Final Exam Study Guide
Final Exam Study Guide ECON103011
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Chapter 1 • Scarcity-restricts options and demands choices, resources are limited • Opportunity cost-the price you paid/the thing you gave up in order to get something • Utility-pleasure or satisfaction • Marginal-extra • Marginal analysis-comparison of marginal benefit and marginal cost • We assume everyone acts with rational self-interest, not selfishly • Other-things-equal/ceteris paribus-the things that aren’t being studied are assumed to have no effect on the results (Pepsi example-we assume we only change the price of Pepsi, not price of Coke or taste of Pepsi etc.) • Microeconomics-the study of individual consumers, firms, or markets (ex. increase in the market of fashion) • Macroeconomics-the study of the market more generally/the entire market (ex. the unemployment of the United States) • Positive economics-economic statements that can be true or false, factual (ex. the economy fell 3 points yesterday) • Normative economics-economic statements that involve value judgment, up for debate (ex. the unemployment rate ought to be lower) • Economizing problem-the need to make choices because economic wants exceed economic means • Budget line-a schedule that shows various combinations of two products a consumer can purchase with specific income (ex. DVD’s and books) • Trade-offs-giving up purchasing one thing in order to purchase another • Economic resources-capital (machines, things that go into the production of consumer goods), entrepreneurial ability (innovative ideas, risk taking, bringing resources together), land (natural resources), and labor (manual and intellectual) • Consumer goods-goods that satisfy consumers immediately • Capital goods-goods that help grow economy, goods that help enhance production of consumer goods • Production possibility curves/tables o Law of increasing opportunity cost-as the production of a particular good increases, the opportunity cost of production of an additional unit increases (ex. additional robot is 4/ , 1/ , / , and 1 unit of pizza), you have to use less skilled resources or more scarce 3 2 materials to produce more units (resources are not interchangeable) o Economic growth-trade, additional resources, education, technology that uses resources more efficiently, shifts curve outward • Fallacy of composition-good for one person doesn’t mean good for society (ex. Google maps) • Direct/positive relationship-both variables move in the same direction • Inverse/negative relationship-two variables move in the opposite direction • Slope-rise divided by run • Y=a + bx where a is the vertical intercept and b is the slope • Slope of zero-horizontal line • Slope of infinity-vertical line Chapter 2 • Economics system-a particular set of institutional arrangements and a coordinating mechanism o Laissez-faire capitalism-government intervention is very minimal and markets and prices are allowed to direct all economic activity § Governments role is limited to protecting private property from theft and establishing a legal environment in which contracts are enforced § Believes that government intervention will lead to corruption o Command systems-governments have total control over all economic activity § Also called communism or socialism § Central planning board appointed by government makes all decisions § Government owns all businesses o Market system-a blend of laissez-faire and command system, some government intervention takes place § Mix of government initiatives and individuals seeking economic growth through their own business decisions, resulting in competition among producers § Defined by the market as the dominant force in the economy • Private property-extensive private ownership of capital, encourages investments, innovation, exchange, maintenance of property, and economic growth • Freedom of enterprise-entrepreneurs and private businesses are free to obtain and use economic resources to produce their choice of goods/services to sell them in their chosen markets • Freedom of choice-enables owners to employ or dispose of their property and money as they see fit • Self-interest-the motivating force of various economic units as they express their free choice • Competition-comes from freedom of enterprise and choice that allows the market system to function o Two or more buyers and sellers acting independently allows no single buyer or firm to dictate price o Freedom of entry or exit into industry allows for adjustments to demand • Market-institution that brings together buyers and sellers • Specialization-using resources of an individual, firm, region, or nation to produce one or a few goods/services rather than an entire range of goods/services o Division of labor-specialization makes use of different abilities, fosters learning by doing, saves time, and increases efficiency of society • Medium of exchange-makes trade easier through the use of money • Barter-swapping goods for other goods • Money-convenient social invention to facilitate exchange of goods and services • Five Fundamental Questions o Goods that continue to make profits will be produced § Profits=total revenue – total costs § Consumer sovereignty-crucial in determining the types and quantity of goods produced § Dollar votes-registry of wants of goods by consumers purchases o Goods will be produced in the most cost-efficient way § Correct mix of labor and capital § Cost of production depends on available technology and prices of resources which helps determine the technique of production o Goods will be bought by the consumers who are willing (maximum willingness-to-pay exceeds price) and able o Markets are dynamic and will adjust to changes in demand by allocating more or less resources to the good (ex. consumers desire more fruit-resources from other goods such as vegetables will switch from those goods to fruits) o Technological advances allow one firm to gain a competitive advantage and gain more profits § Creative destruction-the creation of new products and production methods completely destroy the market positions of firms that are wedded to existing products and methods (ex. cassettes to CD’s to IPods) • Dollar votes accumulated by a firm promotes firm’s capital goods which lead to economic growth • Invisible hand-the underlying competition between consumers and producers that promotes the public/social interest and balances the market system o Efficiency-forces most efficient production to lower total costs o Incentives-greater risk and effort taken by firms leads to greater profits o Freedom-market system freedom of enterprise and choice, free entry and exit into industry • Coordination problem-too difficult for command system to make the millions of decisions consumers and producers make in the market system • Incentive problem-firms in command system have no incentive to gain an edge on other firms (because there aren’t any) so technological advances lack and cost of production does not drop (similar to monopoly) • Circular flow diagram-illustrates the repetitive flow of goods/services, resources, and money for a simplified economy with no government o Households-one or more persons occupying a housing unit o Businesses-commercial establishment that attempts to earn profit by offering goods/services § Sole proprietorship-a business that is owned and managed by one person § Partnership-two or more individuals that own and manage a business with agreement on business decisions § Corporation-an independent legal entity that can acquire resources, own assets, produce and sell goods, incur debt, extend credit, and sue/be sued o Product market-the place goods/services are bought and sold o Resource market-households sell resources to businesses • Profit system-the guide for businesses to make profits • Only owners, in the market system, are liable for risk and loosing money Chapter 3 • Demand-schedule that shows the amount consumers are willing and able to purchase at a given price • Law of demand-other-things-equal, as price falls, the quantity demanded increases o Price acts as an obstacle to buyers o Law of diminishing marginal utility-an additional unit consumed has a lower marginal benefit than the previous unit consumed, consumers are willing to pay less and less for an additional unit (ex. slices of pizza) o Income effect-lower prices make you feel richer because your money goes further and you will buy additional units o Substitute effect-switching product to some other similar product that is cheaper (ex. chicken prices went down, more chicken will be bought because people will substitute chicken for steak) o Demand curve=marginal benefit curve o Only change in price can cause change in quantity demanded, movement along curve o Change in demand shifts curve • Determinants of demand-things that shift demand curve, TRIBE o Taste preference-consumers will consume more of a product if the newspaper publishes an article saying how good it is for you o Related goods § Complementary goods-goods that are used conjointly, as price of complementary goods fall, specific good demand increases § Substitute goods-goods that are used instead, as prices of substitute goods falls, demand for specific goods falls o Income § Inferior goods-cheap goods, as income falls, demand for specific good increases (ex. Raman noodles) § Normal goods-most goods, as income rises, demand for specific good increases (ex. Mercedes) o Buyers-if there is an influx of new buyers, the demand for specific good will increase (ex. baby boom increased demand for baby food) o Expectations-consumers expectations of future prices, if the expectation is that prices for homes will rises in the future, the demand for houses now will increase • Supply-schedule that shows the amount of supply producers are willing and able to produce at a specific price • Law of Supply-other-things-equal, as price rises, the quantity supplied rises o Price acts as an incentive for producers o At some point costs will rise-more production means higher cost of production o Supply curve=marginal cost curve o Prices are the only thing that changes the quantity supplied, movement along curve o Change in supply shifts curve • Determinants of supply-things that shift supply curve, ROTTEN o Resources price-increase in cost of production, decreases profit and decreases supply o Other prices goods-if the price of another good that the producers is able to produce with the same resources increases, the demand for the specific good will decrease (ex. if the price of watermelon goes up, farmers will use there land to produce watermelon instead of cucumbers) o Taxes and subsidies-taxes increase the cost of production and decrease supply, increase in subsidies (money paid to producer by government) decreases cost of production and increases supply o Technology-technological advancement makes production more efficient decreasing cost of production and increases supply o Expectations of producers-the expectation of a price increase in cars in the future will decrease the supply of cars presently o Number of sellers-an increase in the number of sellers will increase the supply • Equilibrium price-the price of a product at the point where the quantity supplied equals quantity demanded • Equilibrium quantity-the quantity of a product at the point where the quantity supplied equals quantity demanded • Production efficiency-the production of any particular good in the least costly way • Allocative efficiency-the particular mix of goods and services most highly demanded by society (occurs at equilibrium) • Surplus-excess supply, quantity supplied is greater than quantity demanded, wasting resources • Shortage-excess demand, quantity demanded is greater than quantity supplied • Complex changes o Change in supply-decreases in supply will raise prices and decrease quantity of demand o Change in demand-decreases in demand will lower prices and decrease the quantity supplied o Supply increases and demand decreases-equilibrium price will drop and the equilibrium quantity will be indeterminate o Supply decreases and demand increases-equilibrium price will raise and the equilibrium quantity will be indeterminate o Supply and demand increase-equilibrium price will be indeterminate and equilibrium quantity will raise o Supply and demand decrease-equilibrium price will be indeterminate and equilibrium quantity will drop • Price ceiling-a legal limit on the maximum price of a product, rent control, causes shortages because the price decreases and the producer’s profit goes down and causes quantity supplied decrease and quantity demanded increase • Price floor-a legal limit on the minimum price of a product, cigarettes/minimum wage, causes surplus because the price rises and the producer’s profits rise and causes quantity supplied to increase and quantity demanded to decrease Chapter 6 • Business Cycle-long-run economics growth and the short-run fluctuations in output and employment that macroeconomics focuses on • Recession-when growth is negative for a period of time (usually defined as two straight quarters of negative growth) • Real GDP/real gross domestic product-measures the value of final goods and services produced within the borders of one country during a specific period of time (usually one year) • Nominal GDP-allows economists to compare GDP from year to year and country to county by adjusting all GDP’s to one common currency of a single year (usually current year) • Unemployment-the state a person is in if he cannot currently get a job despite being willing, able, and looking for work • Inflation-an increase in the overall level of prices • Industrial Revolution gave way to the beginning of a gradual increase in the standard of living which had never before been experienced • Modern economic growth-output per person rises • Savings-occurs when a person’s income, after taxes, exceeds their spending • Investment-resources are allocated to economic growth or future output or capital goods o Financial investment-investing in stocks and bonds o Economic investment-investing in capital goods that lead to economic growth • To increase future production, country as a whole must save more for investing than it spends which leads to trade-offs of consumption goods • Households are the source of savings while banks and financial institutions are the source of investing • Macroeconomics takes into account expectations about the future • If investors are pessimistic about future returns, they will invest less which will slow future economic growth • Shocks-situations in which the expected outcome does not occur o Demand shocks-unexpected changes in demand occur o Supply shocks-unexpected changes in supply occur (ex. OPEC owning all oil companies decreases supply in order to raise prices) • Inventory-a store of output that has been produced but not yet sold • Inflexible or sticky prices-prices of certain goods that take time to change, mostly inflexible in the short-run, leading industries to change employment when demand changes (ex. most goods, newspapers, haircuts) • Flexible prices-prices of certain goods that have the ability to change quickly (ex. corn, oil, gasoline) • Inflexible prices usually occur o Consumers are more easily able to plan when prices are constant, so producers keep them steady o Companies that are losing demand could lower price in order to increase demand, but opposing companies will likely also drop prices when this occurs, which leads to a price war, which will hurt the company that first cut prices so companies will avoid price wars (ex. Pepsi and Coke) o Over time however, prices become more flexible as employees are willing to accept pay cuts • Great Recession o Caused by demand shock o Bubble over the real estate market that had a sudden boom for the first time in history (had not risen in the past 100 years) o A bubble is created when one market becomes the sources of savings (1500 tulips, 2000 housing market) o The value of people’s wealth grew from growth of value of homes and financial investments and these people took equity line credit on their homes which had an artificial value o These credits eventually were not able to be paid and people owed more money on their homes than their homes were worth and bank had to foreclose and now owned a lot of houses which lead individuals and banks to declare bankruptcy o Minsky explanation-bubble involved too many people in the real estate market o Austrian explanation-the Federal Bank set interest rates too low which promoted extending too many bad loans o Minsky solution-government involvement to stimulate government by buying bad mortgages (stimulate solution) o Austrian solution-let people and companies go bankrupt and raise interest rates and the market will correct itself (structural solution) Chapter 7 • National income accounting-the techniques used to measure the overall production of a country’s economy • GDP-defines output as a dollar value for all final goods and services produced within the borders of one country • Intermediate goods-products that are purchased for resale or further processing or manufacturing • Final goods-products that are purchased by their end users • Multiple counting-including in the GDP the value of intermediate goods as well as final goods • Value added-the market value of a firm’s output less the value of the inputs the firm has bought from others (the value a company has added to a good) • Public transfer payments-not included in GDP, government payments for welfare and social security • Private transfer payments-not included in GDP, transfer of money from one individual to another • Stock market transactions-not included in GDP, buying and selling stocks • Expenditures approach-view GDP as the sum of all the money spent in buying all the goods produced o Personal consumption expenditures-the expenditures of a household on durable and non-durable goods and services § Durable goods-products that have expected lives of three years or more (10% of PCE) § Nondurable goods-products with less than three years expected life (30% of PCE) § Services-the work done by lawyers, hair stylists, doctors, mechanics (60% of PCE) o Gross private domestic investment-all final purchases of machinery, equipment, and tools, all construction, changes in inventory, and money spent of research and development (all included in GDP) o Net private domestic investment-only investments in the form of added capital (=gross investment – depreciation) o Government purchases-expenditures for goods and services that government consumes in providing public services, expenditures for publicly own capital (schools and highways), and government expenditures on R&D o Net exports = exports – imports o GDP = personal consumption expenditures + gross private domestic investment + government purchases + exports - imports • Income approach-view GDP through understanding the income and rent of the production of all the goods o Compensation of employees-wages and income paid by business to employees o Rents-income received by households and businesses that supply property resources o Interest-money paid by private businesses to the suppliers of loans used to purchase capital o Proprietors’ income-net income of sole proprietor, partnerships, and other unincorporated businesses o Corporate profits-earnings of corporations o Taxes on production and imports-sales tax, excise tax, business property tax, license fees, and custom duties o National income-the total of all sources of private income plus government revenue from taxes on production and imports o Consumption of fixed capital-huge depreciation charge made against private and publicly owned capital each year (money lost to the “consumption” or use of capital) • Net domestic product (or national income) = GDP – consumption of fixed capital (GDP adjusted for depreciation) • Personal income-includes all income receive, whether earned or unearned • Disposable income-personal income less personal taxes • Real GDP-nominal GDP (not adjusted for inflation) adjusted to one specific year’s value of all goods o Price index-measure of the price of a specified collection of goods and services in a given year as compared to the price of an identical collection of goods and services in a reference year o Base year-the year that all prices of the collection of goods are based off of o Price index = (price of market basket for a specific year) / (price of same market basket in base year) o Real GDP = nominal GDP / price index Chapter 8 • Economic growth-an increase in real GDP or GDP per capita over some period of time • Real GDP per capita = real GDP / population • Rule of 70-provides a quantitative grasp of the effect of economic growth o Approximate numbers of years required to double GDP = 70 / annual percentage rate of growth • Growth has lead to improved goods and services, added leisure, and has had effects on the environment and quality of life • Modern economic growth-sustained ongoing increases in living standards that can cause dramatic increases in the stand of living within less than a single human lifetime, brought about by the industrial revolution in the 1900’s • Leader countries-countries that develop and use the most advanced technology • Follower countries-countries that use advanced technology that was developed by leader countries • Industrial structures that promote modern economic growth o Strong property rights o Patents and copyrights o Efficient financial institutions o Literacy and widespread education o Free trade o Competitive market system • Supply factors-increases in the quantity and quality of natural and human resources, increases in supply of capital goods, and improvements in technology • Demand factor-to actually achieve higher production potential created when the supply factors increase of improve, households, businesses, and the government must also expand their purchases of goods and services so as to provide a market for all the new output that can potentially be produced • Efficiency factor-to reach its full production potential, an economy must achieve economic efficiency as well as full employment • Labor productivity-measured as real output per hour of work, total output divided quantity of labor employed to produce it • Labor-force participation rate-the percentage of the working-age population actually in the labor force • Growth accounting-the bookkeeping of the supply side elements such as productivity and labor inputs that contribute to changes in real GDP over some specific period of time o Technological advance-accounts for 40% of productivity growth, innovative as well as managerial advances o Growth of capital-30% of productivity growth, includes infrastructure (highways and bridges, public transit systems, wastewater treatment facilities, water systems, airports, educational facilities, and so on) o Education and training-15% of productivity growth, includes human capital (the knowledge and skills that make a person more productive) o Economies of scale and resource allocation-15% of productivity growth • Information technology-new and more efficient ways of delivering and receiving information through the use of computers, WiFi, wireless phones, and the Internet • Start-up firm-a firm focused on creating and introducing a particular new product or employing a specific new production or distribution method • Increasing returns-a situation in which a given percentage increase in the amount of inputs a firm uses leads to an even larger percentage increase in the amount of output the firm produces • Network effect-the idea that each new product sold has an increased value (ex. cell phones and the Internet) • Learning by doing-perfecting new production techniques Chapter 9 • Business cycle-recurring increases and decreases on the level of economic activity over periods of years o Peak-the point in the business cycle at which business activity has reached a temporary maximum, the point at which the recession begins o Recession-a period of declining real GDP, accompanied by real income and higher unemployment o Trough-the point in a business cycle at which business activity has reached a temporary minimum, the point at which expansion begins o Expansion-the phase in the business cycle in which real GDP, income, and employment rises • Reasons for fluctuations in real GDP o Irregular innovations-new innovations expand the market while they are being introduced, but lead to a decline after they are fully introduced into the market o Productivity changes-output per unit of input increases leads to expansion in real GDP but lack of increases leads to decline in real GDP o Monetary factors-nation’s central banking system can alter real GDP with increase or decrease of circulating money o Political events-government policies can cause shocks to real GDP o Financial instability-bubbles or bursts can affect real GDP • Durable goods-goods that last more than three years, most affected by business cycle (ex. cars, computers, fridges, household appliances) • Non-durable goods-goods that last less than three years, somewhat insulated from the effects of recession and expansion • Labor force-persons 16 years of age and older who are not in institutions and who are employed or are unemployed and seeking work • Unemployment rate-the percentage of the labor force that is unemployed at any time (unemployed/labor force X 100%) o Part-time employment is labeled as employed even if they want to be full-time o Discouraged workers-employees who have left the labor force because they have not been able to find employment (not included in the labor force and thus makes the unemployment rate seem lower) • Frictional unemployment-a type of unemployment caused by workers voluntarily changing jobs and by temporary layoffs; unemployed workers between jobs (sometimes lasts longer due to benefits of unemployment checks) • Structural unemployment-unemployment of workers whose skills are not demanded by employers, who lack sufficient skill to obtain jobs, or who cannot easily move to locations where jobs are available (more long-term unemployment) • Cyclical unemployment-a type of unemployment caused by insufficient total spending and which typically begins in the recession phase of the business cycle • Full-employment rate of unemployment-the unemployment rate at which there is no cyclical unemployment of the labor force, between 5 and 6 percent in the US because structural and frictional unemployment are impossible to avoid • Natural rate of unemployment-the full-employment rate of unemployment; the unemployment rate occurring when there is no cyclical unemployment and the economy is achieving its full potential output • Potential output-the real GDP an economy can produce when it fully employs its available resources • GDP gap-actual GDP minus potential output, can be positive or negative • Okun’s Law-the generalization that any 1-percentage point rise in the unemployment rate above the full-employment rate of unemployment is associated with a rise in the negative GDP gap by 2 percent of potential output (in 2009 unemployment rate was 4.3% above 5% natural rate and the economy gave up 8.6% of real GDP) • Inflation-a rise in the general level of prices in an economy, each dollar will buy fewer goods and services • Consumer price index-an index that measures the prices of a fixed “market basket” of 300+ goods and services bought by a typical consumer (CPI=price of designated year’s market basket/price estimate of base year’s market basket X 100%) • Deflation-a decline in the general level of prices in an economy • Rate of inflation=(price of market basket in recent year – price of market basket in base year)/price of market basket in base year X 100% • Demand-pull inflation-increases in the price levels resulting from increases in aggregate demand, excess demand drives up the prices of limited output • Cost-push inflation-increases in price levels resulting from an increase in resource costs and per-unit production costs • Government has different strategies to balance the effects of inflation based on whether the cause of inflation is demand-pulling or cost-pushing • Core inflation-the underlying increases in price level after volatile food and energy prices are removed • Nominal income-the number of dollars received by an individual or group for its resources during some period of time • Real income-the amount of goods and services that can be purchased with nominal income during some period of time, adjusted for inflation (=nominal income/price index in hundredths) • Unanticipated inflation-an increase in the price level at a rate greater than expected (government wants inflation rate at 2% per year) o People who receive fixed incomes are hurt by large inflation o People who save see their savings become less effective with large inflation (Germany after WWI) o Lenders see their loans become worthless as inflation rates increase • Cost-of-living adjustments-union workers have built-in adjustments to their income if inflation rates increase significantly • Real interest rates-the interest rate expressed in dollars of constant value (adjusted for inflation) and equal to the nominal interest rate less the expected rate of inflation • Nominal interest rate-the interest rate expressed in terms of annual amounts currently charged for interest and not adjusted for inflation • Hyperinflation-a very rapid rise in the price level; an extremely high rate of inflation (Germany after WWI) Chapter 10 • 45 degree reference line-two dimensional graph that illustrates all the points where consumption equal disposable income where savings equals 0, graphed on the same plot as actual consumption vs. disposable income, the difference between actual and reference line equals savings • Consumption schedule-a table of numbers showing the amounts households plan to spend for consumer goods at different levels of disposable income • Saving schedule-a table of numbers that shows the amounts households plan to save at different levels of disposable incomes • Break-even income-the level of disposable income at which households plan to spend all their disposable income and save none • Average propensity to consume (APC)=consumption/income • Average propensity to save (APS)=saving/income • APS + APC = 1 • Marginal propensity to consume (MPC)=∆ in consumption/∆ in income • Marginal propensity to save (MPS)=∆ in savings/∆ in income • Non-income determinants of consumption and savings o Wealth effect-the tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls o Borrowing increases consumption spending beyond what’s possible without loans, makes incomes go further o Expectations can affect consumption spending (ex. expectations that the prices of fridges will increase will increase current consumption spending) o Real interest rates-when rates are lower, households will save less and spend more on consumption goods and borrow more o Increases in taxes decrease disposable income while not changing real GDP • Expected rate of return=(net profit from capital goods – cost of capital good)/cost of capital good o Interest rates can decrease profits from investment in capital o Inflation can decrease the effectiveness of the money borrowed (ex. rate of return=10%, interest rates=15%, and inflation=10%, the investment is still profitable because interest rate – inflation 5% is less than rate of return 10% à profit from the capital investment- 5% return) • Investment demand curve-a curve that shows the amount of investment demanded by an economy at a series of real interest rates • Shifts in investment demand curve o When cost of maintenance of capital goods increase, the expected rate of return decreases and investment demand curve shifts left o As business taxes increases, investment demand curve shifts left o Improvements in technology and production efficiency shifts investment demand curve right o When the economy is overstocked with production facilities and excess inventory, the investment demand curve shifts left as the expected rate of return decreases o If firms plan to increase their inventories, the investment demand curve shifts right o If executives are optimistic about future sales and production, the investment demand curve shifts right o Investments is the most volatile spending o Expectations can quickly change and alter investment spending o Capital goods can be used longer than expected and older equipment can be fixed to lengthen its lifespan o Innovations are inconsistent and alter profits which alter investment spending o Profits can quickly change and alter the investment spending • Multiplier-the ratio of a change in equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand (=∆ in real GDP/initial ∆ in spending) o Initial change in spending (usually by government) will set off a spending chain throughout the economy that will grow the real GDP rapidly o Example-government spends $5 billion and goes to profits, wages, etc à multiply by propensity to consume (0.75) and $3.75 billion is spent à repeat multiplying by 0.75 and $2.81 billion is spent à $20 billion increase in real GDP ($15 billion spent and $5 billion saved) o Multiplier=1/(1-MPC) o Multiplier=1/(MPS) o Increase in real GDP is not actually that large because some consumption is spent on imports and to pay additional taxes o Increase in real GDP can be less than calculated because inflation can occur and decrease the effects of government stimulus (increases in spending can lead to inflation) o Actual multiplier is in reality much lower than the calculated multipliers Chapter 11 • Planned investment-the amount firms plans to invest • Investment schedule-a table of numbers that shows the amount firms plan to invest at various possible values of real GDP (assumption is that investment is constant) • Investment only changes with expected rate of returns and stays constant over changes in real GDP (greater rate of real interest rates or rate of returns the greater the investments) • Aggregate expenditures schedule-a table of numbers showing the total amount spend on final goods and final services at different levels of real GDP (=Consumption + investment) • Equilibrium GDP occurs when C + I g GDP = aggregate expenditures o When equilibrium is not met and aggregate expenditures is less than GDP, inventory would increase by the difference (output is greater than consumption) o If GDP is less than aggregate expenditures, inventory would decrease by the difference and it would be considered unplanned investment (output is less than consumption) o Graphical approach-equilibrium occurs when aggregate expenditures intersects the 45- degree line on the real GDP vs. aggregate expenditures graph • Leakage-withdrawal of potential spending from the income-expenditures stream via savings, tax payments or imports, a withdrawal that reduces the lending potential of the banking system, leads to a decline in total output because GDP is greater than consumption • Injection-an addition of spending to the income-expenditures stream, a potential replacement for leakage o If injection is greater than leakage, then consumption will be greater than GDP • Unplanned changes in inventories-changes in inventories that firms did not anticipate, changes that occur because unexpected increases/decreases in consumption, failure of spending to match output therefore firms add/remove to/from their inventory • Multiplier = ∆ in output (or GDP) / ∆ in investment (resulting from a change in the rate of return of real interest rate) • Net exports = exports – imports o Exports will have similar effects as an increase in investment, increases/decreases equilibrium GDP by the net export times the multiplier o ∆ in equilibrium GDP = net export X multiplier • Tariffs can be put in place to increase GDP by suppressing imports, however this leads to retaliation by other countries putting tariffs on our exports leading to minimal change • Government purchases must be accounted for when looking at equilibrium GDP and must be subjected to the multiplier similarly to net exports and changes in investment • Equilibrium GDP o GDP = aggregate expenditures = consumption + investment spending + net exports + government purchases = C +aI g X n G o Consumption = GDP – taxes – savings = disposable income – savings • Lump-sum tax-a tax that collects a constant amount (the tax revenue of government is the same) at all levels of GDP • Recessionary expenditure gap-the amount by which the aggregate expenditures schedule must shift upward to increase real GDP to its full-employment, noninflationary level o Keynes’ solution-increase government spending, a $5 increase in G can increase GDP by $20 because of the multiplier (X4) • Inflationary expenditure gap-the amount by which the aggregate expenditures schedule must shift downward to decrease the nominal GDP to its full-employment noninflationary level Chapter 12 • Aggregate demand-a schedule or curve that shows the total quantity of goods and services that would be demanded at various price levels (as the price level decreases, real GDP increases, inverse relationship) o Real balance effect-the tendency for increases in the price level to lower the real value (or purchasing power) of financial assets with fixed money value and as a result to reduce total spending and real output and conversely for decreases in price level (higher price level means your money doesn’t go as far and is less effective and therefore you won’t purchase as much) o Interest-rate effect-the tendency for increases in price levels to increase the demand for money, raise interest rates, and as a result reduce total spending and real output in the economy (increases the interest rates, increases the demand for money and since there is only so much money, real output demanded falls) o Foreign purchases effect-the inverse relationship between net exports of an economy and its price level relative to foreign price levels (as the price level rises and the exchange rate stays constant foreigners will buy less of our exports) • Determinants of aggregate demand-factors such as consumption spending, investment, government spending, and net exports that if they change shift the aggregate demand curve o Consumer spending-if consumers decide to buy more at each level of output curve will shift right § Consumer wealth-sudden increases in the perceptions of people’s wealth leads to a shift right (housing market increase, stock market boom) § Household borrowing-as households borrow more money spending increases, as savings increase to pay off debt spending decreases § Consumer expectations-expectations about future real income affects spending § Personal taxes-a decrease in taxes increase disposable income and increases spending o Investment spending-a decline in investment spending will shift the aggregate demand curve to the left § Real interest rates-an increase in the money supply lowers the interest rates and increases investment spending shifting aggregate demand right § Expected returns-lower expected returns decreases investment spending o Government spending-increases in government spending will shift curve right o Net export spending-increases in exports shifts aggregate demand curve right § National income abroad-when incomes of other countries increase they spend more and buy more of US exports shifting curve right § Exchange rates-when the rate of exchange from euros to dollars decreases (more dollars per euro) the dollar can go further for foreigners and exports will increase shifting curve to the right • Aggregate supply-a schedule or curve showing the total quantity of goods and services that would be supplied (produced) at various price levels o Immediate-short-run aggregate supply curve-an aggregate curve for which real output, but not price level, changes when the aggregate demand curve shifts; a horizontal aggregate supply curve that implies an inflexible price level o Short-run aggregate supply curve-an aggregate supply curve relevant to a time period in which input prices (particularly nominal wages) do not change in response to changes in price level (up-sloping curve with increasing slope because above full-employment per- unit production cost greatly increases) o Long-run aggregate supply-the aggregate supply curve associated with a time period in which input prices (especially nominal wages) are fully responsive to changes in price level, real GDP does not change on the price level changes • Determinants of aggregate supply-factors such as input prices, productivity, and the legal- institutional environment that, if they change, shift the aggregate supply curve o Input prices § Domestic resource prices-increases in wages shift the curve left § Prices of imported resources-decreased prices in US imported resources shifts the curve right o Productivity = total output / total inputs § Per-unit production cost = total input cost / total output § A decrease in per-unit cost/productivity shifts the curve right o Legal institutional environment § Business taxes and subsidies-as taxes increase the productivity decreases and the curve shifts left § Government regulation-more regulation leads to more costs and shifts curve left • Equilibrium price level-the price at which aggregate demand equals aggregate supply, the price level at which the two lines intersect and this corresponds to a specific equilibrium real output • Changes in equilibrium o Increases in AD: demand-pull inflation-equilibrium price level and output are higher o Decreases in AD: recession and cyclical unemployment-equilibrium output is decreased while price levels tend to stay constant § Fear of price war § Menu costs-the reluctance of firms to cut prices during recessions (that they think will be short-lived) because of the costs of altering and communicating their prices reductions (named after cost of printing new menus at restaurants to displaying changing prices) § Wage contracts-cutting prices only leads to increases in revenue if wages are cut too and contracts keep wages steady § Efficiency wages-an above-market wage that minimizes wage costs per unit of output by encouraging greater effort or reducing turnover, and thus decreases wages leads to a lowering of productivity § Minimum wages-firms cannot lower prices lower than minimum wage o Decreases in AS: cost-push inflation-equilibrium price level is increased while real output is decreased o Increases in AS: full-employment with price-level stability Chapter 13 • Fiscal policy-changes in government spending and tax collections designed to achieve full employment, price stability, and economic growth • Council of Economic Advisors (CEA)- a group of three persons that advises and assists the president of the US on economic matters • Expansionary fiscal policy-an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output o Budget deficit-the amount by which expenditures exceed revenues in any year o Increases in government spending experience the multiplier effect and a $5 increase in government spending can make up the $20 GDP gap o Personal tax cuts also go through the multiplier but more tax cuts must be implemented than government spending because some money cut from taxes is saved o Tax cuts and government can be used together to make reach equilibrium • Contractionary fiscal policy-a decrease in government purchases of goods and services, an increase in net taxes, or some combination for the purpose of decreasing aggregate demand and thus controlling inflation o Budget surplus-the amount by which the revenue of the federal government exceeds its expenditures in any year, caused by demand-pull inflation o Once a new price level is established, it will not move so the equilibrium GDP has to be shift to have the demand meet the higher price level at the GDP wanted o Book example-taxes must be increased or spending must decrease by $3 billion in order to get GDP back to $510 billion • Built-in stabilizer-a mechanism that increases government’s budget deficit (or reduces surplus) during a recession and increases government’s budget surplus (or reduces deficit) during an expansion without any action by policy makers (tax system) o Progressive tax-a tax for which the average tax rate rises with GDP o Proportional tax-a tax for which the average tax rate remains constant as GDP rises or falls o Regressive tax-a tax for which the average tax falls as GDP rises o The more the progressive the tax system, the greater the economy’s stability • Cyclically adjusted budget-the estimated annual budget deficit or surplus that would occur under existing tax rates and government spending levels if the economy were to operate at its full employment level of GDP for a year (compares actual government expenditures with the tax revenues that would have occurred if the economy had achieved full-employment GDP) • Cyclical deficit-deficit that occurs from a recession, not fiscal policies put in place by government (cyclical adjusted budget equals zero) • 2003 Bush cut taxes which increased output and employment • 2008 Congress pushed an economic stimulus package which cut taxes and delivered checks to taxpayers which lead to a jump in the federal budget (many people saved this money instead of spending it or paid off loans) • 2009 Congress used more money to stimulate economy with increased government spending • Problems of timing o Recognition lag-the delay between the time the beginning of the recession/depression and the time it takes to see there is a problem o Administrative lag-the time it takes for the administration to take action and implement solutions o Operational lag-the time it takes for the implemented solutions to take affect • Political business cycle-fluctuations in the economy caused by the alleged tendency of Congress to destabilize the economy reducing taxes and increasing government expenditures before elections and to raise taxes and lower expenditures after elections • Crowding-out effect-a rise in interest rates and a resulting decrease in planned investment caused by the federal government’s increased borrowing to finance budget deficits and refinance debts • Public debt-the total amount owned by the federal government to the owners of government securities, equal to the sum of past government budget deficits less government budget surpluses • US government securities-US treasury bills, notes, and bonds used to finance budget deficits, the component of the public debt • Federal debt held by the public as a percentage of GDP in 2012 is 70% • Because 67% of the public debt is owned by Americans to minimize the debt Americans would have to pay higher taxes to give back to those Americans holding the debt o This would redistribute wealth from lower and middle class to wealthy groups increasing the income distribution • External public debt-the portion of the public debt owed to foreign citizens, firms, and institutions • Public investments-government expenditures on public capital (such as roads, highways, bridges, etc.) and on human capital (such as education, training, and health) Chapter 14 • Medium of exchange-any item sellers generally accept and buyers generally use to pay for a good or service • Unit of account-a standard unit in which prices can be stated and the value of goods and services can be compared • Store of value-an asset set aside for future use • Liquidity-the degree to which an asset can be converted quickly into cash with little or no loss of purchasing power • M1 Money-makes up 24% of total money supply (comprised of currency and checkable deposits) o Federal Reserve notes-paper money issued by the Federal Reserve Banks o Token money-bills or coins for which the amount printed on the currency bears no relationship to the value of the paper or metal embodied within it; for currency still circulating, money for which the face value exceeds the commodity value o Checkable deposits-any deposit in a commercial bank or thrift institution against which a check may be written § Commercial banks-a firm that engages in the business of banking (accepts deposits, offers checking accounts, and makes loans) § Thrift institution-a savings and loan association, mutual savings bank, or credit union • M2 Money-makes up all total money supply (includes M1 money and near money-certain highly liquid financial assets that do not function directly or fully as medium of exchange but can be readily converted into currency or checkable deposits) o Savings account-a deposit in a commercial bank or thrift institution on which interest payments are received o Money market deposit accounts (MMDA)-interest-bearing accounts offered by commercial banks and thrift institutions that invest deposited funds into a variety of short-term securities o Time deposit-an interest-earning deposit in a commercial bank or thrift institution that the depositor can withdraw without penalty after the end of a specific period of time o Money market mutual fund (MMMF)-mutual funds that invest in short-term securities o M2 money=M1 + savings deposits, including MMDA + small-denominated time deposits + MMMF’s held by individuals • Paper currency is debt held by the government and checkable deposits are debt held by commercial banks and thrift institutions • Value of Money o Legal tender-any form of currency that by law must be accepted by creditors (lenders) for the settlement of financial debt o Money’s value is derived from the supply and demand curve for the money issued by the government and the purchasing power of the money is dependent on the combination of those two • Dollar value of money = 1 / the price level (if the price level rises the dollar value of money increases and the purchasing power increases) • Federal Reserve System-the US central bank, consisting of the Board of Governors of the Federal Reserve and the 12 Federal Reserve Banks, which controls the lending activity of the nation’s national bank and thrifts and thus the money supply o Board of Governors-the seven-member group that supervises and controls the money and banking system of the US o Federal Reserve Banks-the 12 banks chartered by the US government that collectively acts as the central bank of the US. They set monetary policy and regulate the private banking system under direction of the Board of Governors and the Federal Open Market Committee (quasi-public banks owned by private commercial banks but operate on the instruction of the government) o Federal Open Market Committee-the 12-member group within the Federal Reserve System that decides US monetary policy and how it is executed through open-market operations • Fed functions, responsibilities, and independence o Issuing currency, setting reserve requirements and holding reserves (deciding on how much money is in circulation and how much must be held), lending to financial institutions in case of emergency (2008 crisis), providing for check collections (adjusts two banks money balance when checks are exchanged), fiscal agent (manages money brought in and spent my government), supervising banks, and controlling money supply (influence interest rates) o Federal Reserve was set up to be independent from political unrest and constantly changing policies • 2007 and 2008 crisis o Subprime mortgage loans-high-interest-rate loans to home buyers with above-average credit (mortgage lenders sold these loans to investment companies and when the mortgages went bad many investment companies could not repay their loans they had taken to buy the bad mortgages) o Mortgage-backed securities-bonds that represent claims to all or part of the monthly mortgage payments from the pools of mortgage loans made by leaders to borrowers to help them purchase residential property (the lenders sold hundreds of these bundled mortgages as bonds and made a lump sum while others collected mortgage payments for their investment and then lenders took the money and invested in companies that bought the mortgage-backed securities and were hit hard when mortgages went bad) o Securitization-the process of aggregating many individual debts, such as mortgages or student loans, into a pool and then issuing new securities (typically bonds) backed by the pool. The holders of the new securities are entitled to receive debt payments made in the individual financial debts in the pool (thought this was safe as it shed risk) o AIG then backed/insured the securitization (bonds that were bundles of bad mortgages) o Failures-the mortgages that was underlying all these bonds and bundles and insurances went bad à Countrywide, Washington Mutual bank, and Wachovia bank had to be bought out à Merrill Lynch lost more in two years than it had made in the past decade (it had bought some of the bad loans in bundles from the lenders) and Lehman Brothers, Goldman Sachs, Morgan Stanley, along with others suffered great loses à AIG suffered great loses because it had not set aside enough money to account for all the loses and could back their insurance claims that came from the failed mortgage bundles it had insured • Response to the Great Recession o Troubled Asset Relief Program (TARP)-a 2008 federal government program that authorized the US Treasury to loan up to $700 billion to critical financial institutions and other US firms that were in extreme financial trouble and therefore at high risk of failure (saved many financial institutions that would have caused a great ripple effect if they had failed) o Moral hazard-the possibility that individuals or institutions will change their behavior as the result of a contract or agreement (a bank may make riskier loans when they know their loans are insured or backed and they are prone to great lose) o As a last resort, the Fed is responsible for giving an influx of currency and lending to failing system to keep them afloat • Post Great Recession o Financial services industry-the broad category of firms that provide financial products and services to help households and businesses earn interest, receive dividends, obtain capital gains, insure against losses, and plan for retirement. Includes commercial banks, thrift institutions, insurance companies, mutual fund companies, pension funds, investment banks, and security firms o Before the 2007, the banks were becoming fewer and larger, consolidating o Wall Street Reform and Consumer Protection Act of 2010-the law that gave authority to the Fed to regulate all large financial institutions, created an oversight council to look for growing risk to the financial system, establishing a process for the federal government to sell off assets of large failing financial institutions, provided federal regulatory oversight of asset-backed securities, and created a financial consumer protection bureau within the Fed Chapter 15 • Fractional reserve banking system-a system in which commercial banks and thrift institutions hold less than 100 percent of their checkable-deposit liabilities as reserves of currency held in bank vaults or as deposits at the central bank • Goldsmith receipts were the first form of paper money and realized that they could give out more receipts than the gold they held • Balance sheet-a statement of assets, liabilities, and net worth of a firm or individual at some given time • Vault cash-cash held by the bank in vaults and cash drawers • Required reserves-the funds that each commercial bank and thrift institutions must deposit with its local Federal Reserve Bank to meet the legal reserve requirement; a fixed percentage of each bank’s checkable deposits • Reserve ratio-the fraction of checkable deposits that each commercial bank must hold as reserves at its local Federal Reserve Bank or in its own bank vault (=commercial bank’s required reserves / commercial bank’s checkable-deposit liabilities) • In 2008, the Fed began paying banks interest on reserves in order to keep the banks from making bad investments • Excess reserves-the amount by which a commercial bank’s actual reserves exceed its required reserves (=actual reserves – required reserves) • Assets=reserves and liabilities=checkable deposits • When a check is exchanged from one bank to another, it is sent the the Federal Reserve Bank and the reserves of each bank are changed by the amount of the check • A loan can be made up to the amount of excess reserves, but not greater • A loan creates checkable deposits, and when the loan is spent to another bank, the reserves of the first bank decrease along with its checkable deposits • A loan creates money and the money is destroyed when the loan is repaid • A security (public bond bought by banks) work the same as loans • Two goals of banks o Profit-banks loan money and buy securities in order to increase profit from interest o Liquidity/safety-must find a compromise between assets that earn higher returns and liquid assets that earn no returns o Banks can lend other banks overnight money that give decent returns but a liquid o Federal funds rate-the interest that US banks and other depository institutions charge one another on overnight loans made out of their excess reserves • Multiple-deposits expansion-an initial checkable deposit placed in one can is lent to a second bank after subtracting 20% for required reserves and then to a third and fourth and so on, an initial investment of $100 creates an initial loan of $80 which through all the banks creates $400 in extra money (100/20=multiplier=5 which is multiplied by $80 to get final amount loaned or amount of money created=$400) • Money multiplier=1/required reserve ratio • Maximum checkable-deposit creation=excess reserves X monetary multiplier Chapter 16 • Monetary policy-a central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price-level stability, full employment, and economic growth • Transactions demand for money-the amount of money people want to hold for use as a medium of exchange (to make payments); varies directly with nominal GDP • The larger the total money value of goods and services exchanged in the economy, the larger the amount of money needed to negotiate those transactions • Asset demand for money-the total amount of money people want to hold as a store of value; this amount varies inversely with the interest rate • Total demand for money=transaction demand for money plus asset demand for money • Equilibrium interest rate-the point at which the total money demanded (D =D + D ) equals m t a supply of money (an increase in the supply of money will lower the interest rate) • Bond prices fall when the interest rates rise (in order to keep the pay out the same the amount invest must change to accommodate the changing interest rate) • Open-market operations-the purchases and sales of US government securities that the Fed undertakes in order to influence interest rates and the money supply; one method by which the Fed implements monetary policy • Purchasing bonds by Fed from commercial banks o Securities of the Fed increase (assets) and the reserves of the commercial banks increase (liabilities for Fed) o Securities of the commercial banks decreases (assets) and the reserves of the commercial banks increase (asset for commercial banks) no net asset change but excess reserves are created o The excess reserves are lent out and go through multiplier effect to become $4000 in bank system lending and $1000 in increased reserves in the banking system ($5000 is the total increase in the money supply) o Money is created from Fed buying securities from the commercial banks o The opposite effect occurs when the Fed sells securities to commercial banks and a $1000
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