Economics 161
Principles of Economics
Quiz #1
Spring 2012
Rules of Engagement
The quiz is worth 10 points to be added
onto the next exam after the curve is
computed.
The quiz is open book, open note, and
students may freely collaborate in small
groups.
Current Events
 The current recession
was started by the
collapse in the housing
markets.
 It was exacerbated by
the financial crises
which affected credit
markets.
Timeline of Government revenues versus
government outlays (or spending) as a
percentage of GDP- Reagan Tax Cuts
Reagan
Obama

The president’s response was a huge increase in government
spending, an attempt to raise taxes, and an increase in
government regulation of businesses.
Question





Suppose the economy started out in long run equilibrium before the current recession.
Depict the short run effects of the housing crisis.
 Indicate on your graph what happens to Real GDP, the price level, interest rates and
investment.
 How does the Permanent Income hypothesis impact your answer?
 Show how your answer to 1(a) will change if the general public perceives the drop in housing
prices to be permanent.
Suppose the government did nothing in response to the housing crisis. How would the economy
adjust in the long run? Depict on your graph and explain.
In response to the crisis, President Obama increased government spending and argued for an
increase in income tax rates. Depict the effect of these policies on the economy in the short run.
Suppose the president’s response included an increase in government regulation of businesses
which increased their costs. Depict the effect of increased regulation on the economy in the short
run.
Factors That Change Aggregate Demand
The collapse of the
housing market causes a
negative wealth shock, i.e.
a decrease in people’s
wealth.
The decrease in wealth
causes a decrease in
consumption and a drop in
AD
The first step in the analysis is to identify what has changed in the world, whether it affects AD or
AS, and which way to shift the curves.
The decrease in wealth causes a decrease in AD, a drop in
Real GDP, a decrease in the price level and an increase in
unemployment.
Interest
Rate
S2-Temporary
S2-Permanent
The decrease in wealth causes a decrease in savings, an
increase in the interest rate and decrease in investment.
Savings
Permanent Income Hypothesis. If the drop in housing prices is
viewed as permanent, the drop in AD will be greater and the
decrease in savings will be smaller.
In the long run, if housing market recovers, the economy will
self correct back to the original equilibrium because
unemployment will rise, wages will fall, and the SRAS will shift
to the right.
Investment
If the drop in housing prices is permanent the LRAS will shift
to the left.
Dollars Saved or
Invested
Price
Level
All
Other
Goods
LRASPerrmanentLRAS
SRAS
SRASTemporary
New SR
Equilibrium
Institutional
PPF
New SR
Equilibrium
AD
Physical PPF
AD2-Permanent
Natural GDP
Good X
Real GDP
Permanent Income Hypothesis
 If the decrease in wealth is permanent:
Decrease in AD will be greater.
Change in savings will be smaller.
 If the decrease in wealth is temporary:
Decrease in AD will be smaller.
Change in savings will be greater.
 Because with a permanent change in wealth, people will
downgrade their lifestyle.
 With a temporary change in wealth, people will try to
maintain their lifestyle.
Cher is selling her Malibu
mansion for a staggering $45
million.
The ‘Believe’ singer built the
three-storey property, which
overlooks the Pacific Ocean, in
1992.
The 14,000 sq ft house boasts
six bedrooms, seven
bathrooms, a theatre, gym,
tennis court, swimming pool
and guest house.
Property tax is $675,000
($56,250 per month) plus
insurance $450,000 (37,500).
Running the house (electricity,
gardening, cleaning, repairs,
etc,) is approxiamtely $10,000
per month.
Monthly Nut:
$56,250+$37,500+$10,000=
$103,750
Government Policies.
Interest
Rate
Increase in government regulation that increases cost of
production shifts the SRAS to the left.
S2-Temporary
S2-Permanent
Savings
Increase in taxes reduces aggregate demand.
Boost in government spending increases AD- maybe.
The net effect of the President’s policies is unknown because
they work in conflicting directions.
Investment
Dollars Saved or
Invested
Price
Level
All
Other
Goods
LRAS
SRASRegulation
SRAS
New SR
Equilibrium
New SR
Equilibrium
AD4-Government Spending
Institutional
PPF
AD
Physical PPF
AD
AD3-Taxes2-Permanent
Natural GDP
Good X
Real GDP