Economics 104 Chapter 5 Review Questions Answers ANSWERS TO QUESTIONS FOR REVIEW 1 The National Economy Why do economists pay more attention to national economies for example the U S or Canadian economies than to state or provincial economies such as California or Ontario Each national economy has its own rules of the game that is its own laws regulations customs and conventions for conducting economic activity U S gross domestic product provides a measure of the performance of the national economy and of how it interacts with the rest of the world 2 The Human Body and the U S Economy Based on your own experiences extend the list of analogies between the human body and the economy as outlined in this chapter Then determine which variables in your list are stocks and which are flows Answers will vary Students could describe parallels between the food that the body needs for energy and growth with the savings that an economy must generate to fuel investment and economic growth Food and savings are examples of flow variables are measured over a period of time When a body is weighed a human has an objective idea of his or her size at a certain point in time When the government measures the inventory of the economy the economy has a measure of its size at a particular point in time Weight and inventory are examples of stock variables 3 Stocks and Flows Differentiate between stock and flow variables Give an example of each Stock variables are measures at a given point in time such as height weight checking account balance Flow variables measure something over an interval such as annual income monthly budget 4 Economic Fluctuations Describe fluctuations in economy activity over time Because economic activity fluctuates how is long term growth possible The economy moves through periods of expansion and periods of contraction Contractions include recessions in which total output and employment decline over a six month period and more serious depressions in which sharp reductions occur in output and employment that last more than a year The end of a contraction is marked by the trough or lowest point After the trough the economy enters an expansion period in which total output increases until the economy reaches its peak The economy grows over time This is possible because the growth during expansions more than offsets the decline during recessions In fact expansions and contractions are measured as movements above and below the long term trend line 5 Economic Fluctuations Why doesn t the National Bureau of Economic Research identify the turning points in economic activity until months or even a year after they occur The economy does not move smoothly through recessions and expansions Throughout each year the economy goes through seasonal fluctuations for example the tourist industry in Colorado expands during the winter months In addition the economy experiences random disturbances such as the impact due to hurricanes or earthquakes The NBER must wait to determine whether a change in the direction of the economy is sustained in order to distinguish the impact of seasonal fluctuations and random disturbances and the movement into a recession or expansion 6 The Great Recession The recession of 2007 2009 was made worse by a global financial crisis Show the effect of the Great Recession on the economy by shifting aggregate demand and or aggregate supply curves as appropriate 7 The Global Economy How are economic fluctuations linked across national economies How could a recession in the United States trigger a recession abroad or vice versa Major economies around the world often fluctuate together Economies are related through international trade finance and migration and ties grow stronger each year A recession in the U S increases unemployment and decreases production in the U S The U S will export fewer goods and services since total production declined and will import fewer goods and services since income declined Foreign production goes unsold and foreign firms eventually cut back production and lay off workers Foreign countries experience lower output and higher unemployment a recession 8 Leading Economic Indicators Define leading economic indicators and give some examples You may wish to take a look at The Conference Board s index of leading economic indicators at http www conference board org data Leading economic indicators are economic statistics that change prior to a change in the overall economy That is they turn downward before a recession and upward before an expansion thus pointing to the future direction of the overall economy Examples include orders for machinery and equipment the stock market index consumer confidence and household spending on durable goods 9 Aggregate Demand and Aggregate Supply Why does a decrease of the aggregate demand curve result in less employment given an aggregate supply curve When aggregate demand decreases along a fixed aggregate supply curve both the price level and the output level drop As aggregate output declines fewer workers are needed and unemployment rises 10 Aggregate Demand and Aggregate Supply Is it possible for the price level to fall while production and employment both rise If it is possible how could this happen If it is not possible explain why not Yes this could occur if aggregate supply and aggregate demand increased Both curves would shift to the right but the aggregate supply curve would shift more than the aggregate demand curve This would force down the price level while increasing production Increased production and a lower price level would also occur if aggregate supply increased along a fixed aggregate demand curve 11 Aggregate Demand Curve Describe the relationship illustrated by the aggregate demand curve Why does this relationship exist Aggregate demand describes an inverse relationship between the average price level of all goods and services and the total quantities of goods and services demanded throughout the entire economy The quantity of aggregate output demanded depends in part on household wealth An increase in the price level decreases the purchasing power of bank accounts and currency Thus households are poorer when the price level increases so they decrease the quantity of aggregate output demanded 12 Demand Side Economics What is the relationship between demand side economics and the federal budget deficit Demand side economics focuses on the ability of the government to affect aggregate demand and thus