Econ Study Guide- Exam 1
Econ Study Guide- Exam 1 Econ 1015
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This 34 page Study Guide was uploaded by Rachel Brown on Saturday February 20, 2016. The Study Guide belongs to Econ 1015 at University of Missouri - Columbia taught by Vitor Trindade in Spring 2016. Since its upload, it has received 124 views. For similar materials see Principles of Macroeconomics in Economcs at University of Missouri - Columbia.
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Rachel Brown Econ 1015 Notes Lecture: 1 Dates: 1/19 Covers Chapters: 1 Dr. Trindade T/Th 12:30-1:45 Lecture #1: Chapter 1 THE FIVE FOUNDATIONS OF ECONOMICS Vocab (Ch. 1) NEED TO KNOW: Scarcity: Refers to the limited nature of society’s resources, given society’s unlimited wants and needs Economics: The study of how people allocate their limited resources to satisfy their nearly unlimited wants Microeconomics: The study of the individual units that make up the economy Macroeconomics: The study of the overall aspects and workings of an economy Incentives: Factors that motivate a person to act or exert effort Opportunity Cost: The highest valued alternative that must be sacrificed in order to get something else Economic Thinking: Requires a purposeful evaluation of the available opportunities to make the best decision possible Marginal thinking: requires decision makers to evaluate whether the benefit of one more unit of something is greater than its cost Markets: Bring buyers and sellers together to exchange goods and services Trade: Is the voluntary exchange of goods and services between two or more parties Comparative Advantage: Refers to the situation where an individual, business, or country can produce at a lower opportunity cost than a competitor can What is Economics? Scarcity o Resources are limited o Dr. Trindade’s definition of Economics: optimization with constrained resources o Also relates to how people and organizations allocate their limited resources to satisfy wants o How people/organizations make decisions o No scarcity no need for economics Micro vs. Macro- What’s the difference? Macro- how the economy as a WHOLE behaves. Examples include inflation, growth, employment, interest rates and productivity Examples of Macro topics include: inflation, economic growth and productivity, interest rates, aggregate demand and supply Micro- Decisions of individuals, households, and business immersed in economy What are the SIX foundations of economics? 1. Incentives Matter 2. Life is about trade-offs 3. Opportunity Costs 4. Marginal Thinking 5. Trade Creates Value 6. People are Rational 1. Incentives Matter Incentives = factors that motivate you to act or exert effort. People will respond to them! Positive Incentives- tax refund, tax credits, pay raise, employee of the month award, stick and smiley face Negative Incentives- Taxes, fees, jail, fines, getting grounded, getting fired, failing class Direct vs. Indirect Incentives: Direct: Easy to recognize o Example: mow my lawn and I’ll give you $40, Get straight A’s and go to Disney World, etc. Indirect: Harder to recognize o The child may have an indirect incentive to cheat! What are Unintended Consequences? Unintended Consequences are an unplanned result (usually negative and unwanted) of an incentive o Example: Social safety net. Most will agree we need a safety net for those who don’t work. But, what if the safety net is higher than they can make at the job? Indirect Incentive: Is to stay on welfare instead of work Incentives and Innovation: Patents and copyrights incentive to innovate Result of strong patent system More innovation since people are rewarded for new popular inventions. However, there’s monopoly power to patent holders 2. Life is About Trade-Offs Without scarcity, decisions incur costs and bring up questions you must think about Ex: If I go to the movie, what should I see? If I go and vote, who should I vote for? Trade-Offs and Policy The government faces tradeoffs as well as us! o Ex: Should we spend our tax dollars on roads or schools? Whichever decision they make will come with a gain and a loss 3. Opportunity Cost Opportunity Cost the highest valued alternative that must be sacrificed in order to get something else. NOT ALL ALTERNATIVES, JUST THE BEST CHOICE! In other words, what you give up to get something o Ex: you have a high opportunity cost. Here is another example: If a gardener decides to grow carrots, his opportunity cost is the alternative crop that might have been grown instead (let’s say potatoes). In both cases, a choice between two options must be made. Scarcity Choice Opportunity Cost 4. Marginal Thinking Economic thinking: optimization under constrained resources. One way to do this is through marginal thinking Marginal Thinking Evaluate: Is the benefit of one more unit greater than its cost? o Another example: Is staying up that extra hour to studying Facts: Is going to college worth it? Statistically not as likely to be hit by unemployment during a rough economy College grad jobs have better hours usually ad better working conditions Education leads to positive externalities 5. Trade Creates Value Markets bring buyers and sellers together to exchange goods and services Trade the VOLUNTARY exchange of goods and services Benefits both parties Comparative Advantage: Without trade, you would have to produce everything you consume Comparative advantage The situation in which an individual, business or country can produce at a lower opportunity cost than a competitor Trade Specialization You go to Starbucks to get coffee, go to pharmacy when you need meds Rachel Brown Econ 1015 Notes Lecture: 2 Date: 1/21 Covers Chapters: 2 Dr. Trindade T/Th 12:30-1:45 Lecture #2: Chapter 2 Model Building and Gains from Trade Vocab (Ch. 2) NEED TO KNOW: Positive Statement: Can be tested and validated, can be proven true or false Normative Statement: Is an opinion and can’t be tested or validated Ceteris Paribus: Is the concept under which economists examine a change in one variable while holding everything else constant Endogenous Factors: Are the variables that can be controlled for in a model Exogenous Factors: Are the variables that can’t be controlled for in a model Production Possibilities Frontier: Is a model that illustrates the combinations of outputs that a society can produce if all of its resources are being used efficiently Law of Increasing Relative Cost: States that the opportunity cost of producing a good rises as a society produces more of it Absolute Advantage: Refers to the ability of one producer to make more than another producer with the same quantity of resources Consumer Goods: Are produced for present consumption Capital Goods: Help produce other valuable goods and services in the future Investment: The process of using resources to create or buy new capital Scientific Methods In Economics They are similar to “hard sciences” Construct a theory or hypothesis Design experiments to test the theory: actual experiments but more like surveys or any other form of data collection Analyze the data to test the theory Difference from hard sciences Economist’s lab is the world around us Not always able to design experiments Historical data often used Positive and Normative Analysis Positive Statement a claim that can be tested true or false Normative Statement Statement of opinion can’t be tested true or false. Usually contains the words “ought to” or “should be” Economic Models Models: Allow us to understand complex problems Simplified versions of reality Use assumptions Are considered good if they predict accurately Ceteris Paribus = means “other things being equal” in Latin Assumption in which we examine a change in one variable, but hold all other variables constant. Therefore allows us to isolate the effect of a single variable Economic Analysis Endogenous Factors variables controlled for inside a model Exogenous Factors Variables that are not accounted for in a model These variables inside the model can have positive or negative effects Danger of Faulty Assumptions Assumptions in models need to be re-examined often Ex: Assumption that housing prices always rise Production Possibilities Frontier PPF: Combinations of outputs that a society can produce if… o It uses its resources o Efficiently Assumptions of this model: o Resources are fixed o Technology is fixed o Only 2 goods In the PPF figure of wings and pizza, it is downward sloping (L to R) X Axis: Quantity of wings produced Y Axis: Quantity of pizza slices produced Therefore the graph in a combo of (W, P) Production Point Production Bundle Why is it downward sloping? Must give up one good to increase production of the other Why are we unable to produce certain combinations? Scarcity and limited resources Where are the efficient production points? On the line Where are the inefficient points? Inside the PPF, close to origin Why would the economy produce at an inefficient point? Unemployed workers, unused buildings What are the unattainable (unfeasible) points) Points outside the PPF Why is the PPF a straight line? Constant opportunity cost PPF and Opportunity Cost Recall opportunity cost: Highest valued alternative What we give up as a result of an action Opportunity cost in this case is the slope of the PPF *If it asks you what the opportunity cost is of producing a single wing, find rise over run and do the opposite axis as a fraction for the desired product’s opportunity cost* In conclusion- a straight PPF means a constant opportunity cost We can draw a more realistic PPF by assuming a non-constant opportunity cost. The PPF will become bowed outward like a rainbow and doesn’t have a constant slope. As we move from left to right, opportunity cost will increase Law of Increasing Relative Cost Opportunity cost increases as you increase production of a good As we produce more of good A, we have to give up increasingly larger amount of good B Rachel Brown Econ 1015 Notes Lecture: 3 Date: 1/26 Covers Chapters: 2 Dr. Trindade T/Th 12:30-1:45 Lecture #3: Chapter 2 Model Building and Gains from Trade Vocab (Ch. 2) NEED TO KNOW: ~Chapter 2 vocab on previous set of notes ~ PPF and Opportunity Cost Nonlinear PPFs For more realistic PPF, assume a non-constant opportunity cost: PPF “bowed outward” The PPF does not have a constant slope As we move from left to right the slope and therefore the opportunity cost increases Intuition for nonlinear PPFs and for the law of increasing relative cost (=opportunity cost) Inputs (resources) are not perfectly homogenous Some inputs are better at making pizza and some are better at making wings As we expand pizza production, we first use the inputs that are the best They cost relatively little in terms of wings If we keep adding pizza production, we now need to give up inputs that are best at making wings This costs a lot in terms of wings we need to give up Shifts in the PPF So far, technology and resources are fixed. If technology improves or resources increase (or people enter the labor force), the PPF will expand outward making some previously unfeasible good combinations feasible New resources or technology can either affect the production of ONE or BOTH goods Potential Misconceptions About Trade -Trade is a zero-sum game -When two countries trade, one loses and the other gains -We lose when we import more goods from China than they import from us -Each country should maximize the amount that it imports -If the US is more productive in one good, it should produce it instead of importing it -If one country is more productive in making all goods it can’t gain by trading with a less productive country Specialization and Trade Specialization and trade can also create gains If Debra can produce 60 pizzas and 120 wings in a day and Mike can produce 24 pizzas and 72 wings in a day, let’s talk about who has the absolute and comparative advantage. Only comparative advantage will matter here. To analyze this, think about the PPF line. Debra has the CA in pizza production Mike has the CA in wing production Fact: As long as the terms of trade are between the opportunity costs of the trading partners, the trade benefits both sides Trade-off Between Present and Future Consumer goods o Goods produced for current consumption o Food, housing, clothing, entertainment Capital goods o Goods that help produce other valuable goods o Buildings, factories, roads, machinery, computers Investment o Using resources to make new capital Capital Growth and Future Growth When we change the amount of capital invested in the short run, we change: Where we are on the curve in the short run How much in total society will produce shifts of the trade off in long run In the last 20 years, China and India have invested more, compared to the United States and Europe. Result: China and India are sacrificing today’s consumption for a better future and they have higher growth rates Visualizing Investment Today, many are hesitant to invest in capital goods even if it results in larger consumer good production tomorrow Today’s investments may: o Take a long time o Have a large opportunity cost o Have uncertain results In conclusion: -Economists use simplified models to understand how the economy works -The PPF illustrates the benefits of trade and allows us to describe ways to grow the economy -When producers specialize, they focus their efforts on those goods and services for which they have the lowest opportunity cost and trade with others who are good at making something else Rachel Brown Econ 1015 Notes Lecture: 4 Date: 1/28 Covers Chapters: 6 Dr. Trindade T/Th 12:30-1:45 Lecture #4: Chapter 6 Intro to Macroeconomics and GDP Vocab (Ch. 6) NEED TO KNOW: Gross Domestic Product (GDP): Is the market value of all final goods and services produced within a country during a specific period Per Capita GDP: is GDP per person Inflation: The growth in the overall level of prices in an economy Real GDP: is GDP adjusted for changes in prices Economic Growth: Is measured as the percentage change in real per capita GDP Recession: A short-term economic downturn Great Recession: The U.S. recession lasting from December 2007 to June 2009 Business Cycle: A short-run fluctuation in economic activity Economic Expansion: The phase of the business cycle during which the economy is growing faster than usual Economic Contraction: A phase of the business cycle during which the economy is growing more slowly than usual Service: An output that provides benefits without the production of a tangible product Intermediate Good: A good that firms repackage or bundle with other goods for sale at a later stage Final Good: A good sold to final users Gross National Product (GNP): The output produced by workers and resources owned by residents of the nation Consumption ©: The purchase of final goods and services by households excluding new housing Investment (I): Private spending on tools, plant and equipment used to produce future output Government Spending (G): Includes spending by all levels of government on final goods and services Net Exports (NX): Goods minus imports of final goods and services Nominal GDP: GDP measured in current prices, and not adjusted for inflation Price Level: An index of the average prices of goods and services throughout the economy GDP Deflator: A measure of the price level that includes prices of the final goods and services included in GDP Misconception Misconception: There is no reliable way to determine how well the economy is performing But there is an objective measure of macroeconomic performance: The Gross Domestic Product (GDP) Macroeconomics and GDP Macroeconomics: The study of individual units that comprise the economy A single household’s decisions, a single firm’s decisions, etc GDP Gross Domestic Product (GDP) o Total (gross) amount of all goods and services produced within a specific economy o Measured in dollars o We use market value to determine the value of goods and services o We says goods and services because it covers pretty much all topics Do we use final value or intermediate value in GDP? o Total value of the final good/s o Think of it as “value added” by each intermediate producer GDP issue: advances in technology o Technology advances underestimate the growth of the GDP GDP issue: Hedonic Adjustments o “Hedonic” adjustments to GDP: essentially attempt to take into account actual satisfaction derived from the good, gives GDP a better measure this way Production Equals Income Output & income = essentially the same thing Idea: the output you produce is sold, and you receive income for what you sell. You sell 600 cups of coffee at $4 each, so total output is worth $2400. That $2400 in sales is also a measure of income Defining GDP Gross Domestic Product: o The market value of all final goods and services produced in a nation within a specific period of time Functions as a barometer for the economy Output becomes income Output = GDP = Income Three Uses of GDP Data 1. Estimate living standards across different times and different countries 2. Measure economic growth 3. Determine whether an economy is experiencing a short-run expansion of recession Measuring Living Standards Two different measures: Total GDP and Per capita GDP Total GDP o Not the best standard to compare living standards o May be useful to compare economic power or influence o Doesn’t adjust for population size of a country Per capita GDP o GDP per person (GDP divided by population) o AVERAGE living standards in a nation Rachel Brown Econ 1015 Notes Lecture: 5 Date: 2/2 Covers Chapters: 6 Dr. Trindade T/Th 12:30-1:45 Lecture #5: Chapter 6 Introduction to Macroeconomics and GDP Vocab (Ch. 6) NEED TO KNOW: ~Chapter 6 vocab on previous set of notes ~ Use 3 of the GDP: Measuring Business Cycles Business Cycle o Short run fluctuations in economic activity: o They cause output to be above or below the long run trend Parts of the business cycle: o Expansion (middle trough to middle peak) o Contraction (middle peak to middle trough) o Peak o Trough Wee shouldn’t assume that the business cycle is regular Looking Closely at how we measure the GDP Why does the GDP use market value? We can’t just count quantities. Some things are more important than others. Producing corn is more important than producing cars How do we calculate market value? Market value = Q x P 12 billion bushels of corn x $5 per bushel = $60 billion (market value) Why does GDP include both goods and services? Because goods (tangibles) and services (intangibles) still have values and influence in the economy and can have high influences Intermediate vs. Final Goods Intermediate goods: o Goods that firms repackage or bundle with other goods to be sold at a later stage Examples: milk sold at a coffee shop or tires sold to car manufacturer Final goods: o Goods sold to final users or consumers To get an accurate GDP estimate and avoid double counting what do we do? Final goods are included in GDP Intermediate goods are not Alternatively we track all added values COUNT FINAL GOODS ONLY OR COUNT ADDED VALUE Why does the definition of GDP include the phrase “produced in a specific period of time?” Has to do with double counting Don’t want to recount a good that was produced last year Examples: don’t count a resold used car Looking at GDP as Different Types of Expenditures The Bureau of Economic Analysis (BEA) is the U.S. government agency that tallies GDP data, a task is called national income accounting Cell phone as income- the income of all the intermediate goods producers Cell phone as expenditure-the expenditure of the consumer buying it GDP = C + I + G + NX Consumption Consumption o Final purchase of goods and services by households with the exception of new housing Durable Goods o Goods consumed over a long period of time like cars or appliances o Subject to cyclical fluctuations Nondurable goods o Goods consumed over a short time o Groceries, magazines, medicines o Affected less by cyclical fluctuations Investment Investment o Spending on tools, factories, and equipment used to produce future output o Also includes additions to inventories o New home purchases by consumers o Investment is not “investing” in stocks and bonds because this is just an exchange of different forms of wealth Government Purchases Government Purchases o Government employee salaries o “government services” such as projects, national defense, schools, post offices o Transfer payments like welfare or social security does not count. When households spend this income, it will enter the GDP as part of consumption or investment Net Exports (NX) Net Exports: o Exports minus imports o If imports > exports, then NX < 0 o NX represents a small fraction of the total GDP Is it bad that NX is negative? o This is called a trade deficit o More imports means more goods and services for people in this country Real GDP: Adjusting GDP for Price Changes Real GDP: o GDP measure with prices held constant over time Nominal GDP o GDP measured current prices Price Level o An index to measure prices of goods and services in an economy GDP deflator o A measure of the price level that includes prices of final goods and services in GDP o It’s a divider used to “deflate” out inflation from nominal GDP so we can find Real GDP Finding Real GDP 1. We want to adjust the nominal GDP to control for the increase in current prices FORMULA: Real GDP = ( Nominal GDP / Price Level ) x 100 Rachel Brown Econ 1015 Notes Lecture: 6 Date: 2/4 Covers Chapters: 7 Dr. Trindade T/Th 12:30-1:45 Lecture #6: Chapter 7 Unemployment Vocab (Ch. 7) NEED TO KNOW: Unemployment: Occurs when a worker who is not currently employed is searching for a job without success Unemployment Rate (u): The percentage of the labor force that is unemployed Creative Destruction: Occurs when the introduction of new products and technologies leads to the end of other industries and jobs Structural Unemployment: Unemployment caused by changes in the industrial makeup of the economy Frictional Unemployment: Unemployment caused by delays in matching available jobs and workers Unemployment Insurance: A government program that reduces the hardship of joblessness by guaranteeing that unemployed workers receive a percentage of their former income while unemployed Cyclical Unemployment: Unemployment caused by economic downtown Natural Rate of Unemployment (u*): The typical rate of unemployment that occurs when the economy is growing normally Full Employment Output (Y*): The output level produced in an economy when the unemployment rate is equal to its natural rate Labor Force: Includes people who are already employed or actively seeking work Discouraged Workers: Are those who are not working, have looked for a job in the past 12 months and are willing to work but have not sought employment in the last 4 weeks Underemployed Workers: Those who have part time jobs but who would prefer to work full time Labor Force Participation Rate: The percentage of the population that is in the labor force Growth Rates- Nominal GDP Growth How are we going to calculate how fast the economy grows? We will calculate this as a percent change. Nominal GDP growth = percent change in Nominal GDP Example: Nominal GDP growth in 2010 = [ ( GDP 2010 – GDP 2009 ) / GDP 2009 ] x 100 Can growth rate be negative? Yes, this simply means the economy is contracting Growth Rates- Price Level Growth Rate/The Growth Rate of GDP Deflator Price level growth rate = percent change in price level Another useful formula: %∆ Real GDP + %∆ Price Level = %∆ Nominal GDP Shortcomings of GDP Nonmarket Goods o Some goods and services are produced but they are not bought or sold o They create value for society but they are not accounted for o Washing dishes or mowing the lawn are examples o Even more important in less-developed societies where households produce many of their own goods o Making the GDP a poor measure of economic output given that they are not accounted for Underground Economy o These transactions are unaccounted for o Sometimes legal Waitress tips, child cuts a lawn o Sometimes illegal Selling drugs o What is the size of this underground economy? 10% of GDP in the United States 45% in developing countries o Why is the underground economy smaller in the United States? Stronger economy, rule of law and less corruption Quality of the Environment o GDP is unable to distinguish how goods are produced o Equal GDP, but well-being is different. Example: countries A and B produce the same amount of clean energy but it’s not equal in well-being because one country is bigger than the other and therefore needs a higher amount of clean air Leisure Time o GDP does not capture how long it takes to produce goods and services o Average workweeks differ in other countries. USA has an average of a 36 hour work week where as South Korea is at 46 hours per week Does not take the price level into account o Country A produces 10 million units at $5 per unit GDP= 50 million o Country B produces 10 million units at $10 per unit GDP= 100 million o They would still consume the same Alternative Measures of Economic Well-Being The GDP is not a perfect measure of well-being Other measures of well being include: life expectancy, education levels, access to healthcare, crime rates, environmental quality U.S. Recession of 2008-2009 People are unemployed if: They are not currently employed AND they are looking for a job Therefore, if you are not currently looking for a job then you are not considered unemployed Three Types / Reasons for Unemployment Three types/reasons for unemployment o Structural o Frictional o Cyclical Structural Unemployment Structural Unemployment o Unemployment caused by changes in the industrial makeup/structure of the economy o Old industries die and new ones are created o As people move from one industry to another some unemployment is created as they seek a new job Example: Borders bookstore What can structurally unemployed people do? Retrain, reeducate, relocate Frictional Unemployment Frictional Unemployment o Unemployment caused by time delays in matching available jobs and workers o All jobs are the result of a matching process Examples: recent college grads, spouse of a person who moves for a new job, etc o Factors affecting frictional unemployment: Internet Government policies Unemployment insurance Unintended consequence Cyclical Unemployment Cyclical Unemployment o Caused by economic downturns o The “worst” kind of unemployment o Occurs for an unknown length of time Natural Rate of Unemployment (*u) o Typical rate of unemployment in a healthy economy o This is structural and frictional that is under natural o Actual employment rate denoted by “u” Full employment output o Output by an economy with no cyclical unemployment o Actual output denoted by Y Measuring Unemployment Labor Force People who are employed or actively seeking work Who is not in the labor force? Jobless people not actively seeking employment (no efforts made in 4 weeks) Retirees, students, institutionalized Unemployment Rate = (number unemployed/labor force) x 100 Rachel Brown Econ 1015 Notes Lecture: 7 Date: 2/09 Covers Chapters: 7 & 8 Dr. Trindade T/Th 12:30-1:45 Lecture #7: Chapter 7 Unemployment & Chapter 8 Inflation Vocab (Ch. 8) NEED TO KNOW: Deflation: Occurs when overall prices fall Consumer Price Index (CPI): A measure of the price level based on the consumption patterns of a typical consumer Chained CPI: A measure of the CPI in which the typical consumer’s “basket” of goods considered is updated monthly Shoeleather Costs: The resources that are wasted when people change their behavior to avoid holding money Money Illusion: Occurs when people interpret nominal changes in wages or prices as real changes Nominal Wage: A worker’s wage that is current, expressed in dollars Real Wage: The nominal wage adjusted for changes in the price level Menu Costs: The costs of changing prices Output; The production that a firm creates Capital Gains Taxes: Taxes on the gains realized by selling as asset for more than its purchase price Shortcomings of the Unemployment Rate Discouraged Workers o People who want a job but get discouraged and give up looking for one o Are not included in labor force and not considered unemployed o But in fact may want a job Underemployed Workers o Part-time workers who want full time jobs o Workers who are very overqualified at their job o Considered employed Lagging vs. Leading Indicators Leading Indicator: o Helps us predict the future state of the economy: usually change before the economy as a whole does Example: average weekly hours for manufacturing Lagging Indicator o Usually changes after the economy as a whole changes so it doesn’t have much predictive power Example: Average duration of unemployment or changes in the price index Unemployment Timeline Unemployment rate lags economic activity Recovery People reenter the labor force unemployment rate may actually increase The recovery on the unemployment lags the recovery of the economy Who is unemployed? Aggregate number tells us little about who is unemployed and in particular about the duration of their unemployment Other Labor Market Indicators: The Labor Force Participation Rate Formula: Labor Force Participation Rate = (labor force/population)x100 This is the portion of the population that is in the labor force Inflation Rise in the general price level Measured as a growth rate in the average level of prices Deflation: opposite of inflation… price level falls To measure Inflation… The consumer price index We measure inflation with the consumer price index (CPI) A measure of the price level based on the consumption pattern of a typical consumer Includes goods and services in a consumption basket of a typical consumer Bureau of Labor Statistics (BLS) The government agency that reports unemployment data Also reports inflation data Determines how much weight to put on certain consumer prices Computing the CPI BLS surveys Price information on over 8000 goods and services each month 211 categories 38 geographic locations First we compute the price index Price Index = (basket price/basket price in base year)x100 Then inflation is simply the growth in the price index Inflation rate (i) = (PI in final year – PI index in initial year)/PI index ini. year x100 Rachel Brown Econ 1015 Notes Lecture: 8 Date: 2/11 Covers Chapters: 8, very beginning of 9 Dr. Trindade T/Th 12:30-1:45 Lecture #8: Chapter 8 Inflation Vocab (Ch. 8) NEED TO KNOW: ~Chapter 8 vocab on previous set of notes ~ Note: Inflation is just one aggregate number that hides: Prices don’t all move together Clearly, most prices rise over time However, some prices can also fall over time The Accuracy of the CPI Concern: CPI may overstate true inflation (upward bias)- three possible reasons: o Substitution o Changes in Quality o New products and locations Substitution o Micro: when the price of A rises, we buy more B o As we just say, prices of goods rise at different rates o As consumers substitute into cheaper goods, the actual rise in the cost of living may be less than seen in the fixed basket of goods o Since 1999, the BLS has used a formula that accounts for this Quality Changes o Prices may rise because the quality is better o Ex: Flat screen HD TVs o Again, we may observe the rise in the price and overstate how much the cost of living rose o Since consumers are paying more but are enjoying a better product o Since 1999, the BLS has used a careful adjustment method to account for quality changes New goods, services and locations o Electronics such as iPod’s and flash drives Previously, the BLS updated the basket of goods after long delays. This causes upward bias for two reasons o New product prices often drop after a couple of years. If the goods are not placed in the consumption basket for the first two years, that price drop is lost o New retail outlets such as online stores offer better prices than traditional retail stores. If the CPI uses only old retail outlets it will miss these price drops o CPI should keep track of these price drops o New chained CPI in 2000, takes care of this. More difficult to measure but it’s a better indicator of inflation Problems Caused by Inflation If people change their behavior due to inflation then it is considered a cost 1. Shoeleather Costs As prices go up, it becomes more costly to hold money Shoeleather costs are resources that are wasted when people change behavior to avoid holding money In time of hyperinflation, people may get paid every day and need to purchase goods every day or their money will become worthless What is optimal behavior? o Optimal= get paid, go to the bank just a few times a month o Suboptimal= get paid and go to bank every day 2. Money Illusion This is when people interpret nominal wage or nominal price changes as real changes If price AND wages all go up by 2% there is no real change in your purchasing power. People with money illusion think they are richer in this case and they may change their behavior What is optimal behavior and how did it change? o Optimal: (for example) Someone decides to live in Columbia or Chicago based on the real change on their wage o Suboptimal: But if they have money illusion they may move to the wrong city Nominal wage the wage in current dollars Real Wage Nominal wage is adjusted for inflation Another money illusion example: o Nominal wages go up by 3%. Prices go up by 5%. Are you wealthier? No! That would be a money illusion 3. Menu Costs The costs of actually changing prices o Example: a restaurant will have to print new menus for all price changes What is the optimal behavior here and how did it change? o Optimal: restaurant changes their menu once every 5 years o Suboptimal: they change it every half year 4. Uncertainty about future price levels Wage and other input contracts often have a long term commitment. Firms may have to borrow today and pay back the money later Uncertainty about prices may make borrowing riskier What is the optimal behavior here and how did it change? o Optimal: firms invest as long as the investment is profitable o Suboptimal: firms decide that the price increase is too risky, and they decide not to invest 5. Wealth Distribution Wealth can be redistributed between borrowers and lenders o Example: you borrow $50,000 and expect to pay back $60,000 in 5 years o This is a fair interest rate if inflation is 2% o However, supposed inflation is 4%. Who is better/worse off? You are better off, the bank is worse off o If the 4% inflation was expected… The bank would have required more in return for the loan 6. Price Confusion Note that prices are signals. They give sellers information about how much to sell and give buyers information about how much to buy o Example: big fire season in Canada burns lot of forests o In a planned economy, people in the U.S. might be required to buy less furniture, but the price takes care of that Price of wood increases furniture makers see higher costs, supply less price of furniture increases consumers buy less furniture 7. Tax Distortions Capital gains taxes: taxes on the gains realized by selling an asset for more than its purchase price Problem: even if the rise in price is due to inflation only, it is still taxes This may deter investment o Example: Buy a house in 1980 for $80,000 Sell house in 2012 for $230,000 for a $150,000 capital gain. You have to pay taxes on this 150. However, the CPI rose from 80 to 230 in those years so the real value of the house is the same The Cause of Inflation No debate on the cause of inflation o Inflation is caused by expansions in the nation’s money supply So the real question is why the government chooses to increase the money supply. Two important reasons: o The government may issue new money to pay of its debt o Or to stimulate the economy in the short run Loanable Funds Market Loanable Funds Market o Includes places like stock exchanges, investment banks, mutual fund firms, and commercial banks o Wherever borrowers get funds to use for businesses… and savers lend to these businesses Notes about Borrowing Every dollar borrowed requires a dollar saved o Therefore lenders and borrowers need to meet in a marketplace or more likely through an intermediary Interest Rate Interest Rate: Interest rate is the price of loanable funds o Savers: the reward for saving o Borrowers: the cost of borrowing Like other prices, it rises and falls Affected by supply and demand Rachel Brown Econ 1015 Notes Lecture: 9 Date: 2/16 Covers Chapters: 9 Dr. Trindade T/Th 12:30-1:45 Lecture #9: Chapter 9 Savings and Interest Rates Vocab (Ch. 9) NEED TO KNOW: Loanable funds market: The market where savers supply funds for loans to borrowers Interest Rate: A price of loanable funds, quoted as a percentage of the original loan amount Real interest rate: The interest rate that is corrected for inflation Nominal Interest Rate: The interest rate before it is corrected for inflation Fisher Equation: States that the real interest rate equals the nominal interest rate minus the inflation rate Time Preferences: Refers to the fact that people prefer to receive goods and services sooner rather than later Consumption Smoothing: Occurs when people borrow and save in order to smooth consumption over their lifetime Dissaving: Occurs when people withdraw funds from their previously accumulated savings Savings Rate: Personal saving as a portion of disposable (after tax) income Investor Confidence: A measure of what firms expect for future economic activity Inflation and Interest Rates Real Interest Rate o The interest rate corrected for inflation Nominal Interest Rate o The interest rate before it is corrected for inflation o So far we just call it the interest rate Fisher Equation: -Relates inflation to the real and nominal interest rate Real interest rate = nominal interest rate – inflation rate OR Nominal interest rate = real interest rate + inflation rate When will inflation rates be high on a graph? When real and nominal interest rates have a lot of space in between them What factors shift the supply of loanable funds? First, note that many factors affect the demand for a good such as price, advertisement for the good, and consumer’s income. The demand curve isolates one of those factors, which is the price. So when the price changes and consumers buy a different quantity, we see that in the curve as a movement along the demand curve... meaning choosing different points of the curve, with different price/quantity combinations A movement along the supply curve for loanable funds is caused by a change in the interest rate which is the price of borrowing A shift in the supply curve of loanable funds is caused by other factors affecting the supply of loanable funds. We will see that these factors are Changes in income and wealth Changes in time preferences Consumption smoothing 1. Income and Wealth Increases in income generally increase savings o High income people save more than low income people at the same interest rate o Thus, this is a shift in the supply of loanable funds 2. Time Preferences Times preferences refer to the fact that people generally prefer goods sooner than later and funds are no different. Would you rather have $50 now or $50 later? This is why there must be an interest rate. Since loans are paid back at a later date… the borrower compensates the lender with an interest But time preferences are not uniform across individuals and societies o More impatient people who strongly prefer now rather than later therefore at the same interest rate they will save less o More patient people: the time preference is not quite so strong. They will save more. So, if people become more patient or more impatient this will cause a shift in the supply for loanable funds 3. Consumption Smoothing Income changes over a typical lifetime o Young students and elderly retirees don’t work, but most people do earn income in between those years However, young people and retirees still consume goods and services o It is common to wish for consumption smoothing, not to experience large changes in consumption with changes in income o Consumption smoothing is possible by borrowing and lending funds at different stages of life. Therefore if done by large numbers of people it can shift the supply of loanable funds o Early life = borrowing. Prime earning years = saving. Later life = dissaving What factors shift the demand of loanable funds? Demanders of loanable funds are entities who want to borrow money o Driven largely by firms who need to borrow in order to invest o For example large capital projects o Notes that governments also borrow A movement along the demand curve for loanable funds is caused by a change in the interest rate, which is the price of borrowing A shift in the demand curve of loanable funds is caused by other factors affecting the demand of loanable funds. We will see that these factors are changes in the productivity of the capital and the changes in investor confidence 1. Changes in the Productivity of capital If capital becomes more productive, the demand for loans will increase because the returns to investment at a given interest rate will be greater. Therefore this is a shift in the demand for loans. Example- internet makes computers more productive 2. Investor Confidence If a firm thinks the economy will grow in the future it will be more comfortable borrowing more today Changes in capital productivity and investor confidence will shift the demand for loanable funds How do we apply the loanable funds model market? We have looked at supply and demand In equilibrium, supply = demand This will determine the interest rate and the quantity of funds borrowed Equilibrium in the Market for Loanable Funds In equilibrium, savings = investment Supply of loanable funds in people’s savings Demand for loanable funds is firms wanting to borrow for investment purposes We now apply this model to see what happens in two examples. Each example will either shift the supply or demand Example 1: Decline in investor confidence Investor confidence tends to decline when the economy slows down Firms expect reduced sales, and investors expect lower returns on their investments Model predicts that this will result in a lower level of investment and a lower interest rate Investment fell during both U.S. recessions between 2000 and 2012 Example 2: Baby boomers retiring As baby boomers retire, they will begin their time of dissaving and this will shift the supply of funds leftward. Result could be less investment and reduced GDP growth Rachel Brown Econ 1015 Notes Lecture: 10 Date: 2/18 Covers Chapter 10 Dr. Trindade T/Th 12:30-1:45 Lecture #10: Financial Markets and Securities Vocab (Ch. 10) NEED TO KNOW: Financial Intermediaries: Are firms that help to channel funds from savers to borrowers Banks: Private firms that accept deposits and extend loans Indirect Finance: Occurs when savers deposit funds into banks, which then loan these funds to borrowers Direct Finance: Occurs when borrowers go directly to savers for funds Security: A tradable contract that entitles its owner to certain rights Bond: A security that represents a debt that is to be paid Maturity Date: Of a bond is the date on which the loan repayment is due Face/Par Value: The value of the bond at maturity- the amount due at repayment Default Risk: The risk that the borrower will not pay the face value of a bond on the maturity date Stocks: Ownership shares in a firm Secondary Markets: Are markets in which securities are traded after their first sale Treasury Securities: Are the bonds by the US government to pay for national debt Securitization: The creation of a new security by combining otherwise separate loan agreements How do financial markets help the economy? Financial Intermediaries o Firms that channel funds from savers to borrowers like banks Banks o Private firms that accept deposits and extend loans Discussing financial markets is the same as discussing financial intermediaries We care about financial markets because they are the way that firms can finance their investment They connect borrowers (demanders) with savers (suppliers) Crisis 2008: to a large extent it was a crisis in financial markets. The Lehman brothers went bankrupt and the Troubled Assets Relief Program helped other financial institutions. As private investors, we care about them to make better decisions Indirect vs Direct Finance Indirect Finance o Savers deposit funds into banks and banks then loan these to borrowers How do banks make profit? They pay lower interest rates to savers than they charge borrowers Direct Finance o Firms sell a security directly to the public in exchange for funds. Security: stock or bond. Security pays future income and/or gives part ownership of the firm What are the key financial tools for the macroeconomy? Bonds Stocks Treasury Securities Home Mortgages Private Sector Securities Bonds Bonds are used by large established firms when they need money o They are securities issued by the firms and sold into the public o This is an example of direct finance o Firms use the funds generated for investment o Bond is a formal IOU- a contract specifying who owes how much and a date for payment o Information on every bond- name of borrower, repayment/maturity date, amount due at repayment (face value Information on a bond o Maturity date- the loan repayment o Face/Par value- amount due at repayment. Set at the inception of the bond o Dollar Price- The price at inception, the price when the bond is further bought and sold Supply and Demand for bonds o Potential pitfalls to avoid: In the loanable funds analysis, the supply is due to the lenders while the demand is due to the borrowers o In the market for bonds: The supply is due to bond issuers (they supply bonds) who are the borrowers while the demand is due bond buyers who are the lenders Interest rate formula for bonds: o Main thing to understand: when bond prices increase, that will mean that interest rates will decrease. Reason: interest rate is given by the formula: (Face value – Price at inception)/Price at Inception OR (Pm-Po)/Po Example: Price at maturity = 10000 and current price = 7000. Interest rate = (10000-7000)/7000 = .4286 = 42.86% o Reminder: Bond buyers (savers) want the highest possible interest rates and bond sellers (lenders) want lowest possible interest rates Two bond price principles: o 1. The dollar price of a bond determines its interest rate o 2. The dollar price and interest rate of a bond move opposite one another Default Risk: o 2 possibly outcomes for the bond: The borrower pays maturity value of the bond to lender The borrower defaults on the loan Bond Ratings: o Moodys, S&P, Fitch’s o Purpose is to evaluate the default risk of defaulting. They assign a grade according to RISK o What happens when a bond gets downgraded? There is less demand for the bond Stocks Stock shares are… o Ownership shares by a firm o Trade-off for shareholders and firms, compared to bonds: shareholders have some influence in the operations of the firm but they don’t get a promise of being paid anything o Firms have fewer obligations but lose partial ownership Secondary Markets: o Where securities are traded after their first sale o Analogous to used car markets o Often sold to investors through a broker o Enables firms to sell bonds or stocks at higher prices Stock markets are secondary markets o NYSE and NASDAQ are examples Treasury Securities: o US government borrows by selling treasury securities o An auction determines interest rate o Generally considered less risky than other bonds o Play a central role in monetary policy o Active secondary market Home Mortgage Loan o Individuals use mortgages to pay for homes o Market expanded leading up to 2008 recession Securitization o The creation of a new security as a combination of other securities and loan agreements o Diversifies risk, lowers interest rates o Offers new opportunities for lenders o Student loan and home mortgage markets may not exist without the risk diversification of securitization
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