EC202 Final Study Guide
EC202 Final Study Guide EC 202
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Econ 202 Final Study Guide Final is on Wednesday, June 8th: 10:15am in PLC 180 Supply and Demand Supply ● Supply curve: relationship between the price of a good and the quantity supplied of that good ● Law of Supply: price and quantity supplied and positively related Demand ● Demand curve: relationship between the price of a good and the quantity demanded of that good ● Law of Demand: price and quantity demanded and negatively related Equilibrium ● Occurs when the price level is such that the quantity demanded is equal to the quantity supplied (when the demand curve crosses the supply curve) 3 Main Macroeconomic Variables ● Output (GDP, industrial production, etc.) ● Prices (CPI, PCE, etc.) ● Employment (# of people employed, # of hours worked) Growth Rate ● Percentage change in a variable Alternate form to think of GDP (Gross Domestic Product) GDP ● The market value of all final goods and services produced in a country in a given time period ● AKA aggregate output or aggregate income Calculating GDP (expenditure approach): Add up all the things that are purchased minus the imports that weren’t made in the country (GDP=C+I+G+XM) ○ Things that are purchased: ■ Cconsumption by households (buying goods) ■ Iinvestment by firms (factory upgrade) ■ Ggovernment spending (public defense) ■ Xexports to other countries (making goods in the country and selling them to another country) ■ Mimports from other countries (buying goods made in another country) ● “All sales income has to end up in someone’s pocket eventually” Measuring Economic Performance Recession vs. Expansion ● Recession: a period in which real GDP decreases. ○ The growth rate is negative for at least two successive periods ○ Recession lasts from the peak to the trough ● Expansion: a period during in which real GDP increases. ○ This is the entire time from a trough (lowest point) to a peak (highest point) ● Turning point: when an economy hits the trough or peak, we say that it has reached a turning point. Prices ● The price level is the average level of prices and the value of money ● A persistently rising level is calleinflatio (positive growth). ● A persistently falling price level is calldeflation (negative growth). Consumer Price Index (CPI) ● The CPI measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services ○ They are used for the purposes of comparison across time ○ The values of two different indexes cannot be compared ○ The values of a price index are not in terms of dollar(there are NO units) ○ An index is defined to equal 100 in threference base period ○ The reference base period could in theory be any period ● Biases in the CPI: the CPI might overstate the true inflation rate for four reasons: ○ New goods: new types of goods are often more expensive than comparable goods (i.e. computers vs. typewriters) ○ Quality change: some goods improve their quality over time and should be more expensive (2016 TV vs. 1950 TV) ○ Commodity substitution: people substitute away from more expensive goods, keeping the price of the bundle low ○ Outlet substitution: people substitute away from more expensive stores, keeping the price of their bundle low Nominal vs. Real ● Nominal values are influenced by inflatio and real values are NOT Nominal Real Variable is a variable in terms of the is a variable in terms of the prices in the current year prices in a ommon base year (we will be focusing on “real” because it is more accurate to view inflation and such) GDP is the value of goods and is the value of final goods services produced during a and services produced in a given year when valued at given year valued at the prices that prevailed in that the prices of a reference base year same year Wages Wages valued at the prices Wages valued at the prices that prevailed in that same of a reference base year year Inflation Rate ● the percentage change in the price level from one year to the next ● Core inflation: is the CPI inflation rate excluding the volatile elements (of food and fuel) Alternate form to think of Employment/Unemployment Definitions: ● Employed: those who have a job ● Unemployed: those who do not have a job, but would like to have one ● Labor force: those who want to work, whether or not they have a job (employed + unemployed) ● Out of labor force: those who do not have a job, and do not want one, but could have one ● Young and institutionalized: those who cannot work (the young and the elderly) Types of Unemployment ● Frictional: unemployment that arises from normal labor market turnover ● Structural: is unemployment created by changes in technology and foreign competition that change the skills needed to perform jobs or the location of jobs (there’s no way to avoid this) ● Cyclical: is the higher than normal unemployment at a business cycle trough and lower than normal unemployment at a business cycle peak. ● Natural unemployment = frictional + structural ○ The natural unemployment rate is natural unemployment as a percentage of the labor force Full employment ● Full employment is defined as the situation in which the unemployment rate equals the natural unemployment rate (when cyclical is at 0) *this is great! Equations ● Unemployment rate: the percent of the labor force that is unemployed ● The employmenttopopulation ratio: the percentage of the workingage population who have jobs ● The labor force participation rate: the percentage of the workingage population who are members of the labor force Unemployment & Output ● Potential GDP is the quantity of real GDP produced at full employment ● Real GDP minus potential GDP is the output gap ○ Output gap= Real GDPPotential GDP ● The output gap is positiv during expansions, and negative during recessions. Economic Growth ● Economic growth : the sustained expansion of production possibilities measured as the increase in real GDP over a given period Rule of 70 ● The rule of 70 states that the number of years it takes for the level of a variable to double approximately 70 divided by the annual percentage growth rate of the variable Potential GDP ● Potential GDP : the sustainable level of output an economy can produce ● is defined to be the level of real GDP that is achieved when the economy is operating at full employment Labor Productivity ● Amount of additional output created by an additional hour of work Growth ● Increase in capital ● Increase in education ● Increase in technology ● Effect of an increase in labor productivity on potential GDP ○ There is a shift in the production function upwards ○ This directly increases potential GDP ○ Because productivity is higher, the labor demand curve shifts to the right ○ The shift in labor demand increases equilibrium real wage and the full employment level of hours worked ○ The increase in labor further increases potential GDP Theories of Growth ● Classical: the view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level. ○ Prediction: growth will eventually stop, and individual standards of living will eventually fall back to subsistence. ● Neoclassical (Solo model): the view that real GDP per person grows because of increases physical capital per person ■ Because there are diminishing returns to capital, eventually capital per person stops growing. ■ At that point the economy no longer grows, but it also does not fall back to subsistence. ○ Prediction: growth will eventually stop, individual standards of living will not fall ● New: holds that real GDP per person grows because: ■ People continually innovate produce new technologies and increases profits ■ Technological improvements are a public good (can be enjoyed by everyone) ■ Knowledge is notubject to diminishing returns ○ Prediction: growth can potentially continue forever, and individual standards of living will continue to rise Finance, Saving, and Investment Definitions ● Income: the quantity of wage and other income that people receive per unit time ● Wealth: the value of all the things that people own at a given time ● Saving: the amount of income that is not paid in taxes or spent on consumption goods and services, per unit time ● Interest: price of borrowing money ● Gross Investment ○ Investment: specifically means the purchase of physical capital by firms ○ The total quantity of physical capital purchased by firms in a year ○ As firms invest, labor productivity increases ● Depreciation ○ Whereas investment increases the level of physical capital, we also know that over time physical capital can break or become obsolete ○ This general reduction in the level of physical capital isdepreciation ● Net Investment ○ The overall change in the quantity of physical capital when taking into account both gross investment and depreciation ○ Net investment=gross investment depreciation Financial Assets ● Financial Asset : an exchange of funds between a lender and a borrower along with a contract for repayment, potentially including interest ● The price of a financial asset is the amount that is loaned, and the return is the amount that needs to be repaid: ○ return=price + interest ● The interest rate is the growth rate of your principal ● Nominal Interest Rate ○ The interest expressed as a percentage of the loan amount ● Real Interest Rate ○ The nominal interest rate adjusted to remove the effects of inflation ○ Real interest rate = nominal interest rateinflation rate Market for Loanable Funds ● The market for loanable funds is the aggregate of all the individual financial markets ● Demand for Loanable funds: the demand for loanable funds is the relationship between the quantity of loanable funds demanded (by firms, for investment) and the real interest rate. ○ The quantity of loanable funds demanded depends on ■ The real interest rate ■ Expected profit ○ The effect of real interest rates on demand for loanable funds: ■ When the real interest rate is higher, it is more costly to borrow money. ■ Thus the quantity of loanable funds demanded falls (and viceversa). ■ This is a movement along the demand curve. ○ The effect of increased expected profits on demand for loanable funds: ■ When expected profit is higher, firms will want to invest more at any real interest rate ■ When firms want to invest more, their demand for loanable funds increases ■ This shifts the demand curve to the right ● Supply of Loanable Funds: the relationship between the quantity of loanable funds supplied (by individuals) and the real interest rate ○ The quantity of loanable funds depends on: ■ The real interest rate ■ Disposable income ■ Expected future income ■ Wealth ■ Default risk ○ Effect of real interest rates on the supply of loanable funds: ■ When the real interest rate is higher, lenders receive more interest for each loan. ■ Thus the quantity of loanable funds supplied increases (and viceversa). ■ This is a movement along the supply curve. ○ Effect of an increase in disposable income on the supply of loanable funds: ■ When there is an increase in disposable income, individuals tend to save more ■ The increase in saving means an increase in lending at any real interest rate ■ This the supply of loanable funds supplied increases ■ This a shif of the supply curve to the right. ○ Effect of an increase in expected future income or wealth on the supply of loanable funds: ■ When there is an increase in expected future income or wealth, individuals tend to save less ■ The decrease in saving means a decrease in lending at any interest rate ■ Thus the supply of loanable funds supplied decreases. ■ This is a shiftof the supply curve to the left. ○ Effect of an increase in default risk on supply of loanable funds: ■ Default risk is the risk that the person you lent money to does not pay you back. ■ When there is an increase in default risk, individuals are less likely to lend at any real interest rate. ■ Thus the supply of loanable funds supplied decreases. ■ This is ashiftof the supply curve to the left. Markets Money Market ● Describes the supply and demand relationship for money ● Terms: ○ Money vs Loanable funds ■ Individuals demand money, and supply loanable funds (through individuals that are saving) ■ Loanable funds pay interes, where money does not. ■ Loanable funds are less liqui than money ○ Real vs Nominal Interest Rates ■ Nominal interest rate is the given interest rate on a loan ■ Real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the purchasing power of money ■ Real interest rate = nominal interest rate inflation ○ Real vs Nominal Wage ■ Nominal money: money in terms of dollars ■ Real money: money in terms of the purchasing power of dollars ■ Real money = nominal money * (CPI base year/CPI current year ● Demand for money ○ The quantity of money that people plan to hold depends on… ■ The price level:higher prices make us hold more money ■ The nominal interest rate: this is tprice of holding money ■ Real GDP : higher GDP (which is higher income) increases expenditures, so people need more money ■ Financial innovation : financial innovation makes interestbearing assets more liquid, so people hold less money ● Supply of Money ○ Is dictated by the Federal reserve ○ Depends on: ■ The monetary base ■ The required reserve ration ■ The currency drain ratio Money Money ● Money: any commodity or token that is generally acceptable as a means of payment ● Functions of money ○ Means of payment: a means of payment is a method of settling a debt ○ Medium of exchange ● Definition of money: money in the US consists of: ○ Currency: the notes and coins held by households and firms ○ Deposits at banks and other depository institutions ● Measuring money: ○ The two main official measure of money in the US are M1 and M2 ■ M1: consists of currency and traveler’s checks and checking deposit accounts owned by individuals and businesses. ■ M2: Definition of money: money in the US consists of: ● Currency: the notes and coins held by households and firms ● Deposits at banks and other depository institutions ■ consists of M1, and saving deposits, money market mutual funds, and other deposits. Federal Reserve System ● Is the central bank of the US it’s the bank for all other banks ● The public authority that regulates a nation’s depository institutions and controls the quantity of money controls the supply of money ● The Fed’s goals: ○ Keep inflation in check ○ Maintain full employment ○ Moderate the business cycle ○ Contribute toward achieving longterm growth ● Policy Tools: ○ Open market operations: the federal reserve can increase or decrease the money supply ○ Last resort loans: commercial banks are guaranteed to be able to get loans from the Federal Reserve ○ Required reserve ratios: control how much reserves commercial banks must hold. ● Federal Funds Rate: the interest rate that commercial banks charge each other on overnight loans or reserves ○ Very short term borrowing from other banks is done all the time to make sure banks hold the required amount of reserves. ○ The federal funds rate is the price of a very short term loan between banks ● Open Market Operations: ○ The purchase or sale of government bonds by the Fed from or to a commercial bank or the public ■ When the Fed buys securities, it pays for them witnewly created money, so the money supply increases ■ When the fed sells securities, they are paid for wmoney held by banks, so the money supplydecreases. Aggregate Supply & Demand Aggregate Supply ● The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period ● Aggregate supply is the relationship between the quantity of real GDP supplied and the price level. ● Potential GDP= aggregate supply *Time frames: ● Shortrun: think about a couple of years ● Longrun: think about a decade or so ● Longrun aggregate supply ○ The relationship between the quantity of real GDP supplied and the price level, when real GDP is equal to potential GDP ○ Supply curve: a vertical line, because potential GDP not influenced by the price level ○ In terms of wages: The relationship between quantity of real GDP supplied and the price level, wheominal wages are allowed to adjust ● Shortrun aggregate supply ○ The relationship between quantity of real GDP supplied and the price level, when the real GDP may be different from potential GDP ○ Supply curve: an upward sloping line, indicating thas price rises, so does real GDP ○ In terms of wages: The relationship between quantity of real GDP supplied and the price level, whenominal wages are held fixed. ● In the shortrun: ○ The money supply is fixed ○ Real interest rates are fixed ○ Prices are fixed ○ Nominal wages are fixed *This is very important to remember ● In the longrun (aggregate supply curve): ○ Vertical because: ■ It satisfies the law of supply ■ As nominal wages increase, firms decrease supply ■ Potential GDP does not depend on prices ■ Potential GDP never changes Aggregate Demand ● The quantity of real GDP demanded is the total amount of final goods and services produced in the US that people, businesses, governments and foreigners plan to buy. ● Things that affect aggregate demand: ○ The price level ○ Expectations ○ Fiscal policy and monetary policy ○ The world economy ● Shifts in Aggregate Demand: ○ Anything other than a price change will shift the curve ○ Y = C + I + G + M X ● Economic Growth ○ When potential GDP rises ■ Growth shifts the LAS and SAS to the right, by the same amount. ■ Growth increase output and employment. ■ Growth tends to decrease prices. Business Cycle ● The recession and expansions that occur as the economy moves to shortrun equilibrium that is not a longrun equilibrium ● The ADAS model predicts an expansion when one of two things happen: ○ Costs (other than nominal wages) to firms decrease; for example if oil prices fall ○ Aggregate demand rises due to one of the following factors: ■ Changes in expectations ■ Changes in fiscal or monetary policy ■ Changes in the world economy (exports and imports) ● The ADAS model predicts a recession when one of two things happen: ○ Costs (other than nominal wages) to firms increase; for example if oil prices rise ○ Aggregate demand falls due to one of the factors mentioned above Policy ● The ADAS model predicts that government policy can be used to affect the economy through aggregate demand ○ Monetary policy: changes in the money supply that affect investment through interest rates ○ Fiscal policy: changes in taxes that affect consumption or changes in government spending. ● If the government wants to stimulate the economy by increasing aggregate demand , it could: ○ Increase the money supply ■ This decreases interest rates and increases investment ○ Decrease taxes ■ This increases disposable income so people consume more ○ Increase government spending ■ The increases spending directly increases aggregate demand ● If the government wants to slow down the economy by decreasing aggregate demand , it would just do the opposite as above. Schools of Thought ● Classical ○ A classical macroeconomist believes that the economy is selfregulating and always at full employment ○ A new classical view is that business cycle fluctuations are the efficient responses of a wellfunctioning market economy that is bombarded by shocks that arise from the uneven pace of technological change. ● Keynesian (what most modern economists are) ○ A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required ○ A new Keynesian view holds that not only is the money wage rate sticky but so are the prices of goods (means prices/wages don’t immediately adjust) ● Monetarist ○ A monetarist is a macroeconomist who believes that the economy is selfregulating and that it will normally operate at full employment, provided that monetary policy i not erratic and that the pace of money growth is kept steady Unemployment & Inflation Types of Inflation ● Demandpull inflation : an inflation that starts because aggregate demand increases. ○ Increases in aggregate demand: ■ An increase in the quantity of money ■ An increase in government expenditure or decrease in taxes ■ An increase in expected inflation or expected future income ■ An increase in investment stimulated by an increase in expected future profits. ■ An increase in exports or decrease in imports ● The only one that can continually increase is thequantity of money ○ “Labor Fooling Model” Graph ● Costpull inflation: an inflation that starts with an increase in costs. ○ An increase in the money wage ○ An increase in the money price of raw materials (i.e. oil) Expected Inflation ● When the inflation expectations are correct, temporary recessions or expansions due to changes in aggregate demand are impossible. ○ If people correctly anticipated a change in aggregate demand, they would bargain for a different nominal wage right now. ○ This immediately shifts the SAS curve to offset the change in aggregate demand. ○ The end result would be inflation/deflation, but without an expansion/recession. ● If aggregate demand grows faster than expected then: ○ Real GDP moves above potential GDP ○ The inflation rate exceeds its expected rate ○ The economy behaves like it does in a demandpull inflation ● If aggregate demand grows m ore slowly than expected t hen: ○ Real GDP falls below potential GDP ○ The inflation rate slows ○ The economy behaves like it does in costpush inflation. Phillips Curve ● Shows the relationship between the inflation rate and the unemployment rate. ● Just another way to visualize the ADAS model. ● Two time frames for Phillips curves: ○ The shortrun Phillips curve ■ Shows the tradeoff between the inflation rate and unemployment rate, holding constant: ● The expected inflation rate ● The natural unemployment rate ■ With a given expected inflation rate and natural unemployment rate: ● If the inflation rate rises above the expected inflation rate, the unemployment rate decreases ● If the inflation rate is equal to the expected inflation rate, we have full employment ● If the inflation rate falls below the expected inflation rate, the unemployment rate increases. ■ The point corresponding to correct inflation expectations and full employment is always a point on the SRPC ○ The longrun Phillips curve ■ Shows the relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate. ■ In the longrun (along the LRPC) a change in the inflation rate is expected, so the unemployment rate remains at the natural unemployment rate. ■ The point corresponding to correct inflation expectations and full employment is always a point on the LRPC Fiscal Policy Fiscal Policy ● Government spending and taxation ● The Federal Budget ○ The annual statement of the federal government’s outlays (spending) and tax revenues ○ Two purposes: ■ To finance the activities of the federal government ■ To achieve macroeconomic objectives ○ Fiscal policy ■ The use of the federal budget to achieve macroeconomic objectives: ● Full employment ● Sustained economic growth ● Price level stability *The President and Congress make fiscal policy ○ Spending (outlays) ■ The government spends money on: ● Transfer payments ○ i.e. social security ● Expenditure on goods and services ○ National defense ● Debt interest ○ Surplus or Deficit ■ Federal government's budget balance equalreceipts minus outlays ● deficit=receiptsoutlays ■ If receipts exceed outlays, the government hasbudget surplus ■ If outlays exceed receipts, the government hasbudget deficit ■ If receipts equal outlays, the government habalanced budget ● Government Debt ○ The total amount that the government has borrowed ■ Debt is the sum of past deficits minus past surpluses ■ Debt increase when the government has a deficit ■ Debt decreases when the government has a surplus ○ Debt is usually measured as a percentage of GDP ■ debttoGDP = debt/GDP X 100% ● Supplyside effects ○ Fiscal policy has important effects on employment, potential GDP, and aggregate supplyupplyside effects ○ An income tax changes full employment and potential GDP through its effect on the labor market ● Labor market and taxes ○ There are two effects of an increase in taxes ■ It decreases the supply of labo by reducing incentives to work ■ It creates anincome tax wedge: a difference between the takehome wage of workers and the cost of labor to firms ● Potential GDP and taxes ○ An increased tax level will: ■ Reduce the equilibrium quantity of hours worked in the labor market ■ In turn, thidecrease potential GDP ● Taxes and incentives ○ When the government implements proportional taxes, taxes that are a percentage of income or consumption, that changeincentives ■ A (labor) income tax reduces the incentive to work, because takehomepay is lower ■ A tax on consumption has a similar effect, because it increases prices and so reduces real wages ■ A tax on interest income reduces the incentive to save/loan out your money ● Fiscal stimulus ○ The use of fiscal policy to increase production and employment ■ Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no government action ○ Discretionary fiscal policy is a policy action that is initiated by an act of Congress ● Government spending and borrowing ○ In order to spend, the government often has to borrow money. Government borrowing is accomplished primarily by issuitreasury bonds ■ A treasury bond is essentially a loan made by individuals, banks, or foreign governments to the U.S. government ● Bonds ○ Individuals pay for a bond right now, called price of a bond ○ In return the government promises to pay back a certain amount in the future, called theface value of the bond ○ The date at which the government pays back the face value is calledmaturity date ○ The time length between the purchase of the bond and its maturity date is called the erm length ○ The nominal interest rate of the bond is the growth rate of the value of the bond ■ Nominal = face value price/ price *100% ○ When the government borrows money by issuing bonds, it increases real interest rates ■ An increase in government borrowing increase the demand for loanable funds ■ An increase in emand drives prices up ■ In the loanable funds market, the “price” isreal interest rate ● Fiscal policy multiplier ○ Recall the aggregate demand formula ■ Y = C + I + G + M X ○ In order to increase aggregate demand and shortrun output. The government has two fiscal policy tools: ■ Decrease taxes, increasing consumption (C) ■ Increase government spending directly (G) ○ Because an increase in aggregate demand increase output in the shortrun, there is a ultiplier effect. ■ An increase in demand for any reason increase output and employment ■ An increase in output and employment increase aggregate income ■ An increase in aggregate income increases consumption ■ An increase in consumption increase output and employment again ■ Repeat 24 ○ Multiplier effect : an increase in government spending increases output more than oneforone ● Crowding Out Effect ○ On the other hand, an increase in government expenditure usually increases government borrowing and raises the real interest rate ○ With the higher cost of borrowing, investment decreases, which partly offsets the increase in government expenditure ○ Crowding out effect: an increase in government spending increases output less that oneforone ● Government spending multiplier ○ Describes the total effect of an increase in government spending on output ■ If the multiplier effect is bigger that the crowding out effect, the government spending multiplier will be greater than one ■ If the crowding out effect is bigger than the multiplier effect, the government spending multiplier will be less than one ● Time Lags ○ There are three reasons why discretionary fiscal policy might not respond quickly to economic conditions: ■ Recognition lag: the government must realize action is required ■ Lawmaking lag: the government must draft and pass a law ■ Impact lag: laws usually take time to implement in the real world Monetary Policy ● Conducted by the Federal Reserve Board ○ Congress plays no role in making monetary policy decisions, although the Fed makes two reports a year and the Chairman testifies before Congress. ○ The formal role of the President is limited to appointing the members and Chairman of the Board of Governors ● The goals of monetary policy: ○ Maximum employment ○ Stable prices ○ Moderate longterm interest rates ● In the long run, these goals are in harmony and reinforce each other, but in the short run, they might be in conflict ● The key goal of monetary policy is price stability ● Price stability is the source of maximum employment and moderate longterm rates ● How does the FED operate to achieve its goals? ○ By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable. ● Stable prices is the primary goal the Fed pays attention to the business cycle. The Fed tries to minimize the output gap. ○ Output gap = real GDP potential GDP ○ A positive output gap indicates an increase in inflation ○ A negative output gap indicates unemployment above the natural rate ● Instruments ○ The monetary policy instrument is a variable that the Fed can directly control or closely control. ■ Monetary base : this is one option that is easiest to understand ■ Federal funds base : the interest rate at which banks borrow monetary base overnight from other banks ■ In practice, the US Federal Reserve use the Federal funds rate as its instrument ■ That means that the Fed chooses a target Federal funds rate and uses open market operations to increase or decrease interest rates to meet that target ■ When the Fed wants to avoid recession, it lowers the Federal funds rate ■ When the Fed wants to check rising inflation, it raises the Federal funds rate ■ When the Fed wants to lower the Federal Funds rate: ● It increases the quantity of money through open market operations ● All shortterm interest rates fall ● The longterm real interest rate falls ● Investment increases due to lower interest rates ● Aggregate demand increases ● Real GDP growth and the inflation rate increase Laffer Curve ○ In order to understand how tax revenue changes when tax rates increase, there are two mechanisms to consider: ■ An increased tax rate increases revenue per dollar earned ■ An increased tax rate can change incentives so that fewer dollars are earned ○ The relationship between the tax rate and the amount of tax revenue collected is called theLaffer curve ○ The maximum tax occurs at the topmost point of the curve ○ To the left of that point, the curve iupwards sloping , and increasing tax rates will increase revenue ○ To the right of that point, the curve idownwards sloping , and decreasing tax rates will increase revenue ● Supplyside Debate ○ Debate about the effect of a tax cut on government tax revenues: ■ Because it reduces taxes per dollar earned ■ But if it increases incentives to work a lot, then a tax cut could actually increase government revenue ■ Whether or not a tax cut increases revenue depends on where we are on the Laffer curve *most economists believe that the U.S. is on thupwards sloping portion of the Laffer curve this means that a tax cut will usually decrease government revenue. ● Fiscal stimulus ○ The use of fiscal policy to increase production and employment ■ Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no government action ■ Discretionary fiscal policy is a policy action that is initiated by an act of Congress Equations ● Growth rate= ((value in later periodvalue in earlier period)/ value in earlier period)*100 ○ Try to remember: ((newold)/old)*100 ● GDP=C+I+G+XM ■ Cconsumption by households (buying goods) ■ Iinvestment by firms (factory upgrade) ■ Ggovernment spending (public defense) ■ Xexports to other countries (making goods in the country and selling them to another country) ■ Mimports from other countries (buying goods made in another country) ● GDP= income ● Real value = Nominal value * (prices in base period/prices in the current period) ○ Real Wage=nominal wage* (CPI base year/CPI current year) ○ Real money = nominal money * (CPI base year/CPI current year) ● Inflation rate = ((CPI this year CPI last year)/ CPI last year)*100% ○ Try to remember: ((newold)/old)*100% ● The unemployment rate=(#of people unemployed/labor force)*100 ● The employmenttopopulation ratio= (employment/workingage population)*100 ● The labor force participation rate= (labor force/workingage population)*100 ● Output gap = eal GDPPotential GDP ● GDP per capita= GDP/population (dollars per person) ● Labor Productivity = real GDP/aggregate labor hours ● Interest rate= (returnprice)/price *100% ○ Interest rate= (price + interest price)/price *100% ○ interest/price *100% ● Real interest rate = nominal interest rateinflation rate ● DebttoGDP = debt/GDP X 100% ● Nominal (Bonds) = face value price/ price *100% Graphs & Shifts Labor Market and Aggregate Production Shifts in Demand: ● The real wage rate (price of labor) ● Labor productivity (directly related) Shifts in Supply: ● The real wage rate (price of labor) ● Population ● Employmenttopopulation ratio Loanable Funds Market Shifts in Demand: ● The real interest rate (price of loanable funds) ● Expected proﬁt (directly related) Shifts in Supply: ● The real interest rate (price of loanable funds) ● Disposable income (directly related) ● Expected future income (inversely related) ● Wealth (inversely related) ● Default risk (inversely related) Money Market Shifts in Demand: ● The nominal interest rate (price of holding money) ● The general price level (directly related) ● Real GDP (directly related) ● Financial innovation (inversely related) Shifts in Supply: ● The supply of money is dictated by the Federal reserve, but it also depends on: ○ The monetary base (directly related) ○ The required reserve ratio (inversely related) ○ The currency drain ratio (inversely related) Aggregate Supply and Demand Shifts in Demand: ● The price level ● Expectations ○ Individuals’ expectations about future income ○ Individuals’ expectations about inﬂation ○ Firms’ expectations about future proﬁts ● Fiscal policy and monetary policy ○ Taxes (ﬁscal policy) ○ Government spending (ﬁscal policy) ○ The money supply (monetary policy) ● The world economy ○ Exports and imports Shifts in ShortRun Supply: ● The price level ● Costs ○ The nominal wage rate ○ The nominal price of raw materials (e.g. oil prices) ● Economic growth (changes in potential GDP) ○ Full employment labor supply ○ Quantity of capital ○ Level of technology Shifts in LongRun Supply: ● Economic growth (changes in potential GDP) ○ Full employment labor supply ○ Quantity of capital ○ Level of technology Phillips Curve Anything that affects aggregate supply will shift the shortrun Phillips curve ● A change in expected inflation shifts only the shortrun Phillips curve A change in the Unemployment Rate will shift the longrun and shortrun Phillips curve ● This will cause the inflation rate to remain the same Laffer Curve
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