ECON 110 Final Exam Review
ECON 110 Final Exam Review Econ 110
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Spring 2016 ECON 110 Principles of Macroeconomics Chapter Lecture Review This review covers all emphasised notes and topics discussed in lecture. See specific lecture notes for more detailed descriptions of topics and terms. Chapter review questions can be found the supplemental practice problems final review. Chapter 1: Ten Principles of Macroeconomics How People Make Decisions 1. People Face Tradeoffs ○ To get something we want we must usually give up something else in return. ○ Common tradeoffs: ■ Student = time. ■ Society = clean environment vs. high income, efficiency vs. equality. 2. The Cost of Something is What You Give Up to Get It ○ People face tradeoffs. ■ Compare cost with benefits of alternatives. ○ Opportunity cost ■ Whatever must be given up to obtain some item. 3. Rational People Think at the Margin ○ Rational decision maker ■ Make decisions by comparing marginal benefits and marginal costs. ■ Take action only if marginal benefits > marginal cost. 4. People Respond to Incentives ○ “People are motivated by personal benefits.” How People Interact 5. Trade Can Make Everyone Better Off ○ Allows each person to specialize in the activities they do best. ○ Enjoy a greater variety of goods and services at a lower cost. 6. Markets are Usually a Good Way to Organize Economic Activity ○ Allocate economy’s scarce resources. ○ Allow direct interactions between household and firms. ○ Without intervention ■ Guided by the “invisible hand” (a.k.a. Prices and selfinterests). ● Leads them to desirable market outcomes. ○ Corollary: Government intervention ■ Prevents the invisible hand’s ability to coordinate the decisions of the households and firms that make up the economy. Spring 2016 7. Governments Can Sometimes Improve Market Outcomes ○ Enforce rules and maintain institutions that are key to a market economy. ○ Enforce property rights. ○ Promote efficiency, avoid market failure. ○ Promote equality, avoid disparities in economic well being. How the Economy as a Whole Works 8. A Country’s Standard of Living Depends on its Ability to Produce Goods and Services ○ Higher productivity = Higher standard of living. ○ Growth rate of nation’s productivity. ■ Determines growth rate of its average income. ○ “Even with less resources, higher income because increased productivity.” 9. Prices Rise When the Government Prints Too Much Money ○ Inflation ■ An increase in the overall level of prices in the economy. ○ Causes for large or persistent inflation. ■ Growth in quantity of money = Fall in value of money. 10. Society Faces a ShortRun Tradeoff Between Inflation and Unemployment ○ Shortrun effects of monetary injections: ■ Stimulates the overall level of spending. ● Higher demand for goods and services. ■ Firms raise prices; hire more workers; produce more goods and services. ■ Lower unemployment. Chapter 2: Thinking Like an Economist ● Much like scientist, economists: ○ Devise theories ○ Collect data ○ Analyze this data ■ Verify or refute their theories. ● Because economists cannot conduct many experiments, they make assumptions. ○ These assumptions can simplify the complex world. ○ Different assumptions answer different questions that study both shortterm or longrun effects. ● Economist also use economic models like the circular flow diagram to simplify reality to improve our understanding of it and allow us to see what’s truly important. ○ “We build a simple model based off assumptions to explain or reality.” ● Two Markets: ○ Goods and services Spring 2016 ○ Inputs and factors of production ● Production possibilities frontier (PPF) ○ A graph of the combinations of output that the economy can possibly produce. ○ Opp. cost of goods on xaxis = slope of PPF. 1 ○ Opp. cost of goods on yaxis is reciprocal of xaxis opp. cost. ( Slope of PPF . ■ ∴The opportunity cost is the ratio or fraction/proportion of what you give up to get something else. ○ “As we produce more goods/services, it will cost more of the good/product we’re taking resources from.” ○ “A bow out or concave PPF gives us a sense of increasing opportunity cost.” ● Microeconomics The study of how households and firms make decisions and how they interact in markets. ● Macroeconomics The study of economywide phenomena, including inflation, unemployment and economic growth. ○ ∴“The bigger picture.” ● Positive statements claims that attempt to describe the world as it is. ○ ∴Can be confirmed or refuted by evidence. ● Normative statements claims that attempt to prescribe how the world should be. ○ ∴ “Opinionated statements. Include the speaker's view.” ● Economists who advise policymakers sometimes offer conflicting advice. ○ Different values or normative statements. ○ Different scientific judgements. Chapter 3: Interdependence and the Gains from Trade ● Trade benefits everyone in society. ○ Both parties can benefit by specializing in what you’re relatively good at. ○ Without trade to produce the maximum the producers can consume is what they produce on the PPF. ○ Trade is based upon comparative advantage. ● Absolute advantage The ability to produce a good using fewer inputs than another producer. ● Comparative advantage The ability to produce a good at a lower opportunity cost than another producer. ● Principle of Comparative Advantage Each good should be produced by the individual that has the smaller opportunity cost of producing that good. ● One person can have absolute advantage in both goods, but cannot have comparative advantage in both goods. Spring 2016 ● Competitive advantage When the producer can produce goods/services at a lower rate than your competitor. Chapter 4: The Market Forces of Supply and Demand ● Economists use the model of supply and demand to analyze competitive markets. ● In a competitive market, there many buyers and sellers, each of whom has little or no influence on the market price. ○ Price and quantity are determined by all buyers and sellers. ● Demand Relationship between the price of a good and quantity demanded. ● Quantity demanded Amount of a good that buyers are willing and able to purchase. ● Law of Demand The claim that as price increases quantity demanded decreases; Ceteris Paribus (everything else stays the same). ● Always a downward sloping demand curve. ○ In decrease in price = an increase in quantity demand. ● Change in quantity demanded a movement on the same demand curve caused by a change in price. ● Shifts in demand curve = change in demand caused by “shifters”(not same as quantity demand). ○ Shifters include: income, prices of related goods, tastes, expectations, increased number of buyers, and age/ethnicity/religion. ● Supply Relationship between the price of goods and the quantity supplied. ● Quantity supplied Amount of a good that buyers are willing and able to sell. ● Law of Supply The claim that as the prices increase the quantity supplied increase; Ceteris Paribus. ○ Does not apply to all markets, but most. ○ You either accept or decline the price in a competitive market. You cannot change the price. Most decline only if the price is less than the cost of production. ● Shifts in supply curve include input prices, technology, expectations about the future, or number of sellers. A change in these determinants can cause a shift in the supply curve. ● The intersection of the supply and demand curves determines the market equilibrium. ○ At the equilibrium price (a.k.a. the market clearing price), the quantity demanded equals the quantity supplied. ○ Equilibrium point is static, does not move unless there is an external influence on market. ● Surplus is caused by an excess of supply; it happens at the price above equilibrium. ○ Quantity supplied > quantity demanded. ● Shortage is caused by an excess of demand; it happens at the price below equilibrium. ○ Quantity demanded > quantity supplied. Spring 2016 ● Law of supply and demand the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. ● To analyze how any event influences a market and its equilibrium price and quantity, we follow three main steps: 1. See if the change affects supply, or demand, or both. 2. See the direction of shift (right or left). 3. Compare old and new equilibrium. ○ ∴Compare old and new price and old and new quantity. ● A change in price does not change the curve but rather the movement on the same curve. ● Shifts in equilibrium and equilibrium quantity are really based upon the change in direction of both curves (supply and demand) AND how big of a shift is made. No change S Increase in S Decrease in S No change D P same, Q same P down, Q up P up, Q down Increase in D P up, Q up P ambiguous, Q up P up, Q ambiguous Decrease in D P down, Q down P down, Q P ambiguous, Q ambiguous down ● Prices ○ Signals that guide the allocation of resources. ○ Mechanism for rationing scarce resources. ○ Determine who produces each good and how much is produced. Chapter 6: Supply, Demand, and Government Policies ● Price ceiling ○ A legal maximum on the price at which a good can be sold. ○ If the price ceiling is binding, and the quantity demanded exceeds the quantity supplied (a.k.a. shortage). ○ Ex. NYC Rent ● Price floor ○ A legal minimum on the price at which a good can be sold. ○ If the price floor is above the equilibrium price, then the price floor is binding, and the quantity supplied exceeds the quantity demanded (a.k.a. surplus). ○ Ex. Minimum Wage ● Taxes used by the government to raise revenue for public purposes and to influence market outcomes. Spring 2016 ○ Ex. Roads, schools, and national defense. ○ Tax on a market shrinks the size of the market. ● Taxes levied on seller and taxes levied on buyers are equivalent. ○ Wedge between the price that buyers pay and the price that seller receives. ■ The same, regardless of whether the tax is levied on buyers or sellers. ○ Shifts the relative position of the supply and demand curves. ■ Buyers and sellers share the tax burden. ● Tax Wedge the difference created from tax in equilibrium price and new taxed price that the buyer and seller must share paying (either equally or unevenly). ● Tax Incidence Manner in which the burden of a tax is shared among participants in a market. ● Tax burden ○ Falls more heavily on the side of the market that is less elastic. ○ Small elasticity of demand. ■ Buyers do not have good alternatives to consuming this good. ○ Small elasticity of supply. ■ Sellers do not have good alternatives to producing this good. Chapter 10: Measuring a Nation’s Income ● Because every transaction has a buyer and seller, the total expenditure in the economy must equal the total income in the economy. ○ Your income = Your production = Your expenditure ● Gross Domestic Production ○ ∴Production of the nation. ○ Measures the total income and total expenditure of everyone and everything in the economy. ○ Market value of all final goods and services. ○ Produced within a country. ○ In given period of time. ● GDP = Consumption + Investment + Gov. Purchases + (Exports Imports) ○ Consumption, C = spending on goods and services by households. ■ Does not include new housing. ○ Investment, I = spending on new equipment and structures. ■ Includes households’ purchases of new housing. ○ Government purchases, G = spending on goods and services by local, state, and federal governments. ○ Net Exports, NX = the value of goods and services produced domestically and sold abroad minus the value of goods and services produced abroad and sold domestically. Spring 2016 ■ (Exports Imports). ● Nominal GDP “Value of GDP calculated at the current prices.” ○ ∴Nominal = same quantities and price. ● Real GDP “Value of GDP calculate at the constant prices.” ○ ∴Real = Keep the prices the same. ● For the base year ○ Nominal GDP = Real GDP. ● GDP deflator Ratio of nominal GDP to real GDP times 100. ○ Measures the current level of prices relative to the level of prices in the base year. Nominal GDP ○ GDP deflator = Real GDP X 100. ● GDP “the best single measure of the economic wellbeing of a society” ○ Economy’s total income. ○ Economy’s total expenditure. ○ Larger GDP. ■ Good life, better healthcare. ■ Better educational systems. ○ Measures our ability to obtain many of the inputs into a worthwhile life. ○ HOWEVER, it does not include leisure, activities outside markets, and the distribution of income. ● Inflation rate Percentage change in some measure of the price level from one period to the next. GDP deflator 2 − GDP deflator 1 ○ Inflation Rate = GDP deflator 1 X 100 ○ Inflation rate percentage means that al prices increased by said percent from year before. Chapter 11: Measure the Cost of Living ● Consumer Price Index (CPI) ○ Measure of the overall level of prices. ○ Measure of the overall cost of goods and services. ○ Is a fixed quantity and therefore an imperfect measure of the cost of living because the market changes, thus causing consumers to change their spending habits. ○ Different from GDP deflator. ● Calculating CPI 1. Fix the basket. ■ Which prices are most important to the typical consumer. ■ Different weight. 2. Find the prices at each point in time. Spring 2016 3. Compute the basket’s cost. ■ Same basket of goods. ■ Isolate the effects of price changes. 4. Choose a base year and compute the CPI. ■ Base year = benchmark. ● Price of basket of goods and services in current year. ● Divided by price of basket in base year. ● Times 100. ■ Compute the inflation rate. ■ Inflation rate in year 2 = PI in CPI in year 1in X 100 ● To compare dollar figures from different times: ○ Amount in today ′s dollars = Amount in year T dollars X Price level tod y Price level in year T ● Producer price index, PPI. ○ Measure of the cost of a basket of goods and services bought by firms. ○ Changes in PPI are often thought to be useful in preceding changes in CPI. ● Indexation The automatic correction by law or contract of a dollar amount for the effects of inflation. ○ COLA: Cost of living allowance. ● Nominal Interest Rate The interest rate as usually reported without a correction for the effects of inflation. ○ “Interest rate as state without taking inflation into account.” ● Real Interest Rate The interest rate corrected for the effects of inflation. ○ “Interest rate after accounting for inflation.” ○ = Nominal interest rate Inflation rate. Chapter 12: Production and Growth ● Real GDP per person ○ Can determine the living standard of a country. ○ Varies widely from country to country. ● Growth rate ○ How rapidly real GDP per person grew in the typical year. ● Because of difference in growth rates, ranking of countries by income changes substantially over time. ● Productivity Quantity of goods and services produced from each unit of labor input. ○ Key determinant of living standards. ○ Growth in productivity is the key determinant of growth in living standards. ○ An economy’s income is the economy’s output. Spring 2016 ○ Dependent on physical capital (equipment), human capital (knowledge and skills), natural resources, and technological knowledge available to workers. Standard of Living ⇐ Depends on Productivity ⇐ Depends on: Physical capital, human capital, natural resources, Technology ● Government policies can try to influence the economy’s growth through: ○ Encouraging saving and investment ○ Education ○ Promoting of good health ○ Enforcing property rights and political stability ○ Free trade ○ Promoting research and development of technologies ● Diminishing returns The property whereby the benefit from an extra unit of input declines as the quantity of the input increase. ○ Although higher savings leads to higher growth for period of time, growth eventually slows down capital, productivity, and income rise. ○ Proves the catchup effect. ■ Catchup effect Countries that start off poor, tend to grow more rapidly than countries that start off rich. ● Large population ○ More workers to produce goods and services. ■ Larger total output of goods and services. ■ Engine for technological progress and economic prosperity. ○ OR Stretching natural resources. ■ Strain society’s ability to provide for itself. ■ Lower productivity per worker. ■ Lower GDP per worker. Chapter 13: Saving, Investment, and the Financial System ● Financial System the group of institutions in the economy that help to match one person’s savings with another person’s investments. Includes: ○ Bond Market ■ Bond a certificate of indebtedness or an “IOU”. ○ Stock Market ■ Stocks a claim to partial ownership in a firm. ■ Someone cannot own stocks in government! ○ Banks Spring 2016 ■ Take deposits from savers to give loans to borrowers. ■ Facilitate purchases of goods and services through mediums of exchange. ○ Mutual Funds an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds. ● Financial Markets financial institutions through which savers can directly provide funds to borrowers. Two divisions: the bond market and stock market. ○ Financial markets are almost direct financing, no middleman transfer of money. ● Financial Intermediaries financial institutions through which savers can indirectly provide funds to borrowers. ○ Financial intermediaries include middlemen between the buyer and seller. ● Rules of National Income Accounting ○ Closed economy economies that do not interact with other economies. ■ Investments = Savings or I = Y C G or I = S. ○ ∴ In general, saving = investment, or one person’s savings can finance another person’s investment. ● Market for Loanable Funds the market in which those who want to save supply funds and those who want to borrow to invest demand funds. ○ Interest rates are determined by natural supply of funds. ○ Supply of loanable funds created from household savings. ○ Demand of loanable funds created from borrowers wanting to invest. ● If interest changes, it is a change in price which means it leads to a change in quantity of supply and/or demanded, NOT the supply and demand themselves (or the curves themselves). ● In the supply and demand of loanable funds: as interest rate rises, quantity demanded declines and quantity supplied increases. Therefore the demand curve slopes downward and the supply curve slopes upward. ● National savings = Sprivate + Spublic. ○ Sprivate = Y T C. ○ Spublic = T G. ○ ∴ S = (Y T C) + (T G) ● Government policies can affect the economy’s saving and investment. ○ Budget deficit a shortfall of tax revenue from government spending. ■ ∴B udget deficit = T < G ⇒ S. ■ Crowding out a decrease in investment that results from gov. borrowing. ○ Budget surplus an excess of tax revenue over government spending. ■ ∴ Budget surplus = T > G ⇒ +S. Chapter 15: Unemployment Spring 2016 ● Employed: Those who work. This includes all fulltime and parttime paid employees either in a large firm or their own business, unpaid workers in family member’s business, and those temporarily absent from vacations, illness, bad weather, maternity leave, etc. ● Unemployed: Those who are not employed. This includes those who are available for work and tried to find employment during the previous four weeks, and those waiting to be recalled to a job or laid off. ● Not in the Labor Force: Those not employed and not unemployed. This includes fulltime students, homemakers, and retirees. ● Labor Force = the total number of workers, employed and unemployed. ● Unemployment Rate the percentage of labor force that is unemployed. ○ Unemployment rate = Number of Unemploy X 100 Labor Force ○ The unemployment rate is imperfect. This is because some of those who report being unemployed may not be trying to find a job, may want to qualify for government help, or could be working but are being paid “under the table”. ○ Unemployment never reaches zero. ● LaborForce Participation Rate the percentage of the total adult population that is in the labor force. Labor Force ○ Laborforce participation rate = Adult Population100 ● Natural Rate of Unemployment Normal rate of unemployment around which the unemployment rate fluctuates. ○ Calculated by Congressional Budget office. ○ Remember: movement into and out of the labor force is common. Most spells of unemployment are short, most people who become unemployed will soon find jobs. ● Cyclical Unemployment the deviation of unemployment from natural rate. ● Discouraged Workers individuals who would like to work but have given up looking for a job. ● Frictional Unemployment unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills. ○ Some frictional unemployment is inevitable because the economy is always changing. ● Structural Unemployment unemployment that results when the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. ○ Structural unemployment: Q = Labor > Qd Labor. ● Job Search the process by which workers find appropriate jobs given their tastes and skills. ● Government programs facilitates job search. ○ Unemployment Insurance Spring 2016 ○ Minimumwage Laws ● Surplus of workers created by minimum wage = unemployment. ● Union a worker association that bargains with employers over wages, benefits, and working conditions. A type of cartel. ○ Raises wages and worker wellbeing. ○ Causes unemployment because of its effects on the natural equilibrium of labor supplied and demanded. ○ Workers in unions reap the benefit of collective bargaining, while workers not in unions bear some of the cost. ● Collective Bargaining a process by which unions and firms agree on the terms of employment. ● Strike an organized withdrawal of labor from a firm by a union. Can reduce production, sales, and profit. ● Efficiency Wages aboveequilibrium wages paid by firms to increase workers productivity. Increases worker health, worker quality, and worker effort while decreasing worker turnover. ○ Ex. Henry Ford, founder of Ford Motor Company. Chapter 16: The Monetary System ● Money set of assets in an economy that people regularly use to buy goods and services from other people. ○ Ex. Currency and demand deposits. ● Money is a subset of wealth. It is the only thing that can be exchanged for goods universally. ● The Functions of Money: ○ Medium of Exchange item that buyers give to sellers when they want to purchase goods and services. ○ Unit of Account yardstick people use to post prices and record debts. ○ Store of Value item that people can use to transfer purchasing power. ○ Means of Deferred Payments settling your debts with money. ○ Money eliminates the coincidence of wants! ● Commodity Money money that takes the form of a commodity with intrinsic value. ○ Ex. Gold, cigarettes, etc. ● Fiat Money money without intrinsic value. “Worthless unless otherwise used as money.” ○ Ex. The dollar bill. ● Federal Reserve The central bank of the U.S. responsible for regulating the U.S. monetary system. ● Board of Governors Spring 2016 ○ Seven members, 14year terms. ■ Appointed by the president and confirmed by the Senate. ○ The chairman ■ Directs the Fed staff. ■ Presides over board meetings. ■ Testifies regularly about Fed policy in front of congressional committees. ■ Appointed by the president by 4year (renewable) terms. ● Fed’s primary tool: openmarket operations. ○ Openmarket operations The buying and selling of U.S. government bonds. ○ The Fed does not issue bonds, only trades them! ○ Openmarket sale = decrease the money supply. ○ Openmarket purchase = increase the money supply. ● Fed’s tools for controlling the money supply: ○ Discount rate. ○ Bank lending. ○ Reserve requirements. ○ Reserve interest rate. ● The Fed does not control: ○ The amount of money that households choose to hold as deposits in banks. ○ The amount that bankers choose to lend. ● Reserves deposits that banks have received but have not loaned out. ● Reserve Requirements minimum amount of reserves that banks must hold; set by the Fed. ● The money multiplier amount of money the banking system generates with each dollar of reserves. ○ Money multiplier = wheRe R is the required reserve. ● Banks DO NOT CREATE WEALTH! ○ Though they increase supply of money, they create equal amounts of debt for those they loan to; thus an equilibrium. ● Bank Capital resources a bank’s owners have put into the institutions. Used to generate profit. ● Capital Requirement government regulation specifying a minimum amount of bank capital. Assets Liabilities Reserves Deposits Loans Debt Spring 2016 Securities Capital (Owners’ Equity) ● Assets and Liabilities must be equal! ● Leverage use of borrowed money to supplement existing funds for purposes of investment. ● The Federal Funds Rate interest rate at which banks make overnight loans to one another. ○ Fed reserve bank does not determine the federal fund rate. ○ Federal funds do not come from Fed but banks to banks. Chapter 17: Money Growth and Inflation ● Inflation increase in the overall level of prices. ○ Prices shift in order to bring money supply and money demand into balance. ● Hyperinflation extraordinarily high rate of inflation. ● Money Neutrality the proposition that changes in the money supply do not affect real variables. ○ Correct in the longrun, but not completely realistic in shortrun. ● The Inflation Tax revenue the government raises by creating (printing) money. A figurative tax on everyone . “Same effect as if they taxed you and physically took your money.” ● Fisher Effect oneofone adjustment of nominal interest rate to inflation rate. When the Fed increases the rate of money growth, longrun result of higher inflation rate, and higher nominal interest rate. ● Inflation Fallacy Many believe that “Inflation robs people of the purchasing power of his hardearned dollars.” However this is not the case because as prices go up, so do the incomes of the people. ● There are six main costs of inflation: ○ Shoeleather cost resources wasted when inflation encourages people to reduce their money holdings. ○ Menu cost the costs of changing prices. ○ Variability of relative prices the consumer disorientation caused by varying changes of price from inflation. ○ Tax liabilities taxes’ inability to change with inflation and their burden on income earned from savings as consequence. ○ Confusion and inconvenience of changing unit of account confusion caused by consumers’ inability to properly identify the real value of the unit of account. ○ Arbitrary redistribution of wealth the redistribution caused between creditors and debtors.
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