Macroeconomic Essentials (Economics 1B) Unit 5

Questions and Answers

What is the term used to describe the collapse of production, employment, and prices in the industrial world in the 1930s?

The Economic Downturn

The Great Depression (correct)

The Financial Crisis

The Great Recession

Who is considered the founder of macroeconomics?

Karl Marx

Adam Smith

John Maynard Keynes (correct)

John Pape

How many economic schools of thought are identified by John Pape?

3 (correct)

What is the central belief in free market economics regarding human motivation?

Personal gain Signup and view all the answers

What is the term used to describe the economic school of thought that emphasizes the role of government intervention in the economy?

Keynesian economics Signup and view all the answers

What is the primary goal of free market economics?

To promote competition and economic growth Signup and view all the answers

What is the term used to describe the economic school of thought that emphasizes the role of class struggle in shaping economic outcomes?

Marxist economics Signup and view all the answers

What is the term used to describe the economic school of thought that emphasizes the importance of individual freedom and limited government intervention?

Free market economics Signup and view all the answers

What is the main argument of free marketers against high taxes?

Taxes discourage businesses from producing goods and services. Signup and view all the answers

What do free marketers believe is the major obstacle to the success of their economic model?

Government intervention in trade activities. Signup and view all the answers

What type of economic system do free marketers support?

Capitalist economic system. Signup and view all the answers

Which of the following is NOT a characteristic of a free market economy?

Government ownership of businesses. Signup and view all the answers

What do Marxist economists believe should drive an economy?

Cooperation. Signup and view all the answers

What type of economic system do Marxist economists support?

Socialist economic system. Signup and view all the answers

Which of the following is a characteristic of a socialist economic system?

Cooperation among individuals. Signup and view all the answers

Which economist is associated with the development of Marxist economics?

Karl Marx. Signup and view all the answers

Which country has liberalized its economy dramatically, despite being ruled by a communist government?

China. Signup and view all the answers

What is the main difference between free market and Marxist economics?

Free market economists believe in profit-driven economy, while Marxist economists believe in cooperation-driven economy. Signup and view all the answers

Which economic programme has Vietnam instituted to revive its economy?

Doi Moi Signup and view all the answers

What was the main issue with the global economy in the late 1920s?

Drop in production Signup and view all the answers

What did Keynes argue was the root of the economic problem?

Lack of demand Signup and view all the answers

What is the focus of Keynesian economics?

Aggregate demand Signup and view all the answers

According to classical economic theory, what will happen if there is too much labour and not enough demand for it?

Wages will fall Signup and view all the answers

What is the difference between nominal and real wages?

Nominal wages are the amount paid in money terms, while real wages are the value in terms of purchasing power Signup and view all the answers

Why did Keynes argue that nominal wage cuts would be difficult to implement?

Because of laws and wage contracts Signup and view all the answers

What is the name of the law that classical economists believed would always be enforced by price adjustments?

Say's Law Signup and view all the answers

What would happen to consumer demand if nominal wages fell more than prices?

It would decrease Signup and view all the answers

What was one of the criticisms of Keynes' theory?

That it did not take into account human rights violations Signup and view all the answers

What happens when investment falls, perhaps due to falling consumer demand, over-investment in earlier years, or pessimistic business expectations, and saving does not immediately fall in step?

Excessive Saving Signup and view all the answers

According to Keynes, what determines interest rates in the short-run?

The supply of and demand for the stock of money Signup and view all the answers

What is the term used to describe a situation where interest rates cannot fall below a certain level?

Liquidity Trap Signup and view all the answers

What happens to people's incomes and saving during a recession?

They fall Signup and view all the answers

What is the accelerator effect, according to Keynes?

The shift of the investment curve to the left Signup and view all the answers

Why did Keynes disagree with classical theorists' approach to balancing the government budget?

Because it would increase saving, thereby lowering demand for products and labor Signup and view all the answers

What is the main story, according to Keynes, in the interaction between excess supplies in different markets?

Quantity adjustment allowing recessions and possible attainment of underemployment equilibrium Signup and view all the answers

What happens to the business incentive to engage in fixed investment during a recession?

It falls Signup and view all the answers

What is the result of excessive saving, according to Keynes?

Insufficient demand for business output Signup and view all the answers

What is the primary goal of active fiscal policy, according to Keynes?

To stimulate economic activity during a recession Signup and view all the answers

What is the purpose of deficit spending in an economy?

To stimulate economic growth during a recession Signup and view all the answers

What is the term used to describe the increase in final income arising from an increase in government spending?

Multiplier Effect Signup and view all the answers

What is the formula used to calculate the Multiplier Effect?

Multiplier = 1 / (1 - MPC) Signup and view all the answers

What is the assumption made about the workers' salaries in the calculation of the Multiplier Effect?

They spend some of their salaries and save the rest Signup and view all the answers

According to Keynes, what determines the amount of investment?

Long-term profit expectations Signup and view all the answers

What is the main difference between the Classical Model and Keynes' approach to interest rates?

The Classical Model determines investment based on the supply of funds Signup and view all the answers

What is the result of the Multiplier Effect in an economy?

An increase in aggregate demand Signup and view all the answers

What is the term used to describe the process by which an increase in government spending leads to an increase in household income, which in turn leads to an increase in consumption and further increases in income?

The Multiplier Effect Signup and view all the answers

What is the purpose of increasing taxes during boom times in an economy?

To suppress inflation Signup and view all the answers

What is the term used to describe the change in income due to a permanent change in the flow of expenditure?

The Multiplier Effect Signup and view all the answers

What is the primary driver of investment spending?

Expected profitability from the investment Signup and view all the answers

What is the relationship between investment spending and income?

Investment spending is independent of income Signup and view all the answers

What is the equation of the 45° line in figure 5.4?

A = Y Signup and view all the answers

What occurs when the level of income is lower than Yo?

Excess demand Signup and view all the answers

What is the point where the line A=Y intersects the line A = C + I?

The point of equilibrium Signup and view all the answers

What is the level of income at which the aggregate spending function A intersects the 45° line?

Yo Signup and view all the answers

What is the relationship between aggregate spending and total income at equilibrium?

A = Y Signup and view all the answers

What is the purpose of combining C and I to obtain aggregate spending?

To construct a simple macroeconomic model of income determination Signup and view all the answers

According to Keynesian economics, what is the impact of changes in aggregate demand on real output and employment?

It has its greatest short-run impact on real output and employment, not on prices Signup and view all the answers

What is the primary reason for the comeback of Keynesian theory since the mid-1980s?

It was better able to explain the economic events of the 1970s and 1980s Signup and view all the answers

What are the two types of spending in the simple Keynesian macroeconomic model?

Consumption spending and investment spending Signup and view all the answers

What is the condition for an economy to be in equilibrium in the simple Keynesian macroeconomic model?

Aggregate Spending (A) = Aggregate Income (Y) Signup and view all the answers

What is the term used to describe the part of consumption that is independent of the level of income?

Autonomous consumption Signup and view all the answers

What is the relationship between aggregate demand and real output and employment, according to Keynesians?

Changes in aggregate demand have their greatest short-run impact on real output and employment, not on prices Signup and view all the answers

What is the focus of many Keynesians in terms of economic policy?

Combating unemployment Signup and view all the answers

What is the term used to describe the slope of the consumption function?

Marginal propensity to consume Signup and view all the answers

What is the name of the system that, in effect, spread the stern German monetary policy all over Europe?

European Monetary System Signup and view all the answers

What are the six principal tenets of Keynesianism, according to Blinder (1987)?

Three describe how the economy works and three are distinguishing features from other economic theorists on economic policy Signup and view all the answers

Study Notes

Introduction to Macroeconomics

Macroeconomics originated in the 1930s during the Great Depression
Development of macroeconomics led to a better understanding of how to combat economic crises and stimulate long-term growth
John Maynard Keynes made significant contributions to macroeconomic policy

Economic Schools of Thought

There are three main economic schools of thought:
- Free Market Economics (also known as Orthodox Theory, Neo-Classical Theory, Conservative Economics, or Capitalistic Economics)
- Marxist Economics (also known as Socialist Economic Theory or Communist Economic Theory)
- Keynesian Economics (also known as the Theory of the Mixed Economy or Interventionist Economics)

Free Market Economics

Major beliefs:
- Human beings are motivated by profit and self-interest
- Businesses should be given a free hand in all economies
- Competition between businesses should be promoted
Oppose high taxes and nationalization
Believe that government should ensure a conducive environment for business
Support a capitalist economic system with private ownership of factors of production and private property rights
Countries that have practiced free market economics include the USA, Switzerland, and Singapore

Marxist Economics

Major beliefs:
- Human beings are not driven by self-interest
- Economy should be based on cooperation rather than competition
- Property rights should not vest with individuals
Believe that profit should be eliminated
Support a socialist economic system
Countries that have practiced Marxist economics include the former Soviet Union, Cuba, and North Korea

Keynesian Theory

Developed in response to the Great Depression
Emphasizes the importance of aggregate demand in the economy
Argues that the economy can be stuck in a state of underemployment equilibrium
Government intervention is necessary to stimulate demand and achieve full employment

Keynes vs Classical Economic Theories

Keynesian economics focuses on aggregate demand and its effects on output and inflation
Classical economists believe that prices will adjust to achieve full employment
Keynes argued that wages are not flexible and that interest rates cannot fall below zero

Excessive Saving and Recessions

Excessive saving leads to a decrease in aggregate demand
Decrease in aggregate demand leads to a recession
Keynes argued that people will resist nominal wage reductions and that excessive saving results in unemployment

Government Policy and Fiscal Policy

Fiscal policy is the behavior of governments in raising money to fund current spending and investment
Keynes suggested that active government policy is necessary to manage the economy
Deficit spending can stimulate the economy during recessions
Reducing government spending and increasing taxes can help suppress inflation during booms

The Multiplier Effect

The multiplier effect is the change in income due to an exogenous increase in expenditure
The multiplier is calculated as 1 / (1 - MPC), where MPC is the marginal propensity to consume
Example: If the government increases expenditure by R100,000 and the MPC is 0.8, the multiplier is 5, and the cumulative effect is R500,000

Interest Rates

Classical model: supply of funds determines the amount of fixed business investment
Keynesian model: amount of investment is determined by long-term profit expectations and interest rate

Summary of Keynesian Economics

Six principal tenets:
- Aggregate demand is influenced by public and private decisions
- Changes in aggregate demand have a greater impact on real output and employment than on prices
- Prices and wages respond slowly to changes in supply and demand
- Unemployment is subject to the caprice of aggregate demand
- Activist stabilization policy is necessary to reduce the amplitude of the business cycle
- Combating unemployment is more important than conquering inflation### Types of Spending in an Economy
In an economy with households and firms, there are two types of spending: consumption spending (C) and investment spending (I)
Consumption spending (C) is spending by households on consumer goods and services
Investment spending (I) is spending by firms on capital goods

Economy in Equilibrium

The economy is in equilibrium when Aggregate Spending (A) equals Aggregate Income (Y)
Aggregate Spending (A) consists of consumption spending (C) and investment spending (I), i.e., A = C + I
The economy is in equilibrium when C + I = Y

Consumption Function

The consumption function shows the relationship between consumption expenditure by households and total income
The consumption function has three important characteristics
Autonomous consumption is the part of consumption that is independent of the level of income, financed by other sources of income (e.g., savings or credit)
Induced consumption is the part of consumption that is determined by the level of income, indicated by the slope of the consumption function

Investment Spending

Investment spending is more variable and less predictable than consumption spending
Investment spending is often the main cause of fluctuations in economic activity
I is not primarily a function of income, but is determined by:
- Expected profitability from the investment
- Interest rate for borrowing capital or investing capital
- Opportunity cost of using the funds
- Level of risk and or uncertainty

Macroeconomic Model of Income Determination

To construct a simple macroeconomic model, we add C and I at each level of Y
The equilibrium point is where the line A=Y intersects the line A = C + I
The equilibrium level of income Yo is the level of income at which the aggregate spending function A intersects the 45° line
At any level of income lower than Yo, there is excess demand (A > Y), and at any level of income higher than Yo, there is excess supply (A < Y)

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Description

Learn about the origin and development of macroeconomics, from the Great Depression to modern-day economic growth and crisis management. Explore the role of John Maynard Keynes and his contributions to macroeconomic policy.