Economics Theories Flashcards

Which theory predicts that real exchange rates adjust to equalize the purchasing power of currencies across countries?

Answer: Purchasing power parity (PPP)

PPP holds that exchange rates should reflect relative price levels so that a basket of goods costs the same in different currencies.

Behavioral economics challenges classical theory by arguing that human decision-making is often:

Answer: Subject to biases, heuristics, and bounded rationality

Kahneman and Tversky showed that cognitive biases cause systematic departures from the rational actor model.

In the Solow growth model, the 'steady state' is reached when:

Answer: Investment exactly offsets depreciation and population growth

At steady state, new capital investment just replaces worn-out capital and equips new workers, so capital per worker stops changing.

The theory of comparative advantage suggests that trade benefits all countries if each specializes in goods where it has:

Answer: Lowest opportunity cost relative to other goods

David Ricardo showed that specializing in goods with relatively lower opportunity costs allows all trading partners to consume more.

Supply-side economics, popularized in the 1980s, primarily advocates for:

Answer: Tax cuts and deregulation to stimulate production

Supply-siders argue that lower taxes and reduced regulation improve incentives to work, invest, and produce, shifting aggregate supply outward.

The concept of 'crowding out' in macroeconomics refers to:

Answer: Government borrowing raising interest rates and reducing private investment

When government borrows heavily, higher interest rates discourage private borrowing and investment, partially offsetting fiscal stimulus.

Which model links a country's interest rates, exchange rates, and capital flows under a fixed exchange rate regime?

Answer: Mundell-Fleming model

The Mundell-Fleming model extends IS-LM to an open economy, showing that under fixed rates, monetary policy loses its effectiveness.