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EC 309: Intermediate Macroeconomics Study Guide

by: Julie Knight

EC 309: Intermediate Macroeconomics Study Guide EC 309

Marketplace > University of Alabama - Tuscaloosa > Economcs > EC 309 > EC 309 Intermediate Macroeconomics Study Guide
Julie Knight
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This study guide covers chapters 1-6. I tried to highlight what the professor said we needed to know for the test.
Intermediate Macroeconomics
Hoda A El-Karasky
Study Guide
EC, EC 309, Macroeconomics, Intermediate Macroeconomics
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This 13 page Study Guide was uploaded by Julie Knight on Saturday February 20, 2016. The Study Guide belongs to EC 309 at University of Alabama - Tuscaloosa taught by Hoda A El-Karasky in Spring2015. Since its upload, it has received 102 views. For similar materials see Intermediate Macroeconomics in Economcs at University of Alabama - Tuscaloosa.


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Date Created: 02/20/16
Hoda Karasky EC 309 Intermediate Macroeconomics Test 1 Study Guide I tried to highlight what she said we specifically needed to know for the test. ***Make sure you can work out the math problems at the end of each chapter! Chapter 1: The Science of Macroeconomics  Macroeconomics- studies the forces that influence the economy as a whole  The macroeconomy affects: o Society’s well being o Your well being o Election outcomes d  Demand equation- Q = D (P, Y )  Supply equation- Q = S (P, PS )  Real GDP- measures the total income of everyone in the economy (adjusted for the level of prices)  Inflation rate- measures how fast prices are rising  Unemployment rate- measures the fraction of the labor force that is out of work  Recession- a sustained period of falling real income  Depression- a very severe recession  Deflation- period of falling prices  Models- a simplified representation of reality, often using diagrams or equations, that shows how variables interact  Endogenous variables- variables that a model tries to explain  Exogenous variables- variables that a model takes as given   Market clearing model- a model that assumes that prices freely adjust to equilibrate supply and demand  Flexible- prices that adjust quickly to equilibrate supply and demand  Sticky- prices that adjust sluggishly and, therefore, do not always equilibrate supply and demand  Microeconomics- the study of how households and firms make decisions and how these decision makers interact in the marketplace o Households and firms optimize Chapter 2: The Data of Macroeconomics  Gross domestic product (GDP)- the market value of all FINAL goods and services produced within an economy in a given period of time o The purpose of GDP is to summarize all the data with a single number representing the dollar value of economic activity in a given period of time o = the total income of everyone in the economy o Or = the total expenditure on the economy’s output of goods and services Hoda Karasky o Expenditure equals income because every dollar a buyer spends becomes income to the seller o Only includes the value of currently produced goods and services (sale of a used good is not included) o Y=C+I+G+NX  National income accounting- the accounting system used to measure GDP and many related statistics  Stock- a quantity measured at a given point in time  Flow- a quantity measured per unit of time o  Value added- the value of output minus the value of the intermediate goods used to produce that output  Imputed value- an estimate of the value of a good or service that is not sold in the marketplace and therefore does not have a market price  Nominal GDP- the value of goods and services measured at current prices  Real GDP- the value of goods and series measured using a constant set of prices  GDP deflator- the ratio of nominal GDP to real GDP Nominal GDP o GDP deflator = 100 Real GDP o measures the price of output relative to its price in the base year o measures the prices of all goods and services produced  National income accounts identity-  Consumption- consists of the goods and services bought by households o Durable goods- last a long time (e.g., cars, home appliances) o Nondurable goods- last a short time (e.g., food, clothing) o Services- intangible items purchased by consumers (e.g., dry cleaning, air travel)  Investment- goods bought for future use o Business fixed investment- spending on plant and equipment o Residential fixed investment- spending by consumers and landlords on housing units o Inventory investment- the change in the value of all firms’ inventories  Government purchases- goods and services bought by federal, state, and local governments o Excludes transfer payments  Net exports- accounts for trade with other countries o Exports – Imports  Gross national product (GNP)- total income earned by the nation’s factors of production, regardless of where located  Inflation- increase in the overall level of prices Hoda Karasky  Consumer price index (CPI)- a measure of the overall level of prices that shows the cost of a fixed basket of consumer goods relative to the cost of the same basket in a base year o Measures the prices of only the goods and services bought by consumers o Assigns fixed weights to the prices of different goods  CPI may overstate inflation for three reasons: o 1) Substitution bias o 2) Introduction of new goods o 3) Unmeasured changes in quality Make sure you know the differences between the CPI and the GDP deflator.   Labor force- the sum of the employed and unemployed  Unemployment rate- the percentage of the labor force that is unemployed o = (number of unemployed)/ (labor force) *100 Chapter 3: National Income: Where It Comes From and Where It Goes  Factors of production- the inputs used to produce goods and services o Capital- the set of tools that workers use o Labor- the time people spend working  Production function- the mathematical relationship showing how the quantities of the factors of production determine the quantity of goods and services produced o Y= F (K, L) o Technology is fixed o The economy’s supplies of capital and labor are fixed  Constant returns to scale- an increase of an equal percentage in all factors of production causes an increase in output of the same percentage o *** be able to calculate if something is constant, increasing, or decreasing returns to scale  Factor prices- the amounts paid to the factors of production  Profit- the income of firm owners o Revenue – Costs  Marginal product of labor (MPL)- the extra amount of output the firm gets from one extra unit of labor, holding the amount of capital fixed o MPL= F (K, L+1) – F (K, L) o MPL= W/P Hoda Karasky o  Diminishing marginal product- holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases  Real wage (W/P)- the payment to labor measured in units of output rather than in dollars  Marginal product of capital (MPK)- the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant o MPK= F (K+1, L) – F (K, L) o MPK= R/P  Real rental price of capital (R/P)- the rental price measured in units of goods rather than in dollars  Economic profit- the amount of revenue remaining for the owners of a firm after all the factors of production have been compensated o EP = Y – (MPL*L) – (MPK*K) o Y= (MPL*L) + (MPK*K) + Economic Profit  Euler’s theorem- states that if the production function has constant returns to scale, then: o F (K, L) = (MPK*K) + (MPL*L)  Accounting profit- the amount of revenue remaining for the owners of a firm after all the factors of production except capital have been compensated o AP= EP + (MPK*K)  Closed economy- a country that does not trade with other counties o Y=C+I+G  Disposable income- income after the payment of all taxes o Y – T  Consumption function- the relationship between consumption and disposable income o C = C (Y – T) Make sure you can find savings (S) using the consumption function. EX: C= 150+.85(Y-T)  0.85  marginal propensity to consume  (Y-T)  disposable income o  Marginal propensity to consume (MPC)- the amount by which consumption changes when disposable income increases by one dollar  Interest rate- measures the cost of the funds used to finance investment  Nominal interest rate- the rate of interest that investors pay to borrow money  Real interest rate- the nominal interest rate corrected for the effects of inflation Hoda Karasky  Investment function: o I = I (r) o  The relationship between government and taxes: o G=T (balanced budget) o G>T (budget deficit) o G<T (budget surplus)  * At the equilibrium interest rate, the demand for goods and services equals the supply   National savings (S)- (Y – C – G) the output that remains after the demands of consumers and the government have been satisfied  Private savings (Y – T – C)- the disposable income minus consumption  Public savings (T – G)- government revenue minus government spending o Y – C(Y – T) – G= I(r) o Then, S= I(r)  Loanable funds- the flow of resources available to finance capital accumulation o * at the equilibrium interest rate, households’ desire to save balances firms’ desire to invest, and the quantity of loanable funds supplied equals the quantity demanded  Crowd out- the reduction in investment that results when expansionary fiscal policy raises the interest rates  * An increase in government purchases causes the interest rate to rise  * An increase in investment demand raises the equilibrium interest rate  Neoclassical theory of distribution- a theory of how national income is divided among the factors of production (capital and labor) Chapter 4: The Monetary System  Money- the stock of assets that can be readily used to make transactions o Store of value- a way to transfer purchasing power from the present to the future Hoda Karasky o Unit of account- provides the terms in which prices are quoted and debts are recorded o Medium of exchange- what we use to buy goods and services  Fiat money- money with no intrinsic value  Commodity money- money with intrinsic value  Money supply- the quantity of money available in an economy  Monetary policy- the government’s control over the money supply o Conducted by a country’s central band (“the Fed”)  Open market operations- the purchase and sale of government bonds  Currency- the sum of outstanding paper money and coins  Demand deposits- the funds people hold in their checking accounts  M= C + D (money supply = currency + demand deposits)  Reserves- the portion of deposits that banks have not lent out o Assets- reserves and outstanding loans o Liabilities- deposits  100% reserve banking- a system in which banks hold all deposits as reserves  Fractional reserve banking- a system in which banks hold a fraction for reserves o These banks CREATE money  Financial intermediation- the process of transferring funds from savers to borrowers  Bank capital- the resources a bank’s owners have put into the bank  Leverage- the use of borrowed money to supplement existing funds for purposes of investment  Capital requirement- a minimum amount of bank capital mandated by regulators  A model of the money supply: o Monetary base (B)- the total number of dollars held by the public as currency (C) and by the banks as reserves (R)  B = C + R o Reserve deposit ratio (rr)- the fraction of deposits that banks hold in reserve  rr = R/D o Currency deposit ratio (cr)- the amount of currency (C) people hold as a fraction of their holdings of demand deposits (D)  cr = C/D  Loss of confidence in banks  cr  m  Banks became more cautious Hoda Karasky  Money multiplier (m)- the increase in the money supply resulting from a one- dollar increase in the monetary base o M = m*B  EX1: C= $200; R= $100; D= $500; B= C+R= $300  EX2: B= $200; m= $3; M= m*B= $600  Discount rate- the interest rate that the Fed charges on these loans  Reserve requirement- Fed regulations that impose a minimum reserve deposit ratio on banks o Excess reserves- reserves held by banks above the amount mandated by serve requirements o Interest on reserves- the central bank’s policy of paying banks an interest rate for the deposits that they hold as reserves Chapter 5: Inflation  Inflation ( π¿ - the overall increase in prices  Hyperinflation- extraordinarily high inflation  Quantity equation- the identity stating that the product of the money supply and the velocity of money equals nominal expenditure o MV = PT (money*velocity = price*transactions) o Becomes: MV = PY (money*velocity = price*output)  Transactions velocity of money (V)- measures the rate at which money circulates in the economy  Income velocity of money (V)- the number of times a dollar bill enters someone’s income in a given period of time  Velocity- the rate at which money circulates o V= T/M o Then, V= (PY/M)  Real money balances- the quantity of money in terms of the quantity of goods and services it can buy o = M/P  Money demand function- an equation that shows the determinants of the quantity ofdreal money balances people with to hold o (M/P) = kY, o Then, (M/P) = kY, o Then, M(1/k) = PY, o Then, MV = PY  Quantity theory of money- links the inflation rate to the growth rate of the money supply o MV= PY o Hoda Karasky  Seigniorage- the revenue raised by the printing of money  Nominal interest rate (i)- the interest rate that the bank pays; NOT adjusted for inflation  Real interest rate (r)- the increase in your purchasing power; adjusted for inflation o r= i – π  Fisher equation- shows that the nominal interest rate can change for two reasons: o 1) The real interest rate changes o 2) The inflation rate changes  i = r + π  Fisher effect- the one-for-one relation between the inflation rate and the nominal interest rate o According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation; according to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rate  An increase in π causes an equal increase in i o i = r + E π o S = I (determines r)  EX1: V= constant; M= increases 5% per year; Y= increases 2%; r= 4  i = r + π π = 5 – 2 =3  i = 4 + 3 = 7%  change in i = 2 (money supply growth rate)  Y= 1% o Fed does nothing, change in inflation- 1%  to prevent inflation  reduce money supply by 1%  Ex ante real interest rate- the real interest rate people expect at the time they buy a bond or take out a loan  Ex post real interest rate- the real interest rate actually realized  Real variables- Measured in physical units – quantities and relative prices, for example: o Quantity of output produced o Real wage: output earned per hour of work o Real interest rate: output earned in the future by lending one unit of output today  Nominal variables- Measured in money units, e.g., o Nominal wage: Dollars per hour of work. o Nominal interest rate: Dollars earned in future by lending one dollar today. o The price level: The amount of dollars needed to buy a representative basket of goods  Classical dichotomy- the theoretical separation of real and nominal variables in the classical model, which implies nominal variables DO NOT affect real variables o Is said to hold when the values of real variables can be determined without any reference to nominal variables or the existence of money  Monetary neutrality- changes in the money supply do not affect real variables. In the real world, money is approximately neutral in the long run  The social costs of inflation: Hoda Karasky o 1) Costs when inflation is expected  (a) Shoeleather cost- the costs and inconveniences of reducing money balances to avoid the inflation tax    i   real money balances  (b) Menu costs- the cost of changing prices  increases inflation  increases changes  (c) Relative price distortions- Firms facing menu costs change prices infrequently.  Example: A firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall. o Different firms change their prices at different times, leading to relative price distortions…causing microeconomic inefficiencies in the allocation of resources  (d) Unfair tax treatment- Some taxes are not adjusted to account for inflation, such as the capital gains tax  Ex: capital gains tax  (e) General inconvenience- Inflation makes it harder to compare nominal values from different time periods o 2) Costs when inflation is different than people had expected  (a) Arbitrary redistribution of purchasing power  Many long-term contracts not indexed, but based on E .  If  turns out different from E , then some gain at others’ expense o Example: borrowers & lenders  If  > E , then (i  ) < (i  E ) and purchasing power is transferred from lenders to borrowers  If  < E , then purchasing power is transferred from borrowers to lenders o Benefit of inflation:  Nominal wages rarely reduced  Hinders labor market clearing  These are the questions we went over in class: Hoda Karasky Chapter 6: The Open Economy  Net exports- exports minus imports (NX= X – IM) o Y = C + I + G + NX o o  Trade balance- the receipts from exports minus the payments for imports  Net capital outflow- o = S – I o = Net outflow of “loanable funds” o o Positive net capital outflow  trade surplus Hoda Karasky  Trade surplus- an excess of exports over imports  Trade deficit- an excess of imports over exports o  Balanced trade- a situation in which the value of imports equals the value of exports, so net exports equal zero  Small open economy- an open economy that takes its interest rate as given by world financial markets; an economy that, by virtue of its size, has a negligible impact on world markets and, in particular, on the world interest rate  World interest rate (r*)- the interest rate prevailing in world financial markets  Nominal exchange rate (e)- the return to saving and the cost of borrowing without adjustment for inflation o Ex: yen per dollar  Real exchange rate ( ∈¿ - the rate at which one country’s good trade for another country’s goods o Ex: Japanese Big Macs per U.S. Big Macs o ∈ = (eP)/P* o  E in the real world and the model: o In the real world: We can think of ε as the relative price of a basket of domestic goods in terms of a basket of foreign goods o In our macro model: There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output  Purchasing power parity- the doctrine according to which goods must sell for the same price in every country, implying that the nominal exchange rate reflects differences in price levels Hoda Karasky    In class Review: Homework, quizzes, end of chapter questions, Quiz 4 is due Saturday.  Rules for calculating GDP (used goods, imputed values, government spending not including)  Calculation of CPI and GDP deflator o Two definitions of CPI  GDP deflator= nominal GDP/ real GDP  #6. Change RGDP/ change in population o 6/2 – then changes to 6-2=4  the neoclassical theory of distribution- is a theory of how national income is divided among the factors of productions o according to Y= (W/P) (MPL)  consumption function  when government spending increases and taxes increase by an equal amount: o consumption and investment both decrease  quantity equation: MV=PT o MV=PY EC 309 Hoda Karasky  #23. In the long run, according to the quantity theory of money and the classical macro theory, if velocity is constant, then the productive capability of the economy determines the real GDP and the money supply determines nominal GDP  GDP is not the expenditure of everyone in the economy (does not include imported goods)


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