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Unit 5 AP Eco Test Review • Explain the theory of rational expectations. • People optimally use all available information when forecasting the future • For the U.S. economy, which of the theories is the most important reason for the downward slope of the aggregatedemand curve? • Investment is the biggest influence on our economy, so it’s the Interest Rate Effect • If NASA receives an increase in funding, how does this affect the economy? • More jobs, those workers spend money, the stores where they spend money make more profits, i.e. the Multiplier Effect • If the Fed conducts monetary policy, what happens to the money supply and aggregate demand? • An expansionary policy would increase the money supply and aggregate demand would increase. A contractionary monetary policy would decrease the money supply and aggregate demand would decrease. • If the government raises government expenditures, what happens to the economy? • Unemployment should decrease and inflation should rise in the short-run • If the stock market booms, what will happen to aggregate demand? What could the Fed do to offset this? • Aggregate demand should increase because people feel confident about the future. This could lead to inflation, so the fed could decrease the money supply to offset this. • What are the tools of fiscal policy? • Changing taxes and government spending • What did the restrictive monetary policy followed by the Fed in the early 1980s do to the economy? • It decreased inflation, but it increased unemployment and sent the U.S. into a recession • What do we mean by the term automatic stabilizer? What are some examples? • Something built into the economy that kicks in automatically (or without an additional law being passed) to help keep the economy stable when it slows down or when it speeds up. Examples are things like unemployment compensation, graduated income tax, food stamps, welfare. • What happens in the economy if we have an increase in the interest rate? • Investment will decrease, and this will hurt long-term growth. • What is an adverse supply shock? What problem does it create? • Something that would make aggregate supply decrease (natural disaster, OPEC), and it creates stagflation • What is the crowding-out effect? • The government has to borrow money to fund it’s deficit spending, this causes interest rates to rise, this causes investment to decrease, so the economy doesn’t expand by as much as it normally would. • What is the misery index? • When you add the inflation rate and the unemployment rate • What is the relationship between unemployment and inflation? What graph illustrates this concept? • In the short-run, they have an inverse relationship. This is illustrated by the Phillip’s Curve. • What is the sacrifice ratio, and how is it calculated? • It’s how much output you lose when you reduce inflation. You divide the difference in output by the difference in the inflation rate. • What is the shape of the money supply curve? • It’s a vertical line because the money supply is controlled by the Fed. • What will a favorable supply shock do to the Phillips curve, price, output and employment? • It would increase aggregate supply, so the Phillips curve would move to the left. This would also make prices go down, output go up and employment go up. • When the price level falls, what happens to the interest rate? Why? • The normal reason for the price level to fall would be because the economy is slowing down. If the economy is slowing down, then people would not demand as much money. If they are NOT demanding as much money, then interest rates would drop. • Know how to draw and change an AD/AS graph, Money Market graph, Loanable Funds graph, PPC and Philip’s Curve.