Economic ModelsThe selection of variables

• What is the difference between an endogenous variable and an exogenous variable?

• What are the endogenous variables in the simple Keynesian model (chapter 3)?

• What is the difference between a demand shock and a supply shock? Which of these shocks is most prevalent in the simple Keynesian model as applied to the Great Depression?

Planned expenditure

• What are the four components of planned expenditure?

• What are the autonomous versus induced components of the consumption function?

• What is the marginal propensity to consume? • How does the marginal propensity to consume

relate to the marginal propensity to save? • Why did U.S. savings almost vanish in 2001?

The Ep Function

• What is the general linear form for planned spending function?

• What is represented by a 450 line?• At what level of income is the economy in

equilibrium?• What happens to inventory investment when the

economy is out of equilibrium? • How does this influence future production and

income in the movement toward equilibrium income?

The multiplier effect

• How does a change in autonomous spending induce more consumption spending?

• How is the value of the multiplier determined by the marginal propensity to consume domestically?

• How does the multiplier relate to the leakage rate from domestic income?

• How would you derive a leakage function for a private, domestic economy?

Fiscal Policy

• What is the multiplier for government spending? • What is the multiplier for a change in autonomous

taxes? • How can fiscal policy change equilibrium income

through a change in government spending or taxes?

• What is the balanced budget multiplier in the simple Keynesian model?

The Role of Interest Rates on Planned Spending

• What is the difference between “short-term” and “long-term” interest rates?

• What does “the” interest rate in our model represent? • What determines the rate of return (m.e.c.) on a

particular investment project?• How does the rate of return (m.e.c.) relate to the

interest rate to determine the profitable level of investment?

• How does this translate into an investment demand function?

The Fed’s 4 Cylinders

• What are the “four channels” by which the Fed affects planned spending through changes in the interest rate?

• The Case Study describes the Fed in 2001 as a “four-cylinder engine running on only one cylinder.” Which cylinder worked?

The IS Curve

• Why is the autonomous planned spending function, Ap, is sometimes called the “injection function?”

• Why is the induced savings function sometimes called the “leakage function?”

• How do income taxes and imports affect the slope of the “leakage function?”

• How is the IS curve derived from the injection and leakage functions? (Four diagrams)

Slope and Shifts of the IS Curve

• What happens to the slope of the IS curve when autonomous spending is less sensitive to a change in the interest rate?

• What happens to the slope of the IS curve if the leakage rate (slope of the leakage function) is increased?

• How do autonomous changes (including fiscal policy) affect the IS curve?

• How would President Bush’s tax plan affect the IS curve? 

The Money (and Bond) Markets

• What are the three functions of money? • How does the demand for real money

balances relate to real income? • If money and bonds are substitutes and

money pays no interest but bonds pay interest, why would people demand less money when the interest rate increases?

• How does this affect the velocity of money?

The LM Curve

• How does the demand for money relate to real income and the real interest rate?

• Who determines the real money supply, given the price level?

• How can you derive an LM curve for a given demand and supply for money?

• If the Central Bank adds to the money supply by buying bonds, what initially happens to the interest rate?

• How can this affect real income in the economy?

Slope and Shift of the LM Curve

• What happens to the slope of the LM curve if the demand for money is extremely sensitive (interest elastic) to changes in the nominal interest rate (liquidity trap)?

• What is the slope of the LM curve if the demand for money is interest inelastic?

• Which of the two functions results in the velocity of money being volatile?

General Equilibrium

• Why is the IS=LM intersection necessary for general equilibrium income to exist?

• Why does the central bank depend upon the transition between the money market and goods market to effect the economy?

• Does a flat LM curve make monetary policy more or less effective compared with a steeper LM curve? How does this relate to the “liquidity trap?”

• How does a steep IS curve affect the effectiveness of monetary policy?

Choosing Fiscal v. Monetary Policy• Which stabilization policy is likely to have the most

positive influence on economic growth?• Does the fiscal multiplier depend upon monetary

response in the Japanese economy? • What is meant by the crowding out effect?• What conditions in the money market add to the

potential crowding out effect of a fiscal deficit?• Has monetary policy been an effective stimulus to

economic recovery from the 2001 recession?• What about the timing associated with each of the two

policies (recognition, administration, impact lags.)?

Effects of Government Budget

• What determines the budget deficit or surplus?• How does a budget deficit affect domestic savings,

other things equal?• How does a government deficit “crowd out” net

exports as well as investment? • Why are the “twin deficits” not always twins?• How does the government deficit impact on future

generations through investment in the stock of capital?

The Size of Government

• How does war relate to deficits as a share of natural GDP?• How does recession relate to deficits as a share of natural

GDP?• Why happened to the deficit as a percent of natural GDP

after the 1980 recession until 1997?• Why did a government surplus emerge from 1997-2000?• Alan Greenspan’s Testimony

http://www.federalreserve.gov/BoardDocs/HH/2003/february/testimony.htm

The Structural Budget

• What is the difference between the structural budget balance and the actual budget balance, that also includes the effect of cyclical forces?

• How do automatic stabilizers affect the budget deficit or surplus over the cycle?

• Can you derive a budget line, BB, that relates the budget deficit or surplus to real income, for given autonomous spending and the income tax rate?

• How does discretionary government policy affect the level and slope of the budget line?

Actual and Natural Surplus or Deficits

• What is meant by the natural employment surplus or natural employment deficit (NED)?

• Is the current economy experiencing a NED?• How would a change in fiscal policy that lowered t0

affect the NED?• Under what circumstances could this result in a

natural employment surplus in the future?• How does your argument relate to the national

savings rate, including both government savings and private savings?

Solutions to the National Savings Squeeze

• Is borrowing from abroad a permanent solution to the lack of domestic savings?

• What has contributed to the drop in domestic a private saving rates? Will this change in the future?

• Should the government savings rate increase or be reduced?

• What are the distributive effects of the Bush tax reduction plan that could affect the private savings rate?