ECN202 Final Exam Study Guide
ECN202 Final Exam Study Guide ECN 202
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This 40 page Study Guide was uploaded by Kelly Domogala on Monday May 2, 2016. The Study Guide belongs to ECN 202 at University of Rhode Island taught by Liam Malloy in Spring 2016. Since its upload, it has received 157 views. For similar materials see Macroeconomics in Economcs at University of Rhode Island.
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Macroeconomics Study Guide for the Final Chapter 1: Welcome to Economics 1.1: What Economics is and Why It’s Important • Economics is the study of how humans make decisions in the face of scarcity. The Problem of Scarcity: • Scarcity means that human wants for goods, services and resources exceed what is available. The Division of and Specialization of Labor: • Division of labor means that the way a good or service is produced is divided into a number of tasks that are performed by different workers, instead of all the tasks being done by the same person. • Specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. o Workers who specialize in certain tasks often lea rn to produce more quickly and with higher quality. • Economies of scale means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. Trade and Markets: • Specialization requires trade. • Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. 1.2: Microeconomics and Macroeconomics • Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses • Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics: • The theory of consumer behavior and the theory of the firm. Macroeconomics: • An economy's macroeconomic health can be defined by a number of goals: growth in the standard of living, low unemployment, and low inflation • Monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets, is conducted by a nation’s central bank. For the United States, this is the Federal Reserve. • Fiscal policy, which involves government spending and taxes, is determined by a nation’s legislative body. For the United States, this is the Congress and the executive branch, which originates the federal budget. 1.3: How Economists Use Theories and Models to Understand Economic Issues • A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real -world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around i t. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied. • A good model to start with in economics is the circular flow diagram. It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. • The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits. • In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand. 1.4: How Economics Can Be Organized: An Overview of Economic Systems • Traditional economy: the oldest economic system. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). o Because things are driven by tradition, there is little economic progress or development. • Command economy: economic effort is devoted to goals passed down from a ruler or ruling class. o In a command economy, the government decides what goods and services will be produced and what prices will be charged for them. The government decides what methods of production will be used and how much workers will be paid. Many necessities like healthcare and education are provided for free. • A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. o Market economy: decision- making is decentralized. o Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals. Businesses supply goods and services based on demand. Regulations: The Rules of the Game: • There is no such thing as an absolutely free market. • Heavily regulated economie s often have underground economies, which are markets where the buyers and sellers make transactions without the government’s approval. The Rise of Globalization: • Globalization is the expanding cultural, political, and economic connections between people around the world. • Exports are the goods and services that are produced domestically and sold abroad. • Imports are the goods and services that are produced abroad and then sold domestically. • The size of total production in an economy is measured by the gross domestic product (GDP) . Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries. • In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Chapter 2: Choice in a World of Scarcity Introduction to Choice in a World of Scarcity: • Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society. 2.1: How Individuals Make Choices Based on Their Budget Constraint • A budget constraint is the outer boundary of a person’s opportunity set. The opportunity set identifies all the opportunities for spending within their budget. The budget constraint indicates all the combinations of goods the person can afford when they exhaust their budget, given the prices of the two goods. • Any point outside the constraint is not affordable The Concept of Opportunity Cost: • Opportunity cost indicates what must be given up to obtain something that is desired. o Opportunity cost is the value of the next best alternative. • Every choice has an opportunity cost. • Budget = P1 X Q1 + P2 X Q2 Identifying Opportunity Cost: • In many cases, it is reasonable to refer to the opportunity cost as the price. Marginal Decision -Making and Diminishing Marginal Utility: • Marginal analysis means comparing the benefits and costs of choosing a little more or a little less of a good. • Satisfaction is utility • The law of diminishing marginal utility states that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. Sunk Costs: • Sunk costs are costs that were incurred in the pa st and cannot be recovered, o Sunk costs should not affect the current decision. From a Model with Two Goods to One of Many Goods: • Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constrain ts, showing the possible tradeoffs between many different pairs of goods. 2.2: The Production Possibilities Frontier and Social Choices • The constraints faced by society can be shown using a model called the production possibilities frontier (PPF). • The production possibilities frontier plays the same role for society as the budget constraint plays for a person. o Society can choose any combination of the two goods on or inside the PPF. But it does not have enough resources to produce outside the PPF. • Difference between a budget constraint and a PPF? o The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods. In contrast, the PPF has a curved shape because of the law of the diminishing returns. o The second is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has. The Shape of the PPF and the Law of Diminishing Returns: • The law of diminishing returns holds that as additional increments of resources are added to a certain purpose, the marginal benefit from those additional increments will decline. o The law of diminishing returns produces the outward - bending shape of the production possibilities frontier. Productive Efficiency and Allocative Efficiency: • Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. • Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. o Allocative efficiency means producers supply the quantity of each product that consumers demand. • Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole. Why Society Must Choose: • Every economy faces two situations in which it may be able to expand consumption of all goods. o If a society improves efficiency and production on the production possibilities frontier, it can have more of all goods o In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all g oods. The PPF and Comparative Advantage: • Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills. • When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. • Countries’ differences in comparative advantage determine which goods they will choose to produce and trade. • With trade, goods are produced where the opportunity co st is lowest, so total production increases, benefiting both trading parties. 2.3: Confronting Objections to the Economic Approach • When thinking about the economic actions of groups of people, firms, and society, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis • Positive economic statements describe the world as it is. • Normative economic statements describe how the world should be. • The invisible hand is an idea that self -interested behavior by individuals can lead to positive social outcomes o The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions. Chapter 3: Demand and Supply Introduction to Demand and Supply: • The discussion here begins by examining how demand and supply determine the price and the quantity sold in markets for goods and services, and how changes in demand and supply lead to changes in prices and quantities. 3.1: Demand, Supply, and Equilibrium in Markets for Goods and Services Demand for Goods and Services: • Demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. • What a buyer pays for a unit of the specific good or service is calprice. • The total number of units purchased at that price is called the quantity demanded. • A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded . • Economists call this inverse relationship between price and quantity demanded the law of demand. • A table that shows the quantity demanded at each price is called a demand schedule. • A demand curve shows the relationship between price and quantity deman ded, with quantity on the horizontal axis and the price on the vertical axis • Demand refers to the curve and quantity demanded refers to the (specific) point on the curve. Supply of Goods and Services: • Supply is the amount of some good or service a producer is willing to supply at each price. • A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. • Economists call this positive relationship between pric e and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied —the law of supply. • Supply refers to the curve and quantity supplied refers to the (specific) point on the curve. • A supply schedule is a table that shows the quantity supplied at a range of different prices. • A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. Equilibrium- Where Demand and Supply Intersect: • Together, demand and supply determine the price and the quantity that will be bought and sold in a market. • The point where the supply curve (S) and the demand curve (D) cross, is called the equilibrium. • The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). o This common quantity is c alled the equilibrium quantity. • The word “equilibrium” means “balance.” • At any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus. • When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. 3.2: Shifts in Demand and Supply for Goods and Services What Factors Affect Demand?: • Willingness to purchase suggests a desire, based on what economists call tastes and preferences. • Ability to purchase suggests that income is important. The Ceteris Paribus Assumption: • Ceteris paribus assumes that all else is held equal. How Does Income Affect Demand?: • A shift in a demand curve captures a pattern for the market as a whole. • A product whose demand rises when income rises, and vice versa, is called a normal good. • A product whose demand falls when income rises, and vice versa, is called an inferior good. Other Factors That Shift the Demand Curves: • Movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good • Changes in the size and composition of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve. • A substitute is a good or service that can be used in place of anot her good or service. • Complements mean that the goods are often used together, because consumption of one good tends to enhance consumption of the other. • A shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. Summing Up Factors That Change Demand: How Production Costs Affect Supply: • A shift in supply means a change in the quantity suppl ied at every price. • Goods and services are produced using combinations of labor, materials, and machinery, or what we call inputs or factors of production. Other Factors That Affect Supply: • A drought means that at any given price, a lower quantity will b e supplied; conversely, especially good weather would shift the supply curve to the right. • When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, • A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price. • Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. o A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. o Taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price o Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. Summing Up Factors That Change Supply: 3.3: Changes in Equilibrium Price and Quantity: The Four -Step Process • Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of t he supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity. • Step 2. Decide whether the economic change being analyzed affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors? • Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagr am. In other words, does the event increase or decrease the amount consumer want to buy or producers want to sell? • Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity. 3.4: Price Ceilings and Price Floors Price Ceilings: • Laws that government enacts to regulate prices are called Price controls • A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor keeps a price from falling below a certain level (the “floor”). . • When the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate. Price Floors: • Price floors are sometimes called “price supports,” • The result is a quantity supplied in excess of the quantity demanded (Qd). When quantity supplied exceeds quantity demanded, a surplus exists. • Neither price ceilings nor price floors cause demand or supply to change. They simply set a price that limits what can be legally charged in the market. o Remember, changes in price do not cause demand or supply to change. Price ceilings and price floors can cause a different choice of quantity demanded along a demand curve, but they do not move the demand curve. Price controls can cause a different choice of `quantity supplied along a supply curve, but they do not shift the supply curve. 3.5: Demand, Supply, and Efficiency Consumer Surplus, Producer Surplus, Social Surplus: • The amount that individuals would have been willing to pay, minus the amount that they actuall y paid, is called consumer surplus. Consumer surplus is the area labeled F—that is, the area above the market price and below the demand curve. • The amount that a seller is paid for a good minus the seller’s actual cost is called producer surplus. o Producer surplus is the area between the market price and the segment of the supply curve below the equilibrium. • The sum of consumer surplus and producer surplus is social surplus, also referred to as economic surplus or total surplus. In the figure, social surplus is the area F + G. o Social surplus is larger at equilibrium quantity and price than it would be at any other quantity. Inefficiency of Price Floors and Price Ceilings: • The imposition of a price floor or a price ceiling will prevent a market from adjus ting to its equilibrium price and quantity, and thus will create an inefficient outcome. • Along with creating inefficiency, price floors and ceilings will also transfer some consumer surplus to producers, or some producer surplus to consumers. • The loss in social surplus that occurs when the economy produces at an inefficient quantity is called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In the figure, the deadweight loss is the area U + W. • A second change from the price ceiling is that some of the producer surplus is transferred to consumers. • The price ceiling transfers the area of surplus (V) from producers to consumers. o A price ceiling will transfer some producer surplus to consumers —which helps to explain why consumers often favor them. • A price floor will transfer some consumer surplus to producers, which explains why producers often favor them. • Both price floors and price ceilings block some transactions that buyers and sellers would have been willing to make, and creates deadweight loss. Removing such barriers, so that prices and quantities can adjust to their equilibrium level, will increase the economy’s social surplus. Demand and Supply as a Social Adjustment Mechanism: • The demand and supply model emphasizes that prices are not set only by demand or only by supply, but by the interaction between the two. Chapter 4: Labor and Financial Markets Introduction to Labor and Financial Markets: • Labor markets are markets for employees or jobs. Fi nancial services markets are markets for saving or borrowing. • In labor markets job seekers (individuals) are the suppliers of labor, while firms and other employers who hire labor are the demanders for labor. • In financial markets, any individual or firm who saves contributes to the supply of money, and any who borrows (person, firm, or government) contributes to the demand for money. 4.1: Demand and Supply at Work in Labor Markets • The law of demand applies in labor markets this way: A higher salary or wage—that is, a higher price in the labor market—leads to a decrease in the quantity of labor demanded by employers, while a lower salary or wage leads to an increase in the quantity of labor demanded. • The law of supply functions in labor markets, too: A higher price for labor leads to a higher quantity of labor supplied; a lower price leads to a lower quantity supplied. Equilibrium in the Labor Market: • At equilibrium, the quantity supplied and the quantity demanded are equal. Shifts in Labor Demand: • The demand curve for labor shows the quantity of labor employers wish to hire at any given salary or wage rate • A change in the wage or salary will result in a change in the quantity demanded of labor. o If the wage rate increases, employers will want to hi re fewer employees. The quantity of labor demanded will decrease, and there will be a movement upward along the demand curve. o If the wages and salaries decrease, employers are more likely to hire a greater number of workers. The quantity of labor demanded will increase, resulting in a downward movement along the demand curve. • The demand for labor is based on the demand for the good or service that is being produced. o Therefore the demand for labor is called a “derived demand.” • As the demand for the goods and services increases, the demand for labor will increase, or shift to the right, to meet employers’ production requirements. As the demand for the goods and services decreases, the demand for labor will decrease, or shift to the left. • When the demand for the good produced (output) increases, both the output price and profitability increase. As a result, producers demand more labor to ramp up production. • Technology changes can act as either substitutes for or complements to labor. When technology acts as a substitute, it replaces the need for the number of workers an employer needs to hire. An increase in the availability of certain technologies may increase the demand for labor. Technology that acts as a complement to labor will increase the demand fo r certain types of labor, resulting in a rightward shift of the demand curve. o More and better technology will increase demand for skilled workers who know how to use technology to enhance workplace productivity. Those workers who do not adapt to changes in technology will experience a decrease in demand. • An increase in the number of companies producing a given product will increase the demand for labor resulting in a shift to the right. A decrease in the number of companies producing a given product will decrease the demand for labor resulting in a shift to the left. • Complying with government regulations can increase or decrease the demand for labor at any given wage. • As the amount of inputs increases, the demand for labor will increase. As the quantitof other inputs decreases, the demand for labor will decrease. • Similarly, if prices of other inputs fall, production will become more profitable and suppliers will demand more labor to increase production. The opposite is also true. Higher input prices lower demand for labor . Shifts in Labor Supply: • The supply of labor is upward sloping and adheres to the law of supply: The higher the price, the greater the quantity supplied and the lower the price, the less quantity supplied. • An increased number of workers will cause the supply curve to shift to the right. o An increased number of workers can be due to several factors, such as immigration, increasing population, an aging population, and changing demographics. • The more required education, the lower the supply. • Government policies can also affect the supply of labor f or jobs. o On the one hand, the government may support rules that set high qualifications for certain jobs. When these qualifications are made tougher, the number of qualified workers will decrease at any given wage. o On the other hand, the government may a lso subsidize training or even reduce the required level of qualifications. Such provisions would shift the supply curve to the right. o In addition, government policies that change the relative desirability of working versus not working also affect the lab or supply. These include unemployment benefits, maternity leave, child care benefits and welfare policy. • A change in salary will lead to a movement along labor demand or labor supply curves, but it will not shift those curves. Technology and Wage Inequal ity: The Four-Step Process: • Step 1. What did the markets for low -skill labor and high-skill labor look like before the arrival of the new technologies? • Step 2. Does the new technology affect the supply of labor from households or the demand for labor from firms? • Step 3. Will the new technology increase or decrease demand? • Step 4. The new equilibrium Price Floors in the Labor Market: Living Wages and Minimum Wages: • The U.S. government sets a minimum wage, a price floor that makes it illegal for an employer to pay employees less than a certain hourly rate. • A living wage is a wage that ensures a reasonable standard of living o Promoters of living wage laws maintain that the minimum wage is too low to ensure a reasonable standard of living. • At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor exists in this market. For workers who continue to have a job at a higher salary, life has improved. For those who were willin g to work at the old wage rate but lost their jobs with the wage increase, life has not improved. The Minimum Wage as an Example of a Price Floor: • Let’s suppose that the minimum wage lies just slightly below the equilibrium wage level. Wages could fluctuate according to market forces above this price floor, but they would not be allowed to move beneath the floor. In this situation, the price floor minimum wage is said to benonbinding —that is, the price floor is not determining the market outcome. 4.2: Demand and Supply in Financial Markets • Financial capital means savings • Those who save money (or make financial investments, which is the same thing), whether individuals or businesses, are on the supply side of the financial market. Those who borrow money are on the demand side of the financial market. Who Demands and Who Supplied in Financial Markets?: • The price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay a rate of return. • The interest paid to you as a percent of your deposits is the interest rate. • Law of demand: a higher rate of return (that is, a higher price) will decrease the quantity demanded. • Consequently, as the interest rate paid on credit card borrowing rises, more firms will be eager to issue credit cards and to encourage customers to use them. Equilibrium in Financial Markets: • If the interest rate (remember, this measures the “price” in the financial market) is above the equilibrium level, then an excess supply, or a surplus, of financial capital will arise in this market • If the interest rate is below the equilibrium, then excess demand or a shortage of funds occurs in this market. Shifts in Demand and Supply in Financial Markets: • Participants in financial markets must decide when they prefer to consume goods: now or in the future. • This is called intertemporal decision making because it involves decisions across time. • Social Security has shifted the supply of financial capital at any interest rate to the left because workers save more. • When consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right. The United States as a Global Borrower: • The graph shows the demand for financial capital and supply of financial capital into the U.S . financial markets by the foreign sector before and after the increase in uncertainty regarding U.S. public debt. The original equilibrium (0 ) occurs at an eqsuilibrium rate of return0(R ) and the equilibrium quantity is at 0 . • Thus, foreign investors’ diminished enthusiasm leads to a new equilibrium, E1, which occurs at the higher interest rate,1R , and the lower quantity of financial investment1 Q . Price Ceilings in Financial Markets: Usury Laws: • At the price ceiling (Rc), quantity demanded will exc eed quantity supplied. Consequently, a number of people who want to have credit cards and are willing to pay the prevailing interest rate will find that companies are unwilling to issue cards to them. The result will be a credit shortage. • Usury laws impose an upper limit on the interest rate that lenders can charge. 4.3: The Market System as an Efficient Mechanism for Information • An increase in the price of some product signals consumers that there is a shortage and the product should perhaps be economized on. • Those who seek price controls are trying to stifle an unwelcome message that prices are bringing about the equilibrium level of price and quantity. But price controls do nothing to affect the underlying forces of demand and supply, and this can have serious repercussions. • Without this information, it becomes difficult for everyone —buyers and sellers alike—to react in a flexible and appropriate manner as changes occur throughout the economy. Chapter 6: The Macroeconomic Perspective Introduction to the Macroeconomic Perspective: • Three primary goals: economic growth, low unemployment, and low inflation. • Economic growth ultimately determines the prevailing standard of living in a country. Economic growth is measured by the percentage change in real (inflation-adjusted) gross domestic product. • Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who do not have a job but want to work. • Inflation is a sustained increase in the overall level of prices, an d is measured by the consumer price index. • Low inflation—an inflation rate of 1–2%—is a major goal. • We use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two perspectives on macroeconomics: the Neoclassical perspectiv e and the Keynesian perspective • Monetary and fiscal policy influence the macroeconomy 6.1: Measuring the Size of the Economy: Gross Domestic Product • The size of a nation’s overall economy is typically measured by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. o This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. • Each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured either by the total dollar value of what is purchased in the economy, or by the total dollar value of what is produced. GDP Measured by Compone nts of Demand: • This demand can be divided into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. • Consumers’ spending decisions are the largest part of GDP. • Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. • The only part of government spending counted in demand is government purchases of goods or services produced in the economy. • Payments such as social security and Medicare are excluded from GDP because the government does not receive a new good or service in return or exchange. • We must also subtract spending on imports —goods produced in other countries that are purchased by residents of this country . • The net export component of GDP is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X – M). o The gap between exports and imports is called the trade balance. If a country’s exports are larger than its imports, then a country is said to have a trade surplus. • GDP = Consumption + Investment + Government + Trade Balance (Exports -Imports) • GDP = C + I + G + (X – M) GDP Measured by What is Produced: • GDP must be the same whether measured by what is demanded or by what is produced. • The largest part of GDP is services. • Inventories is a small category that refers to the goods that have been produced by one business but have not yet been sold to consumers The Problem of Double Counting: • GDP is defined as the current value of all final goods and services produced in a nation in a year. Final goods are goods at the furthest stage of production at the end of a year. • Double counting is when output is counted more than once as it travels through the stages of production. • Only final goods and services are counted in GDP o Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations • The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. What is Counted in GDP: • Consumption, business, investment, government spending on goods and services, and net exports What is not included in GDP: • Intermediate goods, transfer payments, non-market activities, used goods, and illegal goods Other Ways to Measure the Economy: • We mentioned above that GDP can be thought of as total production and as total purchases. t can also be thought of as total income since anything produced and sold produces income. • Gross national product (GNP) adds what is produced by domestic businesses and labor abroad, and subtracts out any payments sent home to other countries by foreign l abor and businesses located in the United States. In other words, GNP is based more on the production of citizens and firms of a country, wherever they are located. • Net national product (NNP) is calculated by taking GNP and then subtracting the value of ho w much physical capital is worn out, or reduced in value because of aging, over the course of a year. o The process by which capital ages and loses value is called depreciation. • National income, which includes all income to businesses and individuals, and personal income, which includes only income to people. 6.2: Adjusting Nominal Values to Real Values • The distinction between nominal and real measurements refers to whether or not inflation has distorted a given statistic. o The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time. o The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important. Converting Nominal to Real GDP: • GDP deflator is a price index measuring the average prices of all goods and services included in the economy. • Nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. ▯▯▯▯▯▯▯ ▯▯▯ • Real GDP = ▯▯▯▯▯ ▯▯▯▯▯100 o A price index is a two -digit decimal number ▯▯▯▯ ▯▯▯▯ (▯ )▯▯▯▯▯ ▯▯▯▯ (▯ ) • ???????????????? ????????????????????ℎ ???????????????? = ▯▯▯▯ ▯▯▯ (▯ ) ???? 100 = % ????ℎ???????????????? ▯ • Real GDP = Price X Quantity • % Change in Real GDP = % Change in Price + % Change in Quantity 6.3: Tracking Real GDP over Time • A significant decline in real GDP is called a recession. • An especially lengthy and deep recession is called a depression. • When real GDP rises, so does employment. • The highest point of the economy, befo re the recession begins, is called the peak; conversely, the lowest point of a recession, before a recovery begins, is called the trough. o A recession lasts from peak to trough o An economic upswing runs from trough to peak. • The movement of the economy fro m peak to trough and trough to peak is called the business cycle. 6.4: Comparing GDP among Countries • Comparing GDP between two countries requires converting to a common currency. • If we are trying to compare standards of living across countries, we need t o divide GDP by population. Converting Currencies with Exchange Rates: • It is necessary to convert to a “common denominator” using an exchange rate, which is the value of one currency in terms of another currency. • Market exchange rates vary on a day -to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. o PPP-equivalent exchange rates are typically used for cross -country comparisons of GDP. GDP Per Capita: • GDP per capita is the GDP divided by the population. • GDP per capita = GDP/Population 6.5: How Well GDP Measures the Well -Being of Society • While GDP focuses on production that is bought and sold in markets,standard of living includes all elements that affect people’s well-being, whether they are bought and sold in the market or not. Limitations of GDP as a Measure of the Standard of Living: • GDP does not cover leisure time. • GDP does not include actual levels of environmental cleanliness, health, and lea rning. • GDP does not address whether the air and water are actually cleaner or dirtier. • GDP does not address whether life expectancy or infant mortality have risen or fallen • GDP does not address directly how much of the population can read, write, or d o basic mathematics. • GDP does not cover production that is not exchanged in the market. • As women are now in the labor force, many of the services they used to produce in the non -market economy like food preparation and child care have shifted to some ext ent into the market economy, which makes the GDP appear larger even if more services are not actually being consumed. • GDP has nothing to say about the level of inequality in society. GDP per capita is only an average. • GDP also has nothing in particular t o say about the amount of variety available. • GDP has nothing much to say about what technology and products are available. Does a Rise in GDP Overstate or Understate the Rise in the Standard of Living?: • In some ways, the rise in GDP understates the actual rise in the standard of living. o Because GDP does not capture leisure, health, a cleaner environment, the possibilities created by new technology, or an increase in variety, the actual rise in the standa rd of living for Americans in recent decades has exceeded the rise in GDP. GDP is Rough, but Useful: • Even though GDP does not measure the broader standard of living with any precision, it does measure production well and it does indicate when a country is materially better or worse off in terms of jobs and incomes Chapter 7: Economic Growth Introduction to Economic Growth: • Dramatic improvements in a nation’s standard of living are possible. • Period of modern economic growth refers to the last two centuries • Rapid and sustained economic growth is a relatively recent experience for the human race. • The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800 s. • The new jobs of the Industrial Revolution typically offered higher pay and a chance for social mobility. New inventions and investments generated profits, the profits provided funds for new investment and inventions, and the investments and inventions provided opportunities for further profits. • The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany, and other countries. • Most people today are better fed, clothed, and housed than their predecessors two centuris ago. They are healthier, live longer, and are better educated. Rule of Law and Economic Growth: • Economic growth depends on many factors. • Key among those factors is adherence to the rule of law and protection of property rights and contractual rights by a country’s government so that markets can work effectively and efficiently. o Laws must be clear, public, fair, enforced, and equally applicable to all members of society. • Property rights are the rights of individuals and firms to own property and use it as they see fit. • The definition of property includes physical property as well as the right to your training and experience, especially since your training is what determines your livelihood. • Contractual rights are based on property rights and they al low individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. • The World Bank considers a country’s legal system effective if it upholds property rights a nd contractual rights. 7.2: Labor Productivity and Economic Growth • Sustained long-term economic growth comes from increases in worker productivity, which essentially means how well we do things. • Labor productivity is the value that each employed person creates per unit of his or her input. o Being more productive essentially means you can do more in the same amount of time. This in turn frees up resources to be used elsewhere. o The first determinant of labor productivity is human capital. Human capital is the accumulated knowledge (from education and experience), skills, and expertise that the average worker in an economy possesses. Typically the higher the average level of education in an economy, the higher the accumulated human capital and the higher the labor productivity. o The second factor that determines labor productivity is technological change. Technological change is a combination of invention—advances in knowledge—and innovation, which is putting that advance to use in a new product or servic e. o The third factor that determines labor productivity is economies of scale. Recall that economies of scale are the cost advantages that industries obtain due to size. Sources of Economic Growth: The Aggregate Production Function: • To analyze the sources of economic growth, it is useful to think about a production function, which is the process of turning economic inputs like labor, machinery, and raw materials into outputs like goods and services used by consumers. • In macroeconomics, the connection from inputs to outputs for the entire economy is called an aggregate production function. Components of the Aggregate Production Function: • Economists construct different production functions depending on the focus of thei r studies. • The inputs in this example are workforce, human capital, physical capital, and technology. • An aggregate production function shows what goes into producing the output for an overall economy. Measuring Productivity: • An economy’s rate of productivity growth is closely linked to the growth rate of its GDP per capita • Over the long term, the only way that GDP per capita can grow continually is if the productivity of the average worker rises or if there are complementary increases in capital. • A common measure of U.S. productivity per worker is dollar value per hour the worker contributes to the employer’s output. This measure excludes government workers and farming The “New Economy” Controversy: • In recent years a controversy has been brewing among economists about the resurgence of U.S. productivity in the second half of the 1990s. o One school of thought argues that the United States had developed a “new economy” based on the extraordinary advances in communications and information technology of the 1990s. o The most optimistic proponents argue that it would generate higher average productivity growth for decades to come. o The pessimists, on the other hand, argue that even five or ten years of stronger productivity growth does not prove that hig her productivity will last for the long term. • Productivity growth is also closely linked to the average level of wages. Over time, the amount that firms are willing to pay workers will depend on the value of the output those workers produce. o If a few employers tried to pay their workers less than what those workers produced, then those workers would receive offers of higher wages from other profit -seeking employers. o If a few employers mistakenly paid their workers more than what those workers produced, those employers would soon end up with losses. o In the long run, productivity per hour is the most important determinant of the average wage level in any economy. The Power of Sustained Economic Growth: • Even small changes in the rate of growth, when sustained and compounded over long periods of time, make an enormous difference in the standard of living. • Compound growth rate is the rate of growth when multiplied by a base that includes past GDP growth • ???????????? ???????? ???????????????????????????????? ???????????????? ???? (1 + ????????????????????ℎ ???????????????? ???????? ????????????)▯▯▯ = ???????????? ???????? ???????????? ???????????????? 7.3: Components of Economic Growth • The category of physical capital includes the plant and equipment used by firms and also things like roads (also called infrastructure). o Greater physical capital implies more output. o Physical capital can affect productivity in two ways: (1) an increase in the quantity of physical capital and (2) an increase in the quality of physical capital • The category of technology o It includes new ways of organizing work, new methods for ensuring better quality of output in factories, and innovative institutions that facilitate the process of converting inputs into output. o Technology comprises all the advances that mak e the existing machines and other inputs produce more, and at higher quality, as well as altogether new products. Capital Deepening: • When society increases the level of capital per person, the result is ccapital deepening. • Capital deepening refer s to the case when an economy has a higher level of physical and/or human capital per worker • The key dimension for deepening human capital in the U.S. economy focuses more on additional education and training than on a higher average level of work experience. • The current U.S. economy has better -educated workers with more and improved physical cap ital than it did several decades ago, but these workers have access to more advanced technologies. • This recipe for economic growth —investing in labor productivity, with investments in human capital and technology, as well as increasing physical capital —also applies to other economies. Growth Accounting Studies: • Economists have conducted growth accounting studies to determine the extent to which physical and human capital deepening and technology have contributed to growth. • The usual approach uses an aggr egate production function to estimate how much of per capita economic growth can be attributed to growth in physical capital and human capital. o The part of growth that is unexplained by measured inputs, called the residual, is then attributed to growth in technology. • First, technology is typically the most important contributor to U.S. economic growth. • Second, while investment in physical capital is essential to growth in labor productivity and GDP per capita, building human capital is at least as import ant. • A third lesson is that these three factors of human capital, physical capital, and technology work together. o Workers with a higher level of education and skills are often better at coming up with new technological innovations. These technological in novations are often ideas that cannot increase production until they become a part of new investment in physical capital. o New machines that embody technological innovations often require additional training, which builds worker skills further. If the reci pe for economic growth is to succeed, an economy needs all the ingredients of the aggregate production function. A Healthy Climate for Economic Growth: • Both the type of market economy and a legal system that governs and sustains property rights and contractual rights are important contributors to a healthy economic climate. o A healthy economic climate usually involves some sort of market orientation at the microeconomic, individual, or firm decision -making level. o Markets that allow personal and business r ewards and incentives for increasing human and physical capital encourage overall macroeconomic growth. o This market orientation typically reaches beyond national borders and includes openness to international trade. • There are times when markets fail to allocate capital or technology in a manner that provides the greatest benefit for society as a whole. o The role of the government is to correct these failures. • Important areas that governments around the world have cho sen to invest in to facilitate capital deepening and technology: Education, savings and investment, infrastructure, special economic zones (SEZ: These are areas of the country, usually with access to a port where, among other benefits, the government does not tax trade.), and scientific research • A healthy climate for growth in GDP per capita and labor productivity includes human capital deepening, physical capital deepening, and technological gains, operating in a market -oriented economy with supportive government policies. 7.4: Economic Convergence • Some low-income and middle-income economies around the world have shown a pattern of convergence, in which their economies grow faster than those of high -income countries. • The low-income countries have GDP growth that is faster than that of the middle -income countries, which in turn have GDP growth that is faster than that of the high -income countries. Arguments Favoring Convergence: • Several arguments suggest that low -income countries might have an advantage in achieving greater worker productivity and economic growth in the future. • A first argument is based on diminishing marginal returns. Even though deepening human and physical capital will tend to increase GDP per capita, the law of diminishing returns suggests that as an economy continues to increase its human and physical capital, the marginal gains to economic growth will diminish. • An investment in capital deepening should have a larger marginal effect in these countries than in high-income countries, where levels of human and physical capital are already relatively high. Diminishing returns implies that low -income economies could converge to the levels achieved by the high-income countries. • A second argument is that low -income countries may find it easier to improve their technologies than high-income countries. High-income countries must continually invent new technologies, whereas low-income countries can often find ways of applying technology that has already been invented and is well understood. • Finally, optimists argue that many countries have observed the experience of those that have grown more quickly and have learned from it. Moreover, once the people of a country begi n to enjoy the benefits of a higher standard of living, they may be more likely to build and support the market-friendly institutions that will help provide this standard of living. Arguments That Convergence is neither Inevitable nor Likely: • If the growth of an economy depended only on the deepening of human capital and physical capital, then the growth rate of that economy would be expected to slow down over the long run because of diminishing marginal returns. However, there is another cruci al factor in the aggregate production function: technology. • The development of new technology can provide a way for an economy to sidestep the diminishing marginal returns of capital deepening. o Improved technology means that with a given set of inputs, m ore output is possible. o With the combination of technology and capital deepening, the rise in GDP per capita in high-income countries does not need to fade away because of diminishing returns. The gains from technology can offset the diminishing returns i nvolved with capital deepening. o Improvements in technology have not run into diminishing marginal returns. • One reason that technological ideas do not seem to run into diminishing returns is that the ideas of new technology can often be widely applied at a marginal cost that is very low or even zero. • The argument that it is easier for a low -income country to copy and adapt existing technology than it is for a high-income country to invent new technology is not necessarily true, either. • In theory, perhaps, low-income countries have many opportunities to copy and adapt technology, but if they lack the appropriate supportive economic infrastructure and institutions, the theoretical possibility that backwardness might have certain advantages is of little prac tical relevance. The Slowness of Convergence: • Although economic convergence between the high -income countries and the rest of the world seems possible and even likely, it will proceed slowly. o Moreover, as the poor country catches up, its opportunities fo r catch-up growth are reduced, and its growth rate may slow down somewhat. • The slowness of convergence illustrates again that small differences in annual rates of economic growth become huge differences over time. The high -income countries have been building up their advantage in standard of living over decades —more than a century in some cases. Even in an optimistic scenario, it will take decades for the low -income countries of the world to catch up significantly. Chapter 8: Unemployment Unemployment • An unemployed worker is someone who o Is over 16 o Is not currently working o Has looked for work in the last four weeks • Retirees, students, inmates, discouraged workers or stay at home spouses are not unemployed • Being unemployed does not mean you are eligible
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