SPRING 2015
EXAM 1 STUDY GUIDE


Chapter 8: The Business Cycle

1) Know all of the components of the business cycle:
- depression, inflation, expansion, recession, contraction, stagnation, peak, trough, recovery, slowdown, growth rate of GDP, and the GDP gap.

2) Know the conditions and basic causal reasoning of the business cycle:

Recession: 

Output (Q) declines
                            ==> workers are laid-off (N declines)  ==>  wages (w) drop
                                      ==> national income (Y) drops due to loss of jobs
                                                ==> consumer spending drops (C)
                                                          ==> Aggregate Demand (AD) drops
                                                                   ==>prices (P) drop

                            ==> Investment (I) declines  ==> interest rates (r) decline

Expansion:

Output (Q) rises
     ==> workers are re-hired (N rises)  ==> wages (w) rise
                       ==> national income (Y) rises due to new jobs
                                                 ==> consumer spending (C) rises
   ==> Aggregate Demand (AD) rises
    ==> prices (P) rises
    ==> Investment (I) rises  ==> interest rates (r) rise
3.    Classical Theory, Say's Law, and Laissez-faire.

Be able to state and explain Say’s Law, and Laissez-faire.
Classicals say the business cycle is the natural self-adjustment process of the economy and that there is no role for the government to play in trying to stabilize the economy. All recession, depression, inflation is temporary and natural.

4.    Know the History of U.S. Business Cycles by decades as summarized in lecture and as presented in text: periods of  war, deficits, depression, stagflation, periods of longest growth, inflation, et cetera, all the up to the current period.

5.   Know the conditions and general impact of the Great Depression on both the world's economies (especially the U.S.) and on economic theory, as presented in the text and in lecture.



J.M. Keynes & Keynesian Economics 

1) Know the basic "formative" information about John Maynard Keynes:
- his role in and criticisms of the Treaty of Versailles;
- "The Consequences of the Peace";
- his influence on the economic and reconstruction policy after WWII.

2) Know his positions and arguments regarding economic policy during the Great Depression, i.e. regarding balanced budgets, government intervention, government spending, Say's Law, price adjustments, how to end the Depression, et cetera.

3) Know his position on self-adjustment of the economy. Why might the market not self adjust? What role do “sticky prices”,  “sticky wages”, and expectations play in the economy?
4) Know Keynes' analysis of equilibrium. Is it acheivable? How can equilibrium be “undesirable” or “sub-optimal”?

5) Be able to contrast the Classical and Keynesian theories in the following categories:
        - stability versus instability
        - the price adjustment process
        - the importance of prices in macroeconomic decisions of consumers and                         producers.
        - the nature of equilibrium (optimality versus sub-optimality)
        - demand-side analysis versus supply-side analysis
        - the role of government in the economy
        - problems of inflation (expansion) and unemployment (recessions or                             depressions)
6) Explain the meaning following quote from J.M. Keynes in May 1932:
This is the point at which, on the precedent of previous slumps,
we might hope for the beginning of recovery. I am not confident,
however, that on this occasion the cheap-money phase will be
sufficient by itself to bring about an adequate recovery of new
investment. It may still be the case that the lender, with his
confidence shattered by his experiences, will continue to ask for
new enterprise rates of interest, which the borrower cannot
expect to earn…


7) Be able to explain other quotes by Keynes that are provided on the course website on J.M. Keynes.


Chapter 8 & 9: Aggregate Demand
Assembling the Neo-Classical AS-AD Model from Keynesian Expenditure Analysis.

 Overview:

Classical Theory (i.e. Say's Law): 
Supply determines the state of the economy, (PE,QE).

Alfred Marshall:  
In L.R.,  Supply determines the state of the economy, (PE,QE); however,
In S.R.,  Demand determines the state of the economy ,(PE,QE).

J.M. Keynes:  
The L.R. is irrelevant.
Total spending (expenditures) determines that state of the economy, (PE,QE).

Neo-Classical AS-AD Model (A Synthesis):  
In L.R.,  Supply determines the state of the economy, (PE,QE). The  AS line is vertical.
In S.R.,  Demand has some influence on (PE,QE), thus the AS line is flatter or convex.
The AD line is strictly downward sloped, and incorporates all of the Keynesian Expenditure analysis. This macroeconomic AD-AS model strives to be consistent with the Neo-classical microeconomic S-D model.

The Keynesian Expenditure Analysis:
Recall from Chapter 5, Output - Income - Expenditure Accounting Identity:
GDP = Q = Y = E, and E = C + I + G + (X - IM). Together these capture the Keynesian anaylsis of the macroeconomy: Total Expenditures determine the output level of the economy.

Consumer Spending (C)
  • Know all the factors that influence aggregate consumer spending: income, welath, credit, expectations, preferences, et cetera.
  • Know all the details of the Consumption Function:
- The equation and the meaning of all the variables:
C = a + bYD.
a = autonomus spending; the intercept
b = the Marginal Propensity to Consume, the slope.

- Know the importance and all the interpretations of the Marginal Propensity to Consume (MPC): slope of consumption function; the rate of new spending out of new income; et etera.

- Know the graphical representation of the Consumption Function and its meaning.

Investment Spending (I)
  • Know the factors that influence Investment: profit expectations, interest rates, technological change.
  • Know the importance of the volatility of I.
  • Know how the Investment function (curve) is drawn and how it affects E and AD.
Government Spending & Net Exports
  • Know how each of these components (G, X, IM) affect total expenditures (E) and AD.

Macroeconomic Failure
Both as presented in lecture (more detail) and as presented in the text know how Keynes explains the possibility of the macroeconomy failing to acheive an optimal equilibrium: instability, failure to adjust, recessionary gaps, inflationary gaps.




SHORT ANSWER QUESTIONS

1.   State and explain Say’s Law. Explain what is meant by Laissez-faire.

2.   According to Classical Theory (e.g. Say's Law), can a depression persist? Explain your answer.

3.  According to Keynesian Theory, can a depression persist? Explain your answer.

4.   What are 5 objections or criticisms that Keynes makes of the Classical analysis of the macro-economy.

5.   According to Keynesian, what role do “sticky prices”,  “sticky wages”, and expectations play in the economy?

6.   Explain two reasons why the market may not self-adjust, according to Keynes. Give an example illustrating each reason.

7.   In the Keynesian analysis how can equilibrium be “undesirable” or “sub-optimal”?

8. What is the Marginal Propensity to consume? (Note: there are at least 3 ways to define the MPC.)