Economic Models The selection of variables

1. 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?

2. 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?

3. 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?

4. 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?

5. 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?

6. 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?

7. 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?

8. 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)

9. 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? 

10. 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?

11. 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?

12. 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?

13. 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?

14. 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.)?

15. 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?

16. 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

17. 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?

18. 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?

19. 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?