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ECON 252: Final Exam Notes

by: Zach Weinkauf

ECON 252: Final Exam Notes ECON 252

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Zach Weinkauf

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These notes cover Chapter 1 - Chapter 15 notes. Final Exam.
Andres Vargas
Study Guide
Economics, Macroeconomics
50 ?




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This 21 page Study Guide was uploaded by Zach Weinkauf on Saturday April 30, 2016. The Study Guide belongs to ECON 252 at Purdue University taught by Andres Vargas in Fall 2016. Since its upload, it has received 72 views. For similar materials see Macroeconomics in Economcs at Purdue University.


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Date Created: 04/30/16
Ch. 1: The Principles and Practice of Economics 1.1 – The Scope of Economics  Economic Agent – an individual or group that makes choices.  Scarce Resource – things that people want, where the quantity that people want exceeds the quantity that is available.  Scarcity – situation of having unlimited wants in a world of limited resources.  Economics – the study of how agents choose to allocate scarce resources and how those choices affect society. o Positive Economics – describes what people actually do  Analysis that generates objective descriptions or predictions about the world that can be verified with data. o Normative Economics – recommends what people ought to do  Analysis that prescribes what an individual or society ought to do. o Microeconomics – study of how individuals, households, firms, and governments make choices, and how those choices affect prices, the allocation of resources, and the well-being of other agents. o Macroeconomics – study of the economy as a whole – study economy wide phenomena, like the growth rate of a country’s total economic output, the inflation rate, or the unemployment rate. 1.2 – Three Principles of Economics 1. Optimization – trying to choose the best feasible option, given the available information. 2. Equilibrium – special situation in which everyone is simultaneously optimizing, so nobody would benefit personally by changing his or her own behavior. 3. Empiricism – analysis that uses data. 1.3 – The First Principle of Economics: Optimization  Trade-offs – when an economic agent needs to give up one thing to get something else.  Budget Constraint – shows the bundles of goods or services that a consumer can choose given limited budget.  Opportunity Cost – best alternative use of a resource. o Must assign a monetary value.  Cost-benefit Analysis – calculation that adds up costs and benefits using a common unit of measurement, like dollars. 1.4 – The Second Principle of Economics: Equilibrium  In equilibrium, everyone is simultaneously optimizing, so nobody would benefit by changing his/her behavior.  The Free-Rider Problem – exists when an individual or group is able to enjoy the benefits of something without incurring the costs 1.5 – The Third Principle of Economics: Empiricism  Economists want to know if their theories are able to explain what happens in real world. Chapter 2: Economic Methods and Economic Questions 2.1 – The Scientific Method  Scientific Method – name of the ongoing process that economists, other social scientists, and natural scientists use to: o Develop models of the world o Test those models with data  Model – simplified description, or representation, of the world. Sometimes, economists will refer to a model as a theory. o Is an approximation  Data – facts, measurements, or statistics that describe the world. o Empirical Evidence – set of facts established by observation and measurement.  Hypothesis – predictions that can be tested with data.  Mean – sum of all the different values divided by the number of values. 2.2 – Causation and Correlation  Causation – occurs when one thing directly affects another through a cause- and-effect relationship.  Correlation – means that there is a mutual relationship between two things. o Variable – factor that is likely to change or vary. o Positive – implies that two variables tend to move in the same direction. o Negative – implies that two variables tend to move in the opposite direction. o Zero – when variables have movements that are not related.  Reasons why correlation may not imply causality: o Omitted variables – something that has been left out of a study that, if included, would explain why the two variables in the study or correlated. o Reverse Causality – occurs when we mix up the direction of cause and effect.  Experiment – controlled method of investigating causal relationships among variables.  Randomization – assignment of subjects by chance, rather than by choice, to a treatment group or control group.  Natural Experiment – empirical study in which some process – out of control of the experimenter – has assigned subjects to control and treatment groups in a random or nearly random way. 2.3 – Economic Questions and Answers  Good Questions all have two properties: o Address topics that are important to individual agents and/or our society. o Can be answered. Chapter 3: Optimization: Doing the Best You Can 3.1 – Two Kinds of Optimization: A Matter of Focus  Economists believe that optimization describes most of the choices in life.  Optimization in Levels – calculates the total net benefit (total benefit – total cost) of different alternatives and then chooses the best alternative.  Optimization in Differences – calculates the change in net benefits when a person switches from one alternative to another and then uses these marginal comparisons to choose the best alternative.  Behavioral Economics – analyzes the economic and psychological factors that explain human behavior. 3.2 – Optimization in Levels  Optimum – the best feasible choice.  Three steps of optimization in levels: 1. Translate all costs and benefits into common units (ex. Dollars per month). 2. Calculate the total net benefit of each alternative. 3. Pick the alternative with the highest net benefit.  Comparative Statics – comparison of economic outcomes before and after some economic variable is changed. 3.3 – Optimization in Differences: Marginal Analysis  Marginal Analysis – cost-benefit calculation that studies the differences between a feasible alternative and the next feasible alternative. o Will never change the answer to “what is optimal?” but it will change the way you think about optimizing.  Marginal Cost – extra cost generated by moving from one feasible alternative to the next feasible alternative. o Option 2 Cost – Option 1 Cost = Marginal Cost  Principle of Optimization at the Margin – an optimal feasible alternative has the property that moving to it makes you better off and moving away from it makes you worse off.  Three steps of optimization in levels: 1. Translate all costs and benefits into common units. 2. Calculate the marginal consequences between moving between alternatives. 3. Apply the Principle of Optimization at the Margin by choosing the best alternative with the property that moving to it makes you better and moving away makes you worse. Chapter 4: Demand, Supply, and Equilibrium 4.1 – Markets  Market – group of economic agents who are trading a good or service, and the rules and arrangements for trading.  Market Price – price at which sellers and buyers conduct transactions.  Qualities of a Perfectly Competitive Market: 1. Sellers all sell an identical good or service. 2. Any individual buyer or an individual seller isn’t powerful enough on his or her own to affect the market price of that good or service.  Price-taker – buyer or seller who accepts the market price. 4.2 – How do Buyers Behave?  Quantity Demanded – amount of a good that buyers are willing to purchase at a given price.  Demand Schedule – table that reports the quantity demanded at different prices, holding all else equal. o Holding all else equal implies that everything else in the economy is held constant.  Demand Curve – plots the quantity demanded at different prices.  Law of Demand: o QD (quantity demanded) rises  Price falls o QD falls  Price rises  Willingness to Pay – the highest price that a buyer is willing to pay for an extra unit of a good.  Diminishing Marginal Benefit – as you consume more of a good, your willingness to pay for an additional unit declines.  Aggregation– process of adding up individual behaviors.  Market Demand Curve – sum of all individual demand curves of all potential buyers.  Causes that change Demand 1. Changes in tastes and preferences a. Demand Curve Shifts – when QD changes at a given price. b. Movement along demand curve – if good’s price changes and demand curve hasn’t shifted. 2. Changing Income or Changing Wealth a. Normal Good i. Income rises  QD rises ii. Income falls  QD falls b. Inferior Good i. Income rises  QD falls ii. Income falls  QD rises 3. Changing Availability and Prices of Related Goods a. Substitutes i. Price Pepsi falls  QD of Coke falls b. Complements i. Price of Gas falls  QD of Cars rises 4. Changing in the Number and Scale of Buyers – Population 5. Changing Buyers’ Beliefs about the Future a. Price of gas in future falls  QD of gas now falls 4.3 – How do Sellers Behave?  Quantity Supplied – amount of a good or service that sellers are willing to sell at a given price.S  Supply Schedule – table that reports the quantity supplied at different prices, holding all else equal.  Supply Curve – plots the quantity supplied at different prices.  Law of Supply: o Price rises  QS (quantity supplied) rises o Price falls  QS falls  Willingness to Accept – the lowest price that a seller is willing to get paid to sell an extra unit of a good.  Market Supply Curve – sum of the individual supply curves of all the potential sellers.  Causes of Supply Curve shifts: 1. Changing the price of inputs used to Produce the Good a. Input – good or service used to produce another good or sevice. b. Supply Curve Shifts – supply increases  shift right c. Movement along the supply curve – good’s own price changes but SC doesn’t shift. 2. Changes in the technology used to Produce the Good 3. Changes in the Number and Scale of Sellers 4. Changes in Sellers’ Beliefs about the Future 4.4 – Supply and Demand in Equilibrium  Competitive Markets converge to the price at which QS is equal to QD.  Competitive Equilibrium – the crossing point of the supply curve and the demand curve.  Competitive Equilibrium Price – equates QS and QD.  Competitive Equilibrium Quantity – quantity that corresponds to the competitive equilibrium price.  Excess Supply – market price is above equilibrium price, QS exceeds QD.  Excess Demand – market price is below competitive equilibrium price, QD exceeds QS. Chapter 5: The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates 5.1 – Macroeconomic Questions  Income per Capita – income per person. o Number of People in Country / Nation’s Aggregate Income  Recessions – periods (lasting at least two quarters) in which aggregate economic output falls  Unemployed o Does not have a job o Has actively looked for work in prior four weeks o Currently available for work  Unemployment Rate – fraction of the labor force that is unemployed  National income accounts – measure the level of aggregate economic activity in a country  National Income and Product Accounts (NIPA) – system of national income accounts that is used by the U.S. government 5.2 – National Income Accounts: Production = Expenditure = Income  Gross Domestic Product (GDP) – the market value of the final goods and services produced within the borders of a country within a particular period of time  Identity – when two variables are defined in a way that makes them mathematically identical  Factors of Production – inputs of the production process  Circular Flows o Production o Expenditure o Income o Factors of Production  Value Added – firm’s sales revenue - firm’s purchases of intermediate products from other firms  Consumption – market value of consumption goods and consumption services that are brought by domestic households  Investment – market value of new physical capital that is brought by domestic households and domestic firms  Government Expenditure – market value of government purchases of goods and services  Exports – market value of all domestic produced goods and services that are purchased by households, firms, and governments in foreign countries  Imports – market value of all foreign-produced goods and services that are sold to domestic households, domestic firms, and the domestic government  National Income Accounting Identity – Y = C + I + G + X – M, decomposes GDP into consumption + investment + government expenditure + exports – imports  Labor Income – any form of payment that compensates people for their work  Capital Income – any form of payment that derives from owning physical or financial capital 5.3 – What isn’t measured by GDP?  Physical Capital Depreciation  Home Production  The Underground Economy  Negative Externalities  Gross Domestic Product vs. Gross National Product o GNP – market value of production generates by the factors of production – both capital and labor – possessed or owned by the residents of a particular nation  Leisure 5.4 – Real vs. Nominal  Nominal GDP – total value of production (final goods and services), using current market prices to determine the value of each unit that is produced  Real GDP – total value of production (final goods and services), using market process from a specific base year to determine the value of each unit that is produced o Real GDP Growth of 2013 = (Real GDP in 2013 – Real GDP in 2012)/Real GDP in 2012  GDP Deflator = Nominal GDP/Real GDP x 100  Consumer Price Index – 100 times the ratio of the cost of buying a basket of consumer goods using 2013 prices divided by the cost of buying the same basket of consumer goods using the base-year prices  Inflation Rate = (Price Index in 2013 – Price Index in 2012)/ Price Index in 2012 Chapter 6: Aggregate Incomes 6.1 – Inequality around the World  Income per capita = GDP per capita = GDP/Total Population  Purchasing Power Parity (PPP) – constructs the cost of a representative bundle of commodities in each country and uses these relative costs for comparing income across countries  Income per worker = GDP/Number of people in employment  Productivity – value of goods and services that a worker generates for each hour of work  One dollar a day per person poverty line – measure of absolute poverty used by economists and other social scientists to compare the extent of poverty across countries 6.2 – Productivity and the Aggregate Production Function  Three main reasons why productivity differs across countries o Human Capital – each person’s stock of skills to produce output or economic value o Physical Capital – any good, including machines and buildings, used for production  Physical capital stock – an economy is the value of equipment, structures and other non-labor inputs used in production o Technology – uses its labor and capital more efficiently and achieves higher productivity  Aggregate production function – describes the relationship between the aggregate GDP of a nation and its factors of production o Y = A x F(K,H)  Total efficiency units of labor – product of the total number of workers in the economy and the average human capital of each worker  Law of Diminishing Marginal Product – the marginal contribution of a factor of production to GDP diminishes when we increase the quantity used of that factor of production (holding all others constant) 6.3 – The Role and Determinants of Technology  Research and Development – activities directed at improving scientific knowledge, generating new innovations, or implementing existing knowledge in production in order to improve the technology of a firm or an economy  Efficiency of Production – the ability of an economy to produce the maximal amount of output from a given amount of factors of production and knowledge Chapter 7: Economic Growth 7.1 – The Power of Economic Growth  Economic Growth – the increase in GDP per capita of an economy  Growth Rate – change in a quantity between two dates, relative to the baseline  Exponential Growth – situation in which the growth process can be described by an approximately constant growth rate of a variable  Catch Up Growth – growth process whereby relatively poorer nations increase their incomes by taking advantage of knowledge and technologies already invented in another  Sustained Growth – growth process where GDP per capita grows at a positive and relatively steady rate for long periods of time 7.2 – How does a Nation’s Economy Grow?  Saving Rate – designates the fraction of income that is saved  Technology change – process of new technologies and new goods and services being invented, introduced, and used in the economy, enabling the economy to achieve a higher level of GDP for given levels of physical capital stock and total efficiency units of labor 7.3 – The History of Growth and Technology  Subsistence Level – minimum level of income per person that is generally necessary for the individual to obtain enough calories, shelter and clothing to survive  Fertility – number of children per adult or per woman of childbearing age  Malthusian Cycle – preindustrial pattern in which increase in aggregate income lead to an expanding population, which in turn reduces income per capita and puts downward pressure on population  Demographic Transition – decline in fertility and number of children per family that many societies undergo as they transition from agriculture to industry  Industrial Revolution – term used for describing the series of innovations and their implementation in the production process that started to take place at the end of the eighteenth century in Britain 7.4 – Growth, Inequality, and Poverty Appendix: The Solow Growth Model  Steady-state Equilibrium – economic equilibrium in which the physical capital stock remains constant over time  Dynamic Equilibrium – traces out the behavior of the economy over time Chapter 8: Why isn’t the Whole World Developed? 8.1 – Proximate versus Fundamental Causes of Prosperity  Proximate causes of Prosperity – high levels of factors such as human capital, physical capital and technology that result in a high level of GDP per capita  Fundamental Causes of Prosperity – factors that are at the root of the differences in the proximate causes of prosperity  Geography Hypothesis – claims that the difference in geography; climate and ecology are ultimately responsible for the major differences in prosperity observed across the world  Culture Hypothesis – claims that the different values and cultural beliefs fundamentally cause the differences in prosperity around the world  Institutions – formal and informal rules governing the organization of a society including its laws and regulations  Institution Hypothesis – claims that the differences in institutions – that is, in the way societies have organize themselves and shaped the incentives of individuals and businesses – are at the root of the differences in prosperity across the world 8.2 – Institutions and Economic Development  Private property rights – individuals can own businesses and assets and their ownership is secure  Economic Institutions – aspects of the society’s rules that concern economic transactions  Inclusive Economic Institutions – protect private property, uphold law and order, allow and enforce private contracts, and allow free entry into new lines of business and occupations  Extractive Economic Institutions – do not protect private property rights, do not uphold contracts, and interfere with the workings of markets.  Political Institutions – aspects of the society’s rules that concern the allocation of political power and the constraints on the exercise of political power  Creative Destruction – process in which new technologies replace old ones, new businesses replace existing businesses, and new skills make old ones redundant  Political Creative Destruction – process in which economic growth destabilizes existing regimes and reduces the political power of rulers 8.3 – Is foreign Aid the Solution to Poverty? Chapter 9: Employment and Unemployment 9.1 – Measuring Employment and Unemployment  Potential Workers – includes everyone in the general population with three exceptions: o Children under 16 years of age o People on active duty in the military o Institutionalized people, like those in jail or nursing homes  Employed – a person holding a full-time or part-time paid job.  Unemployed – when a worker does not have a job, has actively looked for work in the prior four weeks and is currently available for work.  Labor Force – sum of all employed and unemployed workers.  Unemployment Rate – percentage of labor force that is unemployed. o Unemployment Rate = 100% x (Unemployed/Labor Force)  Labor Force Participation Rate – percentage of potential workers that are in the labor force. o Labor Force Participation Rate = 100% x (Labor Force/Potential Workers) 9.2 – Equilibrium in the Labor Market  Labor Demand Curve – depicts the relationship between the quantity of labor demanded and the wage. o Shifts by:  Changing Output Prices  Changing Demand for the Output Good or Service  Changing Technology  Changing Input Prices  Labor Supply Curve – the relationship between the quantity of labor supplied and the wage. o Shifts by:  Changing Tastes  Changing Opportunity Cost of Time  Changes in Population  Market-Clearing Wage – competitive equilibrium wage; every worker that wants a job can find one: the quantity of labor demanded matches the quantity of labor supplied. 9.3 – Why is there unemployment? 9.4 – Job Search and Frictional Unemployment  Job Search – the activities that workers undertake to find appropriate jobs.  Frictional Unemployment – unemployment that arrives because workers have imperfect information about available jobs and need to engage in a time- consuming process of job search. 9.5 – Wage Rigidity and Structural Unemployment  Wage Rigidity – the condition in which the market wage is held above the competitive equilibrium level that would clear the labor market.  Structural Unemployment – arises when the quantity of labor supplied persistently exceeds the quantity of labor supplied.  Collective Bargaining – contract negotiations between firms and labor unions.  Efficiency Wages – above the wage that workers would accept, where the extra pay increases worker productivity and improves the profitability of the firm.  Downward Wage Rigidity – arises when workers resist a cut in their wage.  Natural Rate of Unemployment – the rate around which the actual rate of unemployment fluctuates.  Cyclical Unemployment – the deviation of the actual unemployment rate from the natural unemployment rate. Chapter 10: Credit Markets 10.1 – What is the credit market?  Debtors – borrowers – economic agents who borrow funds.  Credit – loans that the debtor receives.  Interest Rate – Nominal Interest Rate – i – is the annual cost of a one-dollar loan, so i X L is the annual cost of an $L loan.  Real Interest Rate = Nominal Interest Rate – Inflation Rate  Credit Demand Curve – schedule that reports the relationship between the quantity of credit demanded and the real interest rate. o Factors that shift curve:  Changes in perceived business opportunities for firms.  Changes in household preferences or expectations.  Changes in government policy.  Credit Supply Curve – schedule that reports the relationship between the quantity of credit supplied and the real interest rate. o Factors that shift curve:  Changes in saving motives of households.  Changes in the saving motives of firms.  Credit Market – where borrowers obtain funds from savers. 10.2 – Banks and Financial Intermediation: Putting Supply and Demand Together  Financial Intermediation – channel funds from suppliers of financial capital to users of financial capital.  Securities – financial contracts.  Bank Reserves – consist of vault cash and deposits at the Federal Reserve Bank.  Demand Deposits – funds that depositors can access on demand by withdrawing money from the bank, writing checks, or using their debit cards.  Stockholders’ Equity = Total Assets – Total Liabilities 10.3 – What Banks Do 1. Banks identify profitable lending opportunities. 2. Banks transform short-term liabilities, like deposits, into long-term investments in a process called maturity transformation. 3. Banks manage risk by using diversification strategies and also by transferring risk from depositors to the bank’s stockholders, and in some cases, to the U.S. government.  Maturity Transformation – process by which banks take short-maturity liabilities and invest in long-term assets.  Insolvent – when the value of the bank’s assets is less than the value of its liabilities.  Solvent – when the value of the bank’s assets is greater than the value of its liabilities.  Bank Run – occurs when a bank experiences an extraordinary large volume of withdrawals driven by a concern that the bank will run out of liquid assets which to pay withdrawals. Chapter 11: The Monetary System 11.1 – Money  Money – the asset that people use to make and receive payments when buying and selling goods and service. o Functions:  Medium of Exchange – asset that can be traded for goods and services.  Store of Value – asset that enables people to transfer purchasing power in the future.  Unit of Account – universal yardstick that is used for expressing the worth of different goods and services.  Fiat Money – something that is used as legal tender by government decree and is not backed by a physical commodity (gold, silver, etc.).  Money Supply – adds together currency in circulation, checking accounts, savings accounts, travelers’ checks, and money market accounts. 11.2 – Money, Prices, and GDP  Quantity Theory of Money – Money Supply / Nominal GDP = Constant 11.3 – Inflation  Deflation – rate of decrease of a price index.  Effects of Inflation at Social Level: o A high inflation rate creates logistical costs. o A high inflation rate distorts relative prices. o Inflation sometimes leads to counterproductive policies like price controls.  Benefits of Inflation: o Government revenue is generated when the government prints currency.  Seignorage – government revenue obtained from printing currency. o Inflation can sometimes stimulate economic activity.  Real Wage = Nominal Wage / Price Index 11.4 – The Federal Reserve  Central Bank – government institution that monitors financial institutions, controls key interest rates, and indirectly controls the money supply. These activities constitute monetary policy.  Federal Reserve Bank – name of the central bank in the United States. o Things they do:  Influence short-term interest rates.  Influence the money supply and the inflation rate.  Influence long-term real interest rates.  Liquidity – funds available for immediate payment.  Federal Funds Market – market where banks obtain overnight loans of reserves from one another.  Federal Funds Rate – interest rate that banks charge each other for overnight loans in the federal funds market.  Causes for shift in Demand Curve of FFM: o Economic expansion or contraction. o Changing liquidity markets. o Changing deposit base. o Changing reserve requirement. o Changing interest rate paid by the Fed. For having reserves on deposit at the Fed.  Federal Funds Market Equilibrium – point where supply and demand meet. Real Interest Rate = Nominal Interest Rate – Inflation Rate Realized Real Interest Rate = Nominal Interest Rate – Realized Inflation Rate Expected Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate  Inflation Expectations – beliefs about future inflation rates. Effect of Nominal interest rates 4% for 10 years: 4%x10/10 = 4% Inflation Rate = 4-2 = 2% 37. C 38. A 39. 6 = n – 8 N=14% 40. 6= n – 4 N=10% 1. B 7. D 8. VMP >=Wage. . . C Chapter 12: Short-Run Fluctuations 12.1 – Economic Fluctuations and Business Cycles  Economics Fluctuations/Business Cycle – short-run changes in the growth of GDP. o Co Movement of many aggregate macroeconomic variables o Limited Predictability of Fluctuations. o Persistence in the Rate of Economic Growth.  Economic Expansions – periods between recessions.  Great Depression – started 1929.  Depression – prolonged recession with an unemployment rate of 20 percent or more. 12.2 – Macroeconomic Equilibrium and Economic Fluctuations  Sources of fluctuation: o Real Business Cycle Theory – emphasizes changing productivity and technology. o Keynesian Theory – changing expectations about the future. o Financial and Monetary Theories – emphasize change in prices and interest rates.  Animal Spirits – psychological factors that lead to changes in the mood of consumers or businesses.  Self-Fulfilling Prophecy – situation when expectations of an event induce actions that lead to that event. Chapter 13: Countercyclical Macroeconomic Policy 13.1 – The Role of Countercyclical Policies in Economic Fluctuations  Countercyclical Policies – attempt to reduce the intensity of economic fluctuations and smooth the growth rates of employment, GDP, and prices.  Countercyclical Monetary Policy – conducted by the central bank, attempts to reduce economic fluctuations by manipulating bank reserves and interest rates.  Countercyclical Fiscal Policy – passed by the legislative branch and signed into law by the executive branch, aims to reduce economic fluctuations by manipulating government expenditures and taxes. 13.2 – Countercyclical Monetary Policy  Expansionary Monetary Policy – increases the quantity of bank reserves and lowers interest rates.  Tools of the Fed: o Changing the reserve requirement o Changing the interest rate paid on reserves deposited at the Fed. o Lending from the discount window o Quantitative easing  Long-Term Expected Real Interest Rate = Long-Term Nominal Interest Rate – Long-Term Expected Inflation Rate  Contractionary Monetary Policy – slows down growth in bank reserves, raises interest rates, reduces borrowing, slows down growth in the money supply, and reduces the rate of inflation.  Federal Funds Rate = Long-run federal funds rate target + 1.5(Inflation rate – inflation rate target) + 0.5(Output gap in percentage points)  Output gap = (GDP – Trend GDP)/Trend GDP 13.3 – Countercyclical Fiscal Policy  Expansionary Fiscal Policy – uses higher government expenditure and lower taxes to increase the growth rate of real GDP.  Contractionary Fiscal Policy – uses lower government expenditure and higher taxes to reduce the growth rate of real GDP.  Automatic Stabilizers – components of the government budget that automatically adjust to smooth out economic fluctuations.  Crowding Out – rising government expenditure partially or even fully displaces expenditures by households and firms. Chapter 14: Macroeconomics and International Trade 14.1 – Why and How We Trade  Gains from Specialization – economic gains that society can obtain by having some individuals, regions, or countries specialize in the production of certain goods and services.  Absolute Advantage – producer can produce more units per hour than other producers.  Comparative Advantage – the producer has a lower opportunity cost per unit produced compared to other producers.  Closed Economy – does not trade with the rest of the world.  Open Economy – trades freely with the rest of the world. 14.2 – The Current Account and the Financial Account  Net Exports/Trade Balance – value of the country’s exports minus the value of its imports.  Trade Surplus – excess of exports over imports and is thus the name given to the trade balance when it is positive.  Trade Deficit – excess of imports over exports and is thus the name given to the trade balance when it is negative.  Current Account – sum of net exports, net factor payments from abroad, and net transfers from abroad.  Financial Account – increase in domestic assets held by foreigners minus the increase in foreign assets held domestically. 14.3 – International Trade, Technology Transfer, and Economic Growth  Foreign Direct Investment – investments by foreign individuals and companies in domestic firms and businesses. Chapter 15: Open Economy Macroeconomics 15.1 – Exchange Rates  Nominal Exchange Rate – the rate at which one currency can be traded for another.  e = Units of foreign currency / 1 unit of domestic currency.  Flexible/Floating Exchange Rate – if the government does not intervene in the foreign exchange market.  Fixed Exchange Rate – if the government fixes a value for the exchange rate and intervenes to maintain that value.  Managed Exchange Rate – if the government intervenes actively to influence the exchange rate. 15.2 – The Foreign Exchange Market  Foreign Exchange Market – the global financial market in which currencies are traded and nominal exchange rates are determined. 15.3 – The Real Exchange Rate and Exports  Real Exchange Rate – the ratio of dollar price of a basket of goods and services in the United States, divided by the dollar price of the same basket of goods and services in a foreign country. 15.4 – GDP in the Open Economy  Y = C + I + G + X – M  E = ((Domestic Prices) x e)/Foreign Prices


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