Econ 2013 Study Guide For the Final Exam Chapter 11 Know the basic differences between Classical and Keynesian Economics Classical Economics believes that market and resource prices are flexible and allow the economy to self correct fairly quickly Keynesian Economics believe that market and resource prices are inflexible and therefore the market will not be able to quickly correct itself Know how to calculate the marginal propensity to consume and the expenditure multiplier Also know how the broken window fallacy is related to the expenditure multiplier MPC additional consumption additional income Expenditure Multiplier M 1 1 MPC Broken window fallacy Breaking a window will create work for the window maker and he will spend the money he earns and so forth For the expenditure multiplier to work it must come from resources that otherwise would have been unemployed Money spent on recovery from destruction does not actually benefit society Know what it means for the government to run a budget deficit a budget surplus and a balanced budget T G T G Budget deficit government spending is greater than government revenues Budget surplus government revenue is greater than government spending Balanced budget government revenues taxes is equal to government expenditures T G Know what fiscal policy is and the Keynesian idea of using counter cyclical fiscal policy to stabilize the economy 1 During recessions use expansionary fiscal policy increase government spending 2 During expansions use restrictive fiscal policy decrease government spending reduce taxes increase taxes Understand the timing problems associated with fiscal policy 1 Recognition lag Our ability to forecast is extremely limited 2 Administrative lag Change in fiscal policy requires legislative action which takes a long time Impact lag A change in fiscal policy will not have an immediate impact on the economy 3 Know the automatic stabilizers and how they can promote economic stability without any discretionary change in policy 1 Unemployment compensation Recession More people will be unemployed and receive unemployment benefits so it will increase the budget deficit 1 Expansion Less people will be on unemployment benefits so there will be a budget surplus 2 The corporate profit tax Recession Companies will make less money during a recession so the government will make less money from taxes Expansion The government receives more money from taxes during an expansion so there will be a budget surplus 3 The progressive income tax Recession People will be laid off and paid less during a recession so the government will receive less money and be in a budget deficit Expansion People will be paid more and more people will be employed during an expansion so the government will receive more money from taxes and be in a budget surplus Chapter 12 Know the classical view of why fiscal policy is not as effective as Keynesians originally thought called crowding out which is a reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing Crowding Out a reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing Know the new classical view of why fiscal policy is not as effective as Keynesians originally thought called the Ricardian equivalence which is the belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people will know that higher future taxes are coming Ricardian equivalence belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people will know that higher future taxes are coming Understand the Keynesian view of the paradox of thrift and how it affects the economy Paradox of Thrift When many people drastically increase their savings and reduce consumption total savings may decrease Economy will be worse off Understand the political incentives behind discretionary fiscal policy and why it can lead to amassing huge amounts of debt Politicians overuse expansionary fiscal policy especially around election time and when it is not needed It makes it look like they re doing something and looks good to voters Know what Keynesian and Classical economists have come to agree on about fiscal policy 1 Proper timing is crucial and hard to achieve 2 Automatic stabilizers help redirect the economy 3 Fiscal policy is less potent than originally thought taxes lead to less growth 1 High tax rates discourage work effort and productivity 2 High tax rates reduce capital formation Understand the relationship between taxes and growth and the 3 reasons why high 2 3 High tax rates encourage people to purchase less desired goods just because they are tax deductible Understand the concept of supply side economics The belief that changes in the marginal tax rate will exert important effects on aggregate supply Know that supply side economics is a long run growth strategy and not a short run stabilization tool A lower marginal tax rate will give people the incentive to work more If the lower marginal rate is believed to be long term than it will shift both SRAS and LRAS Chapter 13 Know and understand the 3 important functions of money 1 Medium of Exchange used to buy goods and services 2 Unit of Account a unit of measurement used by most people to post prices and 3 Store of Value An asset that will allow people to transfer purchasing power from keep track of revenues and costs one period to the next Know what is included in M1 and M2 and how they are different M1 currency checkable deposits travelers checks M2 M1 savings deposits time deposits less than 100 000 money market mutual funds Understand how fractional reserve banking works and how the required reserve ratio affects the potential deposit expansion money multiplier Fractional reserve banking A system that permits banks to hold reserves of less than 100 against depositors Required reserve ratio rrr percentage of deposits that banks are required to hold as reserves If a bank is required to hold 20 of its reserves and the bank gets a 10 000 deposit then it can loan out 20 of that which is 8 000 Potential deposit expansion money multiplier The maximum potential increase in the money supply as a ratio of new reserves injected into the banking system Money multiplier inverse of required reserve ratio M 1 rrr Ex If the rrr is 50 of a bank s deposits then M 1 0 5 2 Know that the
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