Macroeconomics Final Exam Study Guide- Zirlott
Macroeconomics Final Exam Study Guide- Zirlott Econ 111
Popular in Macroeconomics
Popular in Department
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
verified elite notetaker
This 14 page Study Guide was uploaded by Matt Cutler on Thursday April 28, 2016. The Study Guide belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Fall 2016. Since its upload, it has received 97 views.
Reviews for Macroeconomics Final Exam Study Guide- Zirlott
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 04/28/16
Macroeconomics Final Exam Study Guide- Zirlott Tuesday, April 26, 20168:40 PM 1. Chapter 4- Supply and Demand (6+ questions from this chapter!!) 1. General Concepts and Terms • Market- a group of buyers and sellers • Competitive market- one with many buyers and sellers, each has a negligible effect on price. • Price is always on the vertical axis, Quantity is always on the horizontal axis. • Market cleared=equilibrium 2. Demand a. Quantity demanded: i. A specific amount of a specific good that buyers are willing and able to purchase at a specific price ii. QD is a point on the demand curve b. Demand curve: i. A SET of various quantities demanded at corresponding prices. It is the curve itself ii. Downward sloping, because of Law of Demand. c. Law of Demand: i. The claim that the quantity demanded falls when the price of the good rises: other things equal. d. Demand Schedule: i. A table that shows the relationship between the price of a good and the quantity demanded. 1) Ex: Mikes demand for video games e. Market Demand: i. Add up the Quantity Demands in the market to get the market demand. 3. Demand Curve Shifters ○ The demand curve shows how price affects QD, other things being equal. A change in the price of the good changes QD and results in a movement along the D curve. ○ The other things are the non-price determinantsof demand (everything besides the price) a. Non-price determinants Shift the demand curve Increase in demand shifts curve to right Decrease shifts curve to the left i. # of buyers (population) 1) Increase number of buyers, shifts D curve to the right ii. Income 1) Increase in income causes shift to the right 2) Demand for an inferior good is negatively related to income. a) i.e. an increase in income causes D to shift to the left. iii. Prices of Related goods 1) Substitutes: move in the same direction. a) Increase in the price of one causes an increase in the demand for the substitute. b) Ex: Coke and Pepsi 2) Complements: move in the opposite direction a) Increase in the price of one causes a decrease in demand for the complement. b) Ex: Peanut Butter and Jelly iv. Tastes 1) Anything that causes a shift in tastes towards a good will increase demand for that good and shift its D curve to the right. And Vice Versa. v. Expectations 1) Ex: if people expect gas prices to rise in the future, Demand will increase for gas now. 2) Ex: if people expect gas prices to fall in the future, demand will fall for the time being, because they are holding out until the price drops. PRICE change causes movement on the curve, all these determinants^^ cause a shift! 4. Supply a. Quantity Supplied: i. Amount of a good that sellers are willing and able to sell at a specific price; Point on supply curve b. Supply Curve: i. Set of various quantities supplied at corresponding points c. Law of Supply: i. The claim that the quantity supplied of a good rises when the price of a good rise, other things equal EC 111 Page 1 things equal ii. Supply always slopes up and to the right iii. Price acts as an incentive. d. Supply Schedule i. A table that shows the relationship between the price of a good and the quantity supplied. 1) Ex: Video game store's supply of video games e. Quantity Supplied i. Sum of all quantities supplied by all sellers at each price. 5. Supply Curve Shifters ○ Only a change in price will move the point on the curve. ○ Other things are non-price determinants of supply and shift the curve a. Input Prices (Wages, prices of raw materials) i. A fall in input prices makes production more profitable at each output price; S curve shifts right. b. Technology (production technology) i. A cost saving technological improvement (increase in production technology) always shifts S curve to the right c. Number of sellers i. Increase in number of sellers increases the quantity supplied at each price; shifts S curve to the right d. Expectations i. Middle east events lead to expectations of higher oil prices ii. Suppliers would reduce supply now in anticipation for future profits they could get by waiting for the higher prices. • Supply and Demand determine price by where they cross: equilibrium. ○ Equilibrium price- the price that equates quantity supplied with quantity demanded ○ Equilibrium quantity- where quantity supplied and demanded are equal ○ Surplus- when quantity supplied is greater than quantity demanded (majority of the time when price is too high) (on a graph: above equilibrium) ○ Shortage- when quantity demanded is greater than quantity supplied (majority of the time when price is too low) (on a graph: below equilibrium) 6. Changes in Equilibrium (Examples) a. Decide whether event shifts S curve, D curve, or both. b. Decide in which direction curve shifts. c. Use supply-demand diagram to see how the shift changes EQ P and Q. i. Ex: market for hybrids 1) Increase in price of gas a) Causes shift right in demand curve for hybrids b) Price and quantity go up 2) New technology reduces cost of producing hybrid cars. a) Supply curve shifts right b) Price falls, quantity rises 3) Price of gas rises AND new technology reduces production costs a) Both curves shift right b) Quantity rises, price is uncertain (because we don’t know how far the curves shifted) ii. Market for Ice Cream 1) Fall in the price of frozen yogurt a) Frozen yogurt is a substitute so demand curve shifts b) Demand curve shifts left c) Price and quantity drop 2) Fall in milk prices a) Input price: supply shift b) Supply curve shifts right c) Price falls, quantity rises 3) Fall in price of frozen yogurt AND fall in milk prices a) D shifts left, S shifts right b) Price falls, effect on Q is unknown 2. Chapter 5- Elasticity (4-5 questions) ○ The flatter the curve, the bigger the elasticity ○ The steeper the curve, the smaller the elasticity 1. Know how to calculate elasticity of demand using the midpoint method. a. Midpoint method: (New-Old)/ Average= percentage change for Elasticity!! 2. Know the 5 types of elasticity and the characteristics and shapes of their demand curves. a. Five different classifications of D curves i. Elastic demand 1) Curve: relatively flat 2) Price sensitivity: relatively high (means Quantity demand changes a lot, more than EC 111 Page 2 2) Price sensitivity: relatively high (means Quantity demand changes a lot, more than price change) 3) Elasticity: greater than 1 ii. Inelastic demand 1) Curve: relatively steep 2) Price sensitivity: relatively low (Quantity only changes a little bit, changes less than price) 3) Elasticity: less than 1 iii. Unit elastic 1) Percentage change in price EQUALS the percentage change in quantity 2) Elasticity of 1 iv. Perfectly inelastic demand 1) Curve: Vertical 2) Price sensitivity: none (Q changes by 0% Price changes) 3) Elasticity: 0 v. Perfectly elastic demand (Demand curve for perfect competition: commercial fisherman, farmers) 1) Curve: Horizontal 2) Price sensitivity: Extreme (Q changes when price stays the same) 3) Elasticity: infinity 3. Know the relationship between elasticity of demand and total revenue. Revenue= Price x Quantity Price effect= more price per unit Quantity effect= less units sold Elasticity will tell you which one is bigger i. If demand is elastic (greater than 1) 1) A price increase causes revenue to fall (lost revenue due to lower Q exceeds increase revenue due to higher P) ii. If demand is inelastic (less than 1) 1) A Price increase causes revenue to increase (Price effect is larger than the quantity effect) 4. Know the determinants of elasticity of demand. i. Elasticity is higher when close substitutes are available. ii. Price elasticity is higher for narrowly defined goods than broadly defined ones 1) Ex: lucky brand jeans vs clothing (higher for jeans) iii. Price Elasticity is higher for luxuries than for necessities 1) Ex: Cruise vs insulin (higher for cruise) iv. Price elasticity is higher in the long run than the short run 1) Ex: gasoline in the short run vs gas in the long run (gas in long run is higher because more choices) 3. Chapter 10- GDP 1. Def. and Concepts. • Gross Domestic Product- measures total income of everyone in the economy ○ GDP also measures total expenditure on the economy's output of Goods and services ○ INCOME=Expenditures 2. What are the four components of GDP? Examples for each component. i. Components of GDP i. Consumption "C" 1) Total spending by households on goods and services 2) Largest component of GDP, Includes Rent and homeowners ii. Investment (I) 1) Total spending on goods that will be used in the production of other goods 2) i.e. capital equipment, structures 3) Inventories (goods produced but not yet sold) (only counts when its going in) 4) Houses that are brand new, never been lived in iii. Government Purchases (G) 1) Spending on goods and services purchased by the government at the federal, state, and local levels. 2) Excludes transfer payments, such as social security or unemployment insurance benefits. iv. Net Exports (NX) 1) Exports minus Imports 3. What goes into the calculation of GDP? What does not go into the calculation of GDP? i. Includes i. Final goods ii. Tangible goods (DVDs, mountain bikes, beer) iii. Intangible services (dry cleaning, concerts, cell phone service) iv. Currently produced goods, not goods produced in the past v. Measures the value of production that occurs within a country's borders, whether done EC 111 Page 3 v. Measures the value of production that occurs within a country's borders, whether done by its own citizens or by foreigners located there. vi. Calculated by year and by quarter ii. Does not include i.Intermediate goods ii.Stocks, Bonds, Mortgages iii.ransfer payments, i.e. social security, unemployment insurance 4. Calculate nominal GDP, real GDP, and the GDP deflator. i. Real versus Nominal GDP a. Nominal GDP: values output using current prices. It is not corrected for inflation i. Current quantity times current price b. Real GDP: values output using the prices of a base year (prices are not changing). Real GDP is corrected for inflation i. BASE YEAR WILL BE GIVEN ii. Base year price times current year quantity ii. The GDP Deflator a. Measure of the overall level of prices Percent change= (new-old)/old b. =nominal GDP divided by real GDP * 100 c. Percentage increase in GDP deflator measures inflation rate 4. Chapter 11- CPI 1. Def. and Concepts. i. CPI a. Measures the typical consumer's cost of living b. The basis of cost of living adjustments (COLAs) in many contracts and in Social Security • BEA (Beauro of economic analysis) inside the department of commerce calculates GDP • BLS calculates CPI 2. Calculating the CPI Index given a fixed basket and prices. i. How is it Calculated a. 5 Steps (must be in order) i. Fix the "basket" 1) The Bureau of Labor Statistics (BLS) surveys consumers to determine what's in the typical consumer's "shopping basket" ii. Find the prices 1) The BLS collects data on the prices of all the goods in the basket iii. Calculate the basket's cost 1) Use the prices to compute the total cost of the basket iv. Choose a base year and compute the index 1) The CPI in any year equals: 2) (Cost of basket in current year/Cost of basket in base year) * 100 v. Compute the inflation rate 1) The percentage change in the CPI from the preceding period equals: 2) Inflation rate = ((CPI this year - CPI Last year)/ CPI last year))*100 3. Problems with the CPI Index and measuring the cost of living (Substitution Bias, Intro of New Goods, Unmeasured Quality Change). i. Problems with the CPI: a. Substitution Bias i. Over time, some prices rise faster than others ii. Consumers substitute towards goods that become relatively cheaper iii. The CPI misses this substitution because it uses a fixed basket of goods iv. Thus, the CPI overstates increases in the cost of living b. Introduction of New Goods i. The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs ii. In effect, dollars become more valuable iii. The CPI misses this effect because it uses a fixed basket of goods. iv. Thus, the CPI overstates increases in the cost of living c. Unmeasured Quality Change (New Car) i. Improvements in the quality of goods in the basket increase the value of each dollar ii. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. iii. Thus the CPI overstates increases in the cost of living ○ Each of these problems causes the CPI to overstate cost of living increases. ○ The BLS has made technical adjustments, but the CPI probably still overstates inflation by about .5 percent each year ○ This is important because Social Security payments and many contracts have COLAs tied to the CPI… could result in a billion dollar difference 4. Differences between the CPI Index and the GDP deflator. i. Contrasting the CPI and GDP Deflator (BOTH MEASURE INFLATION) EC 111 Page 4 ○ This is important because Social Security payments and many contracts have COLAs tied to the CPI… could result in a billion dollar difference 4. Differences between the CPI Index and the GDP deflator. i. Contrasting the CPI and GDP Deflator (BOTH MEASURE INFLATION) a. Imported consumer goods: i. Included in CPI ii. Excluded from GDP deflator b. Capital goods (investment goods) i. Excluded from CPI ii. Included in GDP deflator (if produced domestically) c. The Basket: i. CPI uses fixed basket ii. GDP deflator uses basket of currently produced goods and services 1) This matters if different prices are hanging by different amounts 5. Chapter 15- Unemployment 1. Def. and Concepts. i. Labor Force Statistics ○ Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor ○ Based on regular survey of 60,000 households ○ Based on adult population (16 yrs or older) ○ Discouraged worker- someone who is able to work but has stopped looking for a job 2. What is the labor force? Who is included in the labor force? Who is not included in the labor force? i. The Labor Force a. The total number of workers, Including the employed and unemployed. ii. BLS divides population into 3 groups: i. Employed- (includes military) 1) Paid employees, self-employed, and unpaid workers in a family business, full time and part time workers, and those not working because of a temporary absence from a job (Vacation, health, seasonal) ii. Unemployed: 1) People not working who have looked for work during previous 4 weeks, also includes temporary layoffs who are waiting to be recalled to a job iii. Not in the Labor Force 1) Everyone else (Minors, retirees, inmates, full time students, disabled, discouraged workers, illegal immigrants, and volunteers) 3. Calculating the Labor-Force Participation Rate and the Unemployment Rate. i. Labor Force participation rate: i. % of the adult population that is in the labor force ii. (Labor Force/ Adult Population) * 100 ii. Unemployment rate ("u-rate") i. % of the labor force that is unemployed ii. (# of unemployed/ labor force) * 100 4. Problems with the unemployment rate. i. The U-rate is not a perfect indicator of joblessness or the health of the labor market: i. It excludes discouraged workers. ii. It does not distinguish between full-time and part-time work, or people working part time because full-time jobs are not available iii. Some people misreport their work status in the BLS Survey (Phantom Worker) iv. It does not include workers being paid "under the table" ii. Despite these issues, the u-rate is still a very useful barometer of the labor market & economy 5. What is the Natural Rate of Unemployment and what is it composed of? i. Natural rate of unemployment i. the normal rate of unemployment around which the actual rate fluctuates around (generally around 5-6%) ii. Made up of two things: 1) Frictional Unemployment 2) Structural Unemployment 6. Frictional vs. Structural Unemployment. i. Frictional unemployment a) Occurs when workers spend time searching for the jobs that best suit their skills and tastes b) Short-term for most workers c) Things that make up frictional unemployment i) Job search is the process of matching workers with appropriate jobs Things govt can do to help speed up job search process One. Govt employment agencies- provide information about job vacancies to speed up the matching of workers with jobs Two. Public training programs- aim to equip workers displaced from declining EC 111 Page 5 Two. Public training programs- aim to equip workers displaced from declining industries with the skills needed in growing industries ii) Sectoral shift (Changing economy)- changes in the composition of demand across industries or regions of the country iii) Unemployment insurance (UI) (safety Net) - a govt program that partially protects workers' incomes when they become unemployed One. Increases frictional unemployment Two. Benefits end when a worker takes a job. Three. Increasing or extending unemployment insurance raises frictional unemployment Reduces uncertainty over incomes Gives the unemployed more time to search, resulting in better job matches and thus higher productivity ii. Structural unemployment (Has a graph) a) Occurs when there are fewer jobs than workers b) Usually longer-term c) Occurs when wage is kept above the equilibrium…Three reasons for this: i) Minimum-wage laws The minimum wage may exceed the equilibrium wage for the least skilled or experienced workers, causing structural unemployment But this group is a small part of the labor force, so the min. wage can't explain most unemployment But increasing the minimum wage raises unemployment by increasing the Qs of labor and decreasing the Qd of labor. ii) Unions Union- a worker association that bargains collectively with employers over wages, benefits, and working conditions. When unions bargain successfully, wages and unemployment rise in that industry The typical union worker earns 15-20% higher wages and gets more benefits than a nonunion worker for the same type of work Spillover effect – "Insiders"- workers who remain employed, they are better off. – "Outsiders"- workers who lose their jobs, they are worse off. Some outsiders go to non-unionized labor markets, which increases labor supply and reduces wages in those markets. Are Unions good or bad??? – Critics: They are cartels. They raise wages above equilibrium, which causes unemployment and/or depresses wages in non-union labor markets – Advocates: Unions counter the market power of large firms, make firms more responsive to workers' concerns. iii) Efficiency wages (Not minimum wage) Firms voluntarily pay above-equilibrium wages to boost worker productivity. And by increasing worker productivity, the firms profit can increase as well. Different versions of efficiency wage theory suggest different reasons why firms pay high wages. 4 reasons why firms might pay efficiency wages: – Worker health- paying higher wages allows workers to eat better, makes them healthier and more productive. – Worker turnover- hiring and training new workers is costly. Paying high wages gives workers more incentive to stay, reduces turnover. – Worker quality- offering higher wages attracts better job applicants, increases quality of the firm's workforce (Saban) – Worker Effort- workers can work hard or shirk. Shirkers are fired if caught. Is being fired a good deterrent. 6. Chapter 16- The Federal Reserve System (4-5 Questions) 1. Structure of the Fed i. Federal Reserve (Fed)- the central bank of the U.S. 1) Created in 1913 from the Federal Reserve Act 2) After a series of bank failures in 1907 3) "Panic of 1907" also called "Knickerbocker Crisis"… the failure of the Knickerbocker Trust Company 4) Purpose- to ensure the health of the nation's banking system 5) Made up of a Board of Governors a) 7 members, 14-year terms i) Appointed by the president and confirmed by the Senate EC 111 Page 6 i) Appointed by the president and confirmed by the Senate b) The chairman i) Directs the Fed Staff ii) Presides over board meetings iii) Testifies regularly about Fed policy in front of congressional committees iv) Appointed by the president (4-year term) v) Janet Yellen (Current Chairwoman) 6) The Federal Reserve System a) Federal Reserve Board in Washington, D.C. b) 12 regional Federal Reserve Banks i) Major Cities around the country ii) The presidents- chosen by each bank's board of directors Missouri has 2 regional federal reserve banks 2. The Fed's Monetary Policy Tools (Reserve Requirement, Discount Rate, Open-Market Operations) i. Bank Reserves a. In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans b. The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. Banks can hold the reserves as vault cash or deposits at Fed. c. Banks may hold more than this minimum amount if they choose d. The reserve ratio, R i. =fraction of deposits that banks hold as reserves ii. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed. a. To increase money supply, fed buys govt bonds, paying with new dollars. i. These are deposited in banks, increasing reserves ii. Which banks use to make loans, causing the money supply to expand b. To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse. ○ OMOs are easy to conduct, and are the Fed's monetary policy tool of choice iii. Reserve Requirements (RR)- affect how much money banks can create by making loans a. To increase money supply, Fed reduces RR. i. Banks make more loans from each dollar of reserves, which decreases the reserve ratio and increases the money multiplier and the money supply b. To reduce money supply, Fed raises RR. i. Banks make fewer loans and the process works in reverse. The reserve ratio increases and the money multiplier and the money supply decreases ○ Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking. iv. The Discount Rate- the interest rate on loans the Fed makes to banks ○ When banks are running low on reserves they may borrow reserves from the Fed. a. To increase money supply, Fed can lower discount rate i. Which encourages banks to borrow more reserves from Fed. b. To decrease money supply, Fed can raise discount rate ○ In times of crisis, Discount rate is used more often 3. Solving Monetary Problems dealing with the Federal Reserve and OMO. i. Look at the Monetary Problems worksheet. He wrote down the steps to each problem so it is easy to follow. 7. Chapter 18- Open Economy (6-8 questions) 1. Def. and Concepts. i. Intro a. Trade can make everyone better off b. This chapter introduces basic concepts of international macroeconomics i. The trade balance (trade deficits, surpluses) ii. International flows of assets iii. Exchange rates ii. Closed vs. Open Economies a. A closed economy does not interact with other economies in the world b. An open economy interacts freely with other economies around the world iii. The flow of goods and services a. Exports: i. Domestically-produced g&s sold abroad b. Imports: i. Foreign-produced g&s sold domestically c. Net Exports (NX), aka the trade balance i. =value of exports - value of imports 2. What are NX, trade deficits and surpluses, NCO (capital outflow vs. capital inflow)? EC 111 Page 7 2. What are NX, trade deficits and surpluses, NCO (capital outflow vs. capital inflow)? i. Trade surpluses and Deficits ○ NX measures the imbalance in a country's trade in goods and services Trade deficit: □ An excess of imports over exports, NX<0 and Y<C+I+G Trade Surplus: □ An excess of exports over imports, NX>0 and Y>C+I+G Balanced trade: □ When exports= imports, NX=0 and Y= C+I+G ii. The Flow of Capital a. Net capital Outflow (NCO): i. Domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets b. NCO is also called net foreign investment ○ NCO measures the imbalance in a country's trade in assets When NCO>0, "capital outflow" □ Domestic purchases of foreign assets exceed foreign purchases of domestic assets When NCO<0, "capital inflow" □ Foreign purchases of domestic assets exceed domestic purchases of foreign assets 3. Foreign direct investment vs. foreign portfolio investment (examples of each). i. Foreign direct investment: 1) Domestic residents or firms set up a foreign subsidiary and actively manage the foreign investment, such as, McDonalds opens a fast-food outlet in Moscow, Disney builds a theme park in Hong Kong ii. Foreign Portfolio investment: 1) Domestic residents purchase foreign stocks or bonds, supplying "loanable funds" to a foreign firm, such as, an American buys stock in Toyota 4. Factors that affect NX and NCO. i. Variables that influence Net Exports (NX) a. Consumer preferences for foreign and domestic goods b. Prices of goods at home and abroad c. Incomes of consumers at home and abroad d. The exchange rates at which foreign currency trades for domestic currency e. Transportation costs f. Government policies ii. Variables that influence NCO i. Real interest rates paid on foreign assets ii. Real interest rates paid on domestic assets iii. Perceived risks of holding foreign assets iv. Govt policies affecting foreign ownership of domestic assets 5. National income and national savings identities for an open economy. i. Accounting Identity i. Y=C+I+G+NX ii. Rearranging terms i. Y-C-G=I+NX iii. Since S=Y-C-G i. S=I+NX iv. Since NX=NCO S=National Savings i. S=I+NCO I= Domestic Investment 1) Thus, in an open economy, S=I+NCO 2) Then S-I=NCO and NX 3) When S>I, Then NCO>0 and the excess loanable funds flow abroad in the form of positive net capital outflow. (Trade Surplus) 4) When S<I, then NCO<0 and foreigners are financing some of the country's investment in the form of negative capital outflow. (Trade Deficit) Flowing into the country (PAGE 380!) 6. Exchange rate appreciation vs. depreciation. i. Appreciation and Depreciation a. Appreciate- "Strengthening" i. An increase in the value of a currency as measure by the amount of foreign currency it can buy (it takes more foreign currency to buy one US dollar) ii. A "strong" dollar causes US goods to become more expensive compared to foreign produced goods, so US exports will fall and imports will rise b. Depreciation "Weakening" i. A decrease in the value of a currency as measured by the amount of foreign currency it can buy (it takes less foreign currency to buy one US dollar) ii. A "weak" dollar causes US goods to become less expensive compared to foreign produced goods, so US exports rise and imports fall. 8. Chapter 20- Aggregate Demand and Aggregate Supply EC 111 Page 8 8. Chapter 20- Aggregate Demand and Aggregate Supply 1. Def. and Concepts i. Introduction ○ Over the long run, real GDP grows about 3% per year on average a. In the short run, GDP fluctuates around its trend. i. Recessions: periods of falling real incomes and rising unemployment ii. Depressions: severe recessions (very rare) b. Short-run economic fluctuations are often called business cycles c. Boom- opposite of recession: economic expansions (1990s) d. Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. e. Most economists use the model of Aggregate demand and Aggregate supply to study fluctuations f. This model differs from the classical economic theories economists use to explain the long run ii. The Model of Aggregate Demand and Aggregate Supply ○ Aggregate Demand and Supply look just like the regular supply and demand graph ○ Where they meet is the equilibrium price level (CPI) and output, measured in real GDP!! 2. What is Aggregate Demand (AD)? Why does it slope downward? (Wealth Effect, Interest Rate Effect, Exchange Rate Effect) What would cause the AD curve to shift to the right or left? KNOW TABLE 1 PAGE 431 i. AD curve i. Shows the quantity of ALL goods and services demanded in the economy at any given price level (Economy Wide Demand) ii. Slopes downward because: □ AD is all the goods and services in the economy so AD= C+I+G+NX □ Assume G fixed by govt policy □ To understand the slope of AD, must determine how a change in P affects C, I, NX. 1) The Wealth Effect (P and C) a) Suppose P rises i) The dollars people hold buy fewer goods and services, so real wealth is lower ii) People feel poorer iii) Result: C falls 2) The Interest-Rate Effect (P and I) a) Suppose P rises i) Buying goods and services requires more dollars ii) To get these dollars, people sell bonds or other assets iii) This drives up interest rates iv) Result: I Falls (Recall, I depends negatively on interest rates) 3) The Exchange-Rate Effect (P and NX) a) Suppose P rises i) U.S. interest rates rise (The interest-rate effect) ii) Foreign investors desire more U.S. bonds. iii) Higher demand for $ in foreign exchange market iv) U.S. exchange rate appreciates v) U.S. exports more expensive to people abroad, imports cheaper to U.S. residents vi) Result: NX falls iii. Why the AD curve would Shift 1) Any event that changes C,I,G, or NX a) Except a change in P- will shift the AD curve i) Ex: stock market boom in 1990s, made households feel wealthier, C rises, AD shifts to the right ii) Changes in C Stock market boom/crash Preferences: consumption/saving tradeoff Tax hikes/ cuts iii) Changes in I Firms buy new computers, equipment, factories Expectations, optimism/pessimism Interest rates, monetary policy Investment Tax Credit or other tax incentives iv) Changes in G Federal spending, i.e. defense State & local spending, i.e. roads, schools v) Changes in NX Booms/recessions in countries that buy our exports Appreciation/ depreciation resulting from international EC 111 Page 9 Appreciation/ depreciation resulting from international speculation in foreign exchange market iv. In Summary: From the book 3. What is Aggregate Supply (AS)? What is the difference between Short Run Aggregate Supply (SRAS) and Long Run Aggregate Supply (LRAS)? i. Aggregate Supply Curve i. Shows the total quantity of goods and services firms produce and sell at any given price level ii. Difference between SRAS and LRAS i. Upward-Sloping in the short run ii. Vertical in the long run 4. Why is LRAS perfectly vertical? i. Why is LRAS vertical i. Determined by the economy's stocks of labor, capital, and natural resources, and on the level of technology ii. Factors of production (Real Variables) control the long run economy, not the price level!! (Nominal variable) 5. What would cause the LRAS curve to shift to the right or left? i. Why the LRAS curve would shift a) Caused by anything that changes the factors of production (Land, Labor, Capital, Technology) i.e. immigration increases Labor, causing LRAS to shift right i) Changes in L(Labor) or natural rate of unemployment Immigration Baby-boomers retire Government policies reduce natural unemployment rate ii) Changes in K(Capital) or H(Human education) Investment in factories, equipment More people get college degrees Factories destroyed by a hurricane iii) Changes in natural resources Discovery of new mineral deposits Reduction in supply of imported oil Changing weather patterns that affect agricultural production iv) Changes in Technology Productivity improvements 6. Natural Rate of Output i. Long-Run Aggregate-Supply Curve (LRAS) 1) The natural rate of output is the amount of output the economy produces when unemployment is at its natural rate 2) Also called Potential Output or Full-employment output 7. Why does SRAS slope upward? (Sticky Wage Theory, Sticky Price Theory, Misperceptions Thoery) EC 111 Page 10 7. Why does SRAS slope upward? (Sticky Wage Theory, Sticky Price Theory, Misperceptions Thoery) What would cause the SRAS curve to shift to right or left? KNOW TABLE 2 PAGE 440 i. Short-Run Aggregate Supply (SRAS) □ Upward sloping □ Over the period of 1-2 years (Short run), and increase in P causes an increase in the quantity of goods and services supplied 1) Why Upward sloping Since LRAS is vertical, fluctuations in AD do not cause fluctuations in output or employment Since SRAS slopes up, then shifts in AD do affect output and employment a) Three Theories of SRAS ◊ In each… ◊ Some type of market imperfection ◊ Result: Output deviates from its natural rate when the actual price level deviates from the price level people expected i) The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly – Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on P ,Ethe price level they expect to prevail – If P>Expected price level, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment Hence, higher P causes higher Y, so the SRAS curve slopes upward ii) The Sticky-Price Theory Imperfection: Many prices are sticky in the short run – Due to: menu costs, the costs of adjusting prices – Ex: cost of printing new menus, the time required to change price tags Firms set sticky prices in advance based on PE – Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. – In the short run, firms without menu costs can raise their prices immediately – Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, which increases demand for their products, so they can increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slops upward iii) The Misperceptions Theory (The least influential) Imperfection: firms may confuse changes in P with changes in the relative price of the products they sell. – If P rises above PEa firm sees its price rise before realizing all prices are rising. – The firm may believe its relative price is rising, and may increase output and employment – So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping b) What do all 3 theories have in common? i) Y deviates from YNwhen P deviates from P E Y= Y + a(P-P ) N E 2) Why the SRAS curve might shift 1) Everything that shifts LRAS shifts SRAS, too. 2) Also, PEshifts SRAS. a) If E rises, workers and firms set higher wages i) At each P, production is less profitable, Y falls, SRAS shifts left ii. In Summary: EC 111 Page 11 8. Long Run Equilibrium i. In the long run equilibrium a. P EP b. Y=Y N c. And unemployment is at its natural rate. 9. The Effects of a Shift in AD or SRAS (Stagflation) i. Economic Fluctutions i. Caused by events that shift the AD and/or AS curves ii. Four Steps to analyzing economic fluctuations: 1) Determine whether the event shifts AD or AS 2) Determine whether curve shifts left or right 3) Use AD-AS diagram to see how the shift changes Y and P in the short run 4) Use AD-AS diagram to see how economy moves from new SR eq'm to new LR eq'm iii. The Effects of a shift in AD 1) Event: Housing Mkt Crash a) Affects C, AD curve b) C falls, so AD shifts left c) SR eq'm shows P and Y lower, unemployment higher d) Over time, P falls, SRAS shifts right, Y and unemployment back at initial E levels iv. The Effects of a shift in SRAS 1) Event: Oil prices rise FINAL EXAM QUESTION: What causes Stagflation? a) Increase costs, Shifts SRAS (Assume LRAS constant) • When SRAS shifts left b) SRAS shifts left c) SR equilibrium now at a point where P is higher, Y is lower, unemployment higher i) This is called stagflation, a period of falling output and rising prices 10. Accommodating a shift in SRAS (Government Fiscal or Monetary Policy) i. Step Four: Accommodating an Adverse Shift in SRAS i) If policymakers do nothing, ii) Low employment causes wages to fall, SRAS shifts right, until long run equilibrium is reached. ◊ OR, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift Fiscal policy: government spends more money, shifts AD to the right Monetary policy: The Fed can increase the money supply, causing interest rates to fall, investment to go up, and AD shift to the right . ◊ This will take you back to the natural rate of output NY ), but P is permanently higher 9. Chapter 22- Phillips Curve (2-3 Questions) 1. Def. and Concepts. i. Introduction a. In the long run, inflation and unemployment are unrelated: i. The inflation rate depends mainly on growth in the money supply ii. Unemployment (The natural rate) depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search. b. One of the ten principles: i. In the short run, society faces a trade-off between inflation and unemployment (Phillip's Curve) EC 111 Page 12 (Phillip's Curve) ii. The Phillip's Curve (Only true in the short run) a. Phillip's Curve- shows the short-run trade-off between inflation and unemployment b. 1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the UK 2. Relationship between AD and AS and the Phillips Curve i. Deriving the Phillip's Curve i. Suppose P=100 this year ii. Two possible outcomes for the next year: 1) Aggregate Demand low, small increase in P (i.e. low inflation), low output, high unemployment. a) Scenario A, price level at 103… means inflation rate 3% (U rate 6%) 2) Aggregate Demand High, big increase in P (i.e. high inflation), high output, low unemployment. a) Scenario B, price level at 105… means inflation rate 5% (U rate 4%) 3. How changes in AD and AS affect the Phillips Curve i. For Example: i. Increase in AD will increase output and Price level: 1) This will require more employees, thus lower unemployment rate, however it will spike up the price level causing higher inflation. 2) Thus, low unemployment= high inflation… or high unemployment=low inflation 10. The FollowingTopics will appear randomly throughout the Exam 1. Calculating Real Exchange Rates and Interpreting Them i. Real Exchange Rate i. The rate at which the G&S of one country trade for the G&S of another ii. Real exchange rate = (e x P)/P* iii. Ex: e=nominal exchange rate, i.e., foreign currency per unit of domestic currency 1) Big mac= $2.50 in US 2) Big mac= 400 yen P= domestic price 3) e=120 yen per $ P*= foreign price (in foreign currency) 4) E x P= price in yen of a US Big mac 1) =120yen per $ X $2.50 per big mac 2) =300 yen per US Big Mac 5) Real Exchange rate 1) = 300 yen/ 400 yen 2) =0.75 Japanese Big Macs per US Big Mac 2. Real vs. Nominal Interest Rates. i. Real vs. Nominal Interest Rate i. Nominal Interest rate: i. Not corrected for inflation ii. The rate of growth in the dollar value of a deposit or debt ii. Real interest rate: i. Corrected for inflation ii. The rate of growth in the purchasing power of a deposit or debt ○ Real interest rate (REAL RATE OF GROWTH) = (Nominal interest rate) - (Inflation rate) 3. Understanding the Quantity Equation and using it to solve for Velocity, Money Supply, Real GDP, or Price. i. Velocity Formula: i. V= (P x Y)/ M ii. The quantity Equation (Represents the entire economy) 1) Multiply both sides by M: a) M x V= P x Y ii. The Quantity Theory in 5 Steps: i. V is stable ii. So, a change in M causes nominal GDP (P x Y) to change by the same percentage iii. A change in M does not affect Y: money is neutral, Y is determined by technology and resources iv. So, P changes by same percentages as P x Y and M v. Rapid money supply growth causes rapid inflation 11. Basic Concepts you will see 1. Opportunity Costs i. The OpportunityCost of any item is whatever must be given up to obtain it. 2. Scarcity i. The limited nature of society's resources (Nothing on this planet is unlimited) 3. Efficiency vs. equality 1) Efficiency: when society gets the most from its scarce resources 2) Equality: when prosperity is distributed uniformly among society's members Tradeoff: to achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic "pie" EC 111 Page 13 But this reduces incentive to work and produce, shrinks the size of the economic "pie" 4. Macroeconomics 1) The study of economy-wide phenomena, including inflation, unemployment, and economic growth. 5. The 3 functions of Money i. Medium of exchange- an item buyers give to sellers when they want to purchase g&s ii. Unit of Account- the yardstick people use to post prices and record debts iii. Store of Value- an item people can use to transfer purchasing power from the present to the future 6. Fisher Effect i. The Fisher Effect ○ Nominal Interest rate= Inflation rate + Real interest rate a. In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate b. So, the nominal interest rate adjusts one-for-one with changes in the inflation rate c. This relationship is called the Fisher effect after Irving Fisher, who studied it d. The Fisher Effect i. An increase in inflation causes and equal increase in the nominal interest rate, so the real interest rate is unchanged. In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rate. 7. Real vs. Nominal Variables a. Nominal variables- measured in monetary units (dollars and cents) i. Ex: nominal GDP ii. Nominal interest rate (rate of return measured in $$$$) iii. Nominal Wage- price of labor b. Real Variables- measured in physical units i. Ex: real GDP ii. Real interest rates (measured in output) iii. Real Wage= price of G&S 12. You will NOT need to Study any of the following topics as they will not be on the final!! 1. Chapter 13. 2. Chapter 19. 3. Elasiticity of supply, income elasticity, and cross price elasticity. 4. Correcting Variables for Inflation. 5. Purchasing Power Parity (PPP) 6. Calculating Nominal and Real after tax interest rates. 7. Costs of Inflation, Classical Dichotomy, Money Neutrality, and the Value of Money and the Price Level. □ GOOD LUCK!! :)) EC 111 Page 14
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'