonomous spending is positive when...negative when...
- Government is running a balanced budget or having budget deficit;
- very large budget surplus
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Formula of Z
Z=(autonomous spending)+c1Y
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*Any change in autonomous spending will change output by more than one for one
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The multiplier effect/amplification effect comes from
- demand Z↑
- production Y↑
- income↑
- consumption↑
- hence Y↑>initial shift in demand
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Y=income/production;
Z=...
- Demand
- expenditure
- spending
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Interpreting the multiplier
The sum of all successive increase in production
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How Long Does It Take for Output to Adjust?
assume production responds to demand instantaneously!
assume consumption responds to changes in disposable income instantaneously.
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Deriving IS relationships
- no govt
- Y=Z
- Y=C+Saving
- Z=C+I
- I=Saving
- verify I=saving
- with govt
- Y=C+I+G
- I=Y-C-G
- private saving=Y-T-C
- public saving=T-G
- national saving=Y-C-G
- hence I=national saving
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private saving equation
S=-c0+MPS(Y-T)
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Equilibrium IS equation
I=-c0+(1-c1)(Y-T)+(T-G)(ie the public saving)
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Explain how diseqm leads to inventory investment
Originally the firm produces 100 units and it is the equilibrium output, now it decides to produce 200 units, according to Z=c1Y+autonomous spending, change in demand equals c1(0.5)*100=50, total demand=150, 50 units becomes inventory investment
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what is the paradox of saving
as people attempt to save more, the result is both a decline in output and unchanged saving IN THE SHORT RUN
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mechanism behind paradox of saving-I=S perspective
- s=-c0+MPS(disposable income)
- when consumer wants to save more, c0 ↓
- 1)-c0 ↑, s ↑
- 2)consumption ↓, Z ↓, by eqm, Y↓, S↓
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The government is not omnipotent because
- Changing government spending or taxes is not always easy .
- The responses of consumption, investment, imports, etc, are hard to assess with much certainty. Anticipations are likely to matter .
- Achieving a given level of output can come with unpleasant side effects. Budget deficits and public debt may have adverse implications in the long run.
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mechanism behind paradox of saving-Y=Z perspective
- S=Y-T-C
- Y=C+I+G(Y=Z)
- hence S=I+G-T
- consumer's decision to save more cannot affect I, G, T
- S does not change
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how to calculate GDP deflator
nominal GDP/real GDP(specific base year)
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calculate inflation rate
- Pt: GDP deflator of t
- P(t-1): GDP deflator of t-1
- inflation rate=Pt-Pt-1/Pt-1
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under what condition will chained type GDP and fixed based year GDP give different numbers
- produce more than one good
- otherwise due to the different weights of goods, the estimate is not accurate
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problems with fixed based year
- overest. growth of years after base year and underest growth of years before base year
- frequent revisions
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how to calculate real GDP for 2001 in chained dollars
- matrix: base years dollars as column; years'productions as row
- use column results: production growth rate for both years
- avg production growth rate
- 2000 index:1; 2001 index=1+avg rate
- 2001 GDP in chained=nominal GDP in 2000*2001 index
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how to calculate eqm output and demand
- Y, Yd, C, multiplier, autonomous spending
- output: mutliplier
- demand: C+I+G
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why is tax called automatic stabilizer when T=t0+t1Y
- multiplier=(1-c1+c1t1)
- autonomous spending↑, Y↑, T↑, lessen the ↑in Y
- economy responds less to changes in autonomous spending than in the case where T is independent of Y
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suppose t depends on Y, if autonomous spending ↓, why is balanced budget requirement destabilizing?
- Y↓ and T↓
- to balance budget, ↓G
- Y further ↓
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suppose I=b0+b1Y, if b0 ↑, what is the ↑ in investment?
(b0↑)+ b1*Y↑
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if investment is exogenous(given), saving is
unchanged
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variables which affect demand for money
NOMINAL income $Y, +
i, (-)
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why Interest rate has a negative effect on money demand
- as interest rate increase,
- return of bonds increase,
- people put more wealth on bonds instead of money
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equilibrium condition in the financial market(LM relation) and explain
MS=$Y L(i)
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What does M(money supply) depends on
monetary policy of the central bank
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shifting variables of demand for money
$Y
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effect of buying bonds on bond price and interest rate and implications
- decrease interest rate,
- increase bond price
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effect of changing the RRR
increase M
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a decision of the central bank to lower the interest rate is equivalent to...
increasing money supply
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monetary policy instruments for the central bank to change the money supply
interest rate(federal funds rate, discount rate)
required reserve ratio
open market operations
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shifting variables of LM curve
M
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deriving the LM curve
- increase Y
- Md curve shifts right
- eqm interest rate increase
- (one point of LM)
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investment depends on
level of sales(Y, +)
interest rate(i, -)
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why investment depends on Y
- as output changes,
- demand changes,
- firms change investment in order to keep up capacity with demand
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why ↓M changes output
i↑, investment↓, demand↓, output↓
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why interest rate has a negative effect on investment
- high interest rate,
- cost of borrowing money increase
- investment decrease
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what are the measures of fiscal expansion
- cut tax
- increase government spending
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why is Z an increasing function of Y?
- Y increase,
- C and I increase,
- demand for goods increase
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why is ZZ flatter than 45deg line?
- increase in the output will not lead to an one-for-one increase in demand
- (by a factor of MPC)
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shifting variables of IS curve
ZZ(demand for goods)
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Deriving the IS curve
- increase I
- ZZ curve shift down(through decrease in investment)
- eqm output decrease
- (obtain one point on IS curve)
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exogenous variables in the ISLM model
fiscal policy and monetary policy
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how fiscal expansion change ISLM model
increases the demand in goods market
shift IS curve to the right
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how monetary expansion change ISLM model
increase the money supply
shift LM curve to the right
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is monetary expansion more investment friendly than fiscal expansion?
Yes
fiscal expansion:Y&I increase
monetary expansion: Y increase and i decrease
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changes in autonomous spending has what effect on I
ambiguous
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if investment is independent of interest rate
- IS curve is a vertical line
- fixed ouput
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Decrease in money demand has equivalent effect as
Increase in money supply
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factors that shift money demand
Use of atm: left
Worry about bank failure: right
decrease in price level: right
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Looking at the effect of deficit reduction on investment from investment-saving relationship
I=S+(T-G)
T-G↑, I↑
S=Y-T-C
Y&C↓, Y↓>C↓(MPC), S↓
ambiguous
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If Y is a variable in C and I
Z is an increasing function of Y
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Let M/P=d1Y-d2i, slope of the LM curve…
D1/d2
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direct effect(of output on demand) of the multiplier
captured by c1+b1
horizontal shift of the IS curve
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indirect effect of the multiplier
captured by b2d1/d
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what is crowding out and its implication
increase in output due to shift in IS curve-eqm output
effect of fiscal policy on interest rate limits the ability of fiscal policy to influence output
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larger multiplier mean the sensitivity of consumption and investment to output is
larger
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Effectiveness of fiscal policy depends on
Multiplier
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crowing out(con’t)-why and how the slope of LM curve affect effectiveness of fiscal policy(interest rate)
- G increase,
- Y increase
- money demand increase
- interest rate increase
amount of increase in interest rate depends on slope of LM curve
- d1/d2 is smaller
- the flatter LM curve
- the less increase in interest rate
- less crowding out
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Implication of balanced budget change
follow the direction of G because the effect of G is always greater than that of T
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if there is fiscal contraction, what variables must change?
Y, C&i
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if consumer confidence change, what variables must change?
C, Y, i
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if money supply change, what variables must change?
- i, I, Y, C
- (no change if investment is independent on interest rate)
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definition of real money supply
stock of money measured in terms of goods
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dynamic assumption of ISLM model...
based on the assumption, changing M will lead to... and changing fiscal policy will lead to...
- economy always on LM, only moves slowly to IS
- immediate change in i and no initial change in Y
- gradual change in i and gradual change in Y
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with IS↑ and LM↓, under what condition will I be ambiguous?
- i must ↑
- if output ↓, I is lower
- output↑, I is ambiguous
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slope and intercept of the IS curve
- -(1-c1-b1)/b2;
- c0-c1T+b0+G
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investment is very sensitive to interest rate
- a flatter IS slope
- a less effective fiscal policy(small multiplier)
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increasing M in higher MPC countries leads to...
- since flatter IS
- larger increase in output and smaller decrease in i
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eqm Y ISLM combined: multliplier
1-c1-b1+b2d1/d2
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eqm Y ISLM combined: autonomous spending
c0-c1T+b0+b2/d2(M/P)+G
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why banks keep reserve?
- subject to requirements
- people withdraw money
- depositors write checks
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calculate RRR
bank reserves/checkable deposits
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how banks create checkable deposits
making loans on credit
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US 2001 recession
cause: ↓ in I
policy: ficsal and monetary expansion
outcome: offset part of the ↓ in Y
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arguements for PRC to cut RRR
- affirm:
- encourage banks to lend to small enterprise after credit crisis
- retain investment(western counterpart)
- high i and high RRR, a lot of room
- boost property price
- against:
- labour market holding up
- inflation
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