Final Exam Study Guide
Final Exam Study Guide Econ 322
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This 7 page Study Guide was uploaded by Tulsi on Monday April 25, 2016. The Study Guide belongs to Econ 322 at University of South Carolina taught by Hauk in Spring 2016. Since its upload, it has received 54 views. For similar materials see Intermediate Macroeconomics in Economcs at University of South Carolina.
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Date Created: 04/25/16
Exam 3 Study Guide Monday, April 25, 2012:22 PM Formulas to know: Intertemporal consumption: Y = C + I + G C = c0+ c(Y-T) MPC = C∆ ∆ = c APC (average propensity to consume) = C/Y = c /Y0+ c (1+r)PV = FV PV = FV/(1+r) Function C = MPC ( ∆ ∆y) APC (c/y) Keynesian c +0cY 0<c<1 c0/Y + c Modigliani α*W + β*Y 0<β<1 α*W/Y + β Friedman α*Y P ? Could be 0 α* Y P NeoClassical Model of business Investment Net Investment Function: I = [MPK - P /P(r + δ)] n k Gross Investment Function: I = I [MPK - P /P(r + δ)] + δ*K n k Tobin's Q Ratio: Q = Keynesian Model Y = C + I + G C = 0 + c(Y-T) MPC = C∆ ∆ = c 0<c<1 (marginal propensity to consume) APC (average propensity to consume) = C/Y = c /0 + c If Y increases, APC increases If Y decreases, APC decreases C2 Secular Stagnation Hypothesis Y2 + (1+r) Y1 If Y increases a lot, APC will fall a lot Slope = Indifference curve Intertemporal Consumption Function -(1+r) Y2 -people live for 2 periods Intertemporal budget constraint -people can save and borrow across periods -Income in period 1 is Y1, income in period 2 is Y2 -Maximize utility across both periods subject to a budget constraint C1 -divide consumption across 2 periods Y1 Y1 + Y2/(1+r) (1+r)PV = FV PV = FV/(1+r) -If Y1 increases: -C1, C2 increases Borrow = .5/(1+r) -If Y2 increases: -C1 ,C2 increases -give up X amount of consumption today to get X + interest in the next period Modigliani Life-Cycle Consumption -person expected to live for T years -person expected to retire in R years -Earn an income of Y while working -W is accumulated wealth -C = * W + * Y Exam 3 Study Guide Page 1 -C = * W + * Y Aggregate consumption = α*W + β*Y α= average of 1/T β= average of R/T APC = C/Y = α*W/Y + β (Average propensity to consume) Milton Friedman PermanentIncome Hypothesis -Y = Y + YT -Actual current income = permanent income + transitory income -permanent income: fixed salary -transitory income: income that you can't depend on (like a bonus) -C = α*YP -APC = α* YP Robert Hall: "Random Walk" -combine Permanent Income with Rational Expectations -only unexpected events will affect consumption David Laibson -Behavioral Economics -"Pull of Instant Gratification" -Consumption isnt always rational and is highly influenced by psychological factors SUMMARY TABLE Function C = MPC ( ∆ ∆y) APC (c/y) Keynesian c +0cY 0<c<1 c0/Y + c Modigliani α*W + β*Y 0<β<1 α*W/Y + β Friedman α*Y P ? Could be 0 α* Y P Y Neo-Classical Model of Business Investment -looks at marginal costs/benefits -looks at marginal utilities Production Firms -rents capital and uses it to produce goods and services for consumers Rental Firms -firm that buys capital and rents it out to production firms Production Firm's Problem Marginal Benefits -marginal product of capital (MPK) -how much more do we benefit from renting more capital -Price * MPK = marginal benefit from renting more capital Marginal Costs -R = rental rate of capital Firm will rent until R = P*MPK Rental Firm's Problem Marginal Benefits: -R = P*MPK Marginal Costs: δ*PK= depreciation on capital i*PK= nominal interest ∆ *PK= capital gain Exam 3 Study Guide Page 2 -∆*P =Kcapital gain -Cost of Owning Capital = i*P - *P∆δ*P K K K Pk(i ∆ PK/P K δ) = C.O.C. ∆P KP K π = inflation ratio Pk(i - π+ δ) = C.O.C. i - π = real interest rate P (r + δ) = C.O.C. k -COC/P = P /k(r + δ) Invest in more capital if MPK > P /Pkr + δ) Divest capital if MPK < P /k(r + δ) In long-run, MPK = P /Pkr + δ) Net Investment Function: In= [MPK - P /k(r + δ)] Gross Investment Function: I = I [MPK - P /P(r + δ)] + δ*K n k If interest rate r increases, n and I decrease (movement along IS curve) If MPK increases, I nnd I increase (shift to the right on IS curve) If P /P increases, I and I decrease (shift to the left on IS curve) k n If δ increases, Indecreases and change in I is ambiguous Corporate Income Taxes and Investment -35% of firms "profits" -Define profits as P*MPK - (r + δ)P K -depreciation is hard to measure (δ*P ) K -use historical cost of capital for PK(problematic due to inflation over the years) I = n [MPK - P kP(r + δ)] + δ*K Tobin's Q Ratio: Q = If Q >1, firm should expand investment If Q <1, firm should disinvest Marginal product of capital (MPK) is major determinant of market value of firm's capital PK/P and r + δ determine the replacement cost of firm's capital Is the Stock Market "Efficient?" 1) Efficient markets hypothesis says yes -Market price of stock is rational evaluation of the company given current info about company's business prospects -financial analysts follow major companies and money is traded based on their recommendations -stock prices reflect all information available about a company -stock prices will only change due to unanticipated info about a company -prices follow a "random walk" 2) Keynes's "Beauty Contest" Hypothesis -Psychological factors can drive fluctuations in stock prices -stock prices can change for reasons other than new info about a firm Exam 3 Study Guide Page 3 May 2010: "Flash Crash" -Dow Jones started falling quickly: fell 700 points in an hour -Came back up when market opened next morning -all due to computerized algorithms that automatically sell stocks when Dow starts to fall -people realized what was happening and started buying again, so Dow rose again Residential Investment -purchases of NEW homes and apartments for private use -price of existing homes positively affects supply of new homes -housing demand tends to go up when interest rate (r) is low and vice versa Inventory Investment -Price speculation -Stock-out Avoidance -insurance against unexpectedly large orders -Production smoothing -Demand might be predictable (volatile) than the ability to change supply -Showroom effect -Having a large number/variety of goods makes it easier to satisfy consumer preferences Debt: -accumulated government borrowing over time. -How much money does the gov’t owe at this point in time? -stock variable Deficit: -difference between government spending and tax revenue in a given period of time -new borrowing undertaken by government -flow variable 1) Inflation -tends to benefit borrowers and hurts lenders -may be easier for gov’t to pay off debts, eroding the real value of debt -π=ΔD/D real value of debt would not change. ΔD = reported deficit 2) Uncounted Liabilities -official debt/deficit numbers are understated because they exclude important gov’t liabilities -Social Security and Medicare, gov’t employee pensions -Contingent liabilities: student loans -gov’t could always change the rules 3) Capital Assets -some gov’t borrowing is used to purchase valuable assets -gov’t debt should account for assets as well as liabilities -official debt #s are overstate bc only include liabilities -not all govt assets can be easily liquidated Exam 3 Study Guide Page 4 4) Business Cycle -During a recession, tax revenue goes down, gov’t spending goes up, which increases budget deficit (automatic) -During an expansion, tax revenue goes up, gov’t spending goes down, which decreases budget deficit - state of the economy affects budget deficit 5) Debt held by Public vs Total Government Debt -US govt owes a lot of money to: -Social Security Trust Fund -Medicare Trust Fund -Federal Reserve -Federal Financing bank -US govt owes a lot to itself "Traditional" View of Gov't Debt r LM -Increase in G or decrease in T -IS shifts right -In short run, Y and r increase -Increase in r crowds out investment -In long run, less investment means less economic growth -therefore, there is a trade-off between short-run stimulus and long-run growth IS ' IS Y Ricardian View of Gov't Debt -Ricardian Equivalence: financing gov't spending via debt is equivalent to financing it via taxes -changes in fiscal policy will not have a big effect on consumption -forward looking consumers who want to smooth consumption -If gov't stimulates economy by deficit spending, at some point, G will decrease or T will increase to pay money back -A forward looking consumer would save money today because disposable income is lower in the future -low marginal propensity to consume -stimulus won't work bc Gov't multiplier essentially 0 Does Ricardian Equivalence Work? 1) Consumer Myopia a. Consumers are not always rational and forward-looking 2) Borrowing Constraints a. People who can't borrow money now may have a high marginal propensity to consume Exam 3 Study Guide Page 5 consume 3) People have finite lifespans a. Gov't debt may be long-lived b. Households could have longer life spans Should the federal Government Have a Balanced Budget Amendment? Pro: -fiscal policy is not a good way to stimulate the economy -politicians may put too much weight on short term gains Con: -automatic stabilizers increase deficit during a recession -certain infrastructure projects cost a lot up front, but pay off over time. Deficit spending facilitates this The government should try to balance its "structural" budget -what the budget would be without fluctuations of the business cycle Does Gov't Have an Effect on Monetary Policy? -debt is usually easier to pay off with inflation -highly indebted governments may be tempted to generate inflation Economic Functions of the Financial System 1) Facilitate Investment by Firms S=I, savings = investment 2) Risk-sharing People tend to be risk-averse -leads to development of insurance because people want to pay for it to reduce risk Entrepreneur: -debt finance-> owe the same amount of money to creditors no matter what -equity finance -> owe a fraction of a firm's profits (could be zero) -less risky option 3) Dealing with Asymmetric Information Big issue in insurance markets Adverse Selection: hidden information about a person's attribute that affect propensity to buy insurance Moral Hazard: insurance alters a person's behavior in an unobservable way Exam 3 Study Guide Page 6 Moral Hazard: insurance alters a person's behavior in an unobservable way Economic Functions of the Financial System 1) Financing Investment 2) Sharing Risk 3) Dealing with asymmetric investment a. Adverse selection: hidden information about a person i. Might prevent an entrepreneur from getting as much equity finance as he wants b. Moral Hazard: hidden information about person's behavior i. Might prevent entrepreneur from getting as much equity finance as he wants 4) Foster economic growth a. S = I b. Lots of different types of capital to which savings can be allocated i. R = P * MPK c. Develop institutions that allow savings to be allocated well d. Reporting requirements i. Laws against fraud and market manipulation Financial Crisis of 2008 -Asset Price Boom: 2000-2006 (Housing speculation bubble) -Asset Price Bust: 2007-2009 -Insolvencies at Banks Policy Responses to Financial Crisis and Recession 1) Expansionary Fiscal Policy (more spending, tax cuts) Exam 3 Study Guide Page 7
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