Econ 2006 Exam 3 notes
Econ 2006 Exam 3 notes econ 2006
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This 36 page Study Guide was uploaded by Jordon Prince on Wednesday July 13, 2016. The Study Guide belongs to econ 2006 at Virginia Polytechnic Institute and State University taught by Omid Bagheri in Summer 2016. Since its upload, it has received 10 views. For similar materials see Macroeconomics in Macro Economics at Virginia Polytechnic Institute and State University.
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Econ What is Economics? Scarcity o (D) The limited nature of society’s resources, given society’s unlimited wants and needs. o Nothing is infinite in nature—not even air and water! Economics o The study of how people allocate their limited resources to satisfy their nearly unlimited wants o The study of how people make decisions Microeconomics V.S. Macroeconomics Microeconomics o The study of individual units that make up the economy o Concerned with decisions of individuals, households, and businesses Macroeconomics o The study of an economy as a unit itself o Looks at the broader economy, including inflation, growth, employment, interest rates, and productivity of the economy as a whole The Five Foundations of Economics 1. Incentives matter a. Incentives i. Factors that motivate you to (make decisions) or exert effort b. Positive incentives i. Make choices in order to be better off/rewards ii. Tax fund, pay raise, employee of the month award, sticker and a smiley face, extra credit c. Negative incentives i. Make choices in order not to be worse off/penalties ii. Taxes, jail, fees, fines, spankings, getting grounded, getting fired, failing class Direct and Indirect Incentives Direct incentives o Generally easy to recognize/ result of an action o Firm lowers the gas price to attract more customers Indirect incentives o The (hidden) consequence of the action taken o Pollution is a consequence of the increased quantity demanded 2. Life is about trade-offs a. Governments face trade-offs as well i. Spend tax dollars on education or the highway system? ii. Spend tax dollars on the highway system or a new airport iii. should we penalize polluting companies? 1. Gain: cleaner air, better health 2. Loss: less industry, higher prices in some sectors 3. Opportunity costs a. Opportunity Cost i. Similar to trade-offs, but more restrictive ii. (D) the highest-valued alternative that must be sacrificed in order to get something else iii. Not all alternatives, just the next best choice b. Decision-making key: i. Minimize opportunity cost by selecting the option that has the largest benefit. 4. Marginal thinking a. Requires decision makers to evaluate whether the benefit of one more unit of something is greater than the cost b. Margin examples: one more unit (slice of pizza, production), one more hour of activity (studying, sleeping) 5. Trade creates value a. Markets i. (D) Bring buyers and sellers together to exchange goods and services b. Trade i. (D) The voluntary exchange of goods and services between two or more parties Comparative Advantage Without trade, you would have to produce everything you consume o You would have to make your own food, clothing, housing, and electronics o You would have to do all your own services as well (hair-cutting, plumbing, dentistry, education) Comparative advantage o (D) the situation in which an individual, business, or country can produce at a lower opportunity cost than a competitor allows gains from trade to occur Absolute advantage One person can perform each task more effectively than the other person Consumer Goods Goods produced for current consumption Food, housing, clothing, entertainment Capital goods Goods that help produce other valuable goods Buildings, factories, roads, machinery, computers Investment Using resources to make new capital Characteristics of competitive market Many buyers and sellers No one individual can affect the market price (price takers) Sellers sell identical products Perfect information about the quality and the price of goods Trade costs are low and there is free entry and exit in the market o Example One fisherman does not determine the price of fish at the market Monopoly Imperfect market o Buyer or seller has an influence on the price and/ or more of the characteristics are not satisfied Monopoly o Exists when a single (one) company supplies the entire market for a good or service Demand Demand schedule o Table showing the relationship between price and quantity demanded Demand Curve (function) o Graph of the relationship between price and quantity demanded, i.e the amount of a good or service that buyers are willing to buy at a given price Law of Demand o (D) all other things equal, quantity demanded falls when prices increases, and vice versa o in other words, there is an inverse relationship between prince and quantity demanded An exception: Giffen goods Shifts in Demand Movement along a demand curve o Caused by a change in the price of the good o Inverse relationship between price and quantity demanded Shift in demand o Caused by changes in non-price factors o Entire demand curve will shift to the left or right Demand shifters 1. Changes in income i. Income will obviously affect the amount of goods consumers purchase b. Normal good i. Good in which we buy more of when we get more income and vice versa 1. Steak, Name-brand clothing c. Inferior good i. Good in which we buy less of when we get more income, and vice versa 1. Canned meat, secondhand clothing 2. Price of related goods i. In general, the quantity demanded of a good sold, depends also on the prices of other goods b. Compliments i. Two goods consumed together 1. Milk and cereal, Printers and toner ii. When the price of a complementary good rises, the demand for the related good goes down c. Substitutes i. Goods that can be used in place of each other 1. Coke VS. Pepsi, Pizza Hut and Dominos ii. When the price of a substitute good rises, the demand for the related good goes up 3. Changes in Tastes and Preferences a. A good may become more fashionable or may come into season i. New style becomes popular ii. Demand increases (shifts right) as a result b. A good may go out of style or out of season i. Demand decreases (shifts left) 4. Future expectations a. Our consumption today may depend on what we think the price may be tomorrow b. If there is a belief that the future price of a good will rise, we may buy it now 5. Number of buyers a. Market demand is the sum of all individual demand curves b. When more individual buyers enter the market, the market demand increases, and vice versa 9/16/15 Frictional unemployment (D) unemployment caused by time delays in matching available jobs and workers people don’t instantly take a new job, and they might not want to take the first available job firms don’t always hire the first applicant Example a worker loses his job at burger king and at the same time Mc’Donalds needs to hire employees o then unemployed worker will take some time to search for a new job o Mc’Donalds will take some time deciding how many workers it needs and which applicants to hire Cyclical unemployment (D) unemployment caused by economic downturns The “worst” kind of unemployment because jobs are not available for many people who want to work Unhealthy economy Occurs for an unknown length of time 2008: 18 months, 10% unemployment rate Three Types of Unemployment We should aim for zero unemployment However this aim is not attainable Structural and Frictional unemployment are natural, i.e. are always present (even during periods of economic expansion) Cyclical unemployment is not natural, i.e. present during recessions o During healthy economic periods, cyclical unemployment falls Unemployment rate (D) the percentage rate of labor force that is unemployed unemployment rate (u) is defined as the percentage of the labor force that is unemployed (u)= number unemployed/ labor force * 100 Natural rate of unemployment Natural rate of unemployment (u*) o (D) The typical rate of unemployment that occurs when the economy is growing normally o In other words, the unemployment rate related with structural and frictional unemployment o Remember the unemployment rate denoted by (u), as seen above, is related to the actual unemployment rate, i.e. structural, frictional and cyclical The natural rate of unemployment in US is near 5% Full employment output Full employment output (Y*) o When the unemployment rate (u) is equal to the natural unemployment rate (u*), the output level produced un the economy is called the full unemployment output (Y*) o (D) the output level produced in an economy when the unemployment rate (u) is equal to natural rate of unemployment(u*) The actual employment output is denoted as Y o Real GDP = Y Shortcomings of the Unemployment Rate Discouraged workers o People who want a job but get discouraged and give up looking for work o Are not included in the labor force and not considered unemployed Underemployed workers o Part-time workers who want full-time jobs o Workers who are very overqualified at their job o Considered employed Unemployment timeline o Unemployment rate lags behind economic activity o Recovery happens, people re-enter the labor force, and the unemployment rate can actually increase! Who is unemployed? o Do not know hwo is unemployed o Do not know how long they have been out of work o Short-run unemployment may not be a big concern, but long- term unemployment is a big concern Other Labor Market indicators Labor force participation rate o (D) the percentage of the population that is in the labor force o tells us the fraction of people in a country who are working or looking for work o two countries may have identical population but the labor force may differ Model Building and Gains from Trade Positive and Normative Analysis Positive statement o A claim that can be tested/validated to be true or false o What is the unemployment rate in Virginia State? 4.7% Normative statement o Statement of opinion; cannot be tested/validated to be true or false. What “ought to be” or “should be” o The unemployment rate in Virginia State is low Production Possibilities Frontier Production possibilities frontier (PPF) o Combinations of outputs that a society can produce if all of its resources are being used efficiently Assumptions of this model o Technology fixed o Resources fixed o Simplified two-good analysis Why is the PPF downward-slopping? o Relationship between PPF and opportunity cost o Must give up one good to increase production of another Opportunity cost o Downward-sloping PPF illustrates opportunity costs of production o Whenever society is producing along the PPF, the only way to get more of one good is to accept less of the other PPF and Opportunity Cost (Nonlinear PPFs) A more realistic PPF is nonlinear “bowed outward” o The slope will get steeper as we move from left to right, and opportunity cost will not be constant The PPF reflects the increasing opportunity cost of production, know as the law of increasing relative cost o As you move along the PPF toward a greater quantity of one good, the costs of production increase relative to the costs of producing the other good. o Changes in relative cost mean that society faces a significant trade-off if it tries to produce an extremely large amount of a single good o As we produce more of good A, we have to give up increasingly larger amounts of good B o Refers to the increasing opportunity cost of production that occurs as you move along the PPF Shift in the PPF If the PPF were to expand outward some previously unattainable good combinations would now be possible to produce The PPF could shift graphically in two ways o New resources or technology could be introduced that either Case 1: Affect the production of one good Able to produce more pizzas, but wings production remains unchanged Society can change a new point along the PPF that allows them to produce more of both even though wing production was not enhanced Case 2: Affect the production of both goods Able to produce more pizza and wings More resources allow to produce more of all goods Additional resources could include more people, land, or natural resources Specialization and Trade Absolute advantage o One person can perform each task more effectively than the other person. Trade-off Between Present and Future Consumer goods o Goods produces for current consumption o Food, housing, clothing, entertainment Capital goods o Goods that help produce other valuable goods o Buildings, factories, roads, machinery, computers Investment o Using resources to make new capital The Market at Work: Supply and Demand Competitive Markets Characteristics of a competitive market o A market in which there are so many buyers and sellers that each only has a small impact on the market price and output o No one individual can affect the market price (price takers) No single buyer or seller has any appreciable influence over the price that prevails o Sellers sell identical products o Perfect information about the quality and the price of goods o Trade costs are low and there is free entry and exit in the market Examples o One fisherman does not determine the price of fish at the market Monopoly Imperfect market o Market in which either the buyer or the seller has an influence on the market price Monopoly o When a single company supplies the entire market for a particular good or service o Even in imperfect markets, the forces of supply and demand have a significant influence on producer and consumer behavior Demand Law of demand o Inverse relationship between prince and quantity demanded: If price goes up, quantity demanded decreases If price goes down, quantity demanded increases Inverse: two variables move in opposite directions o Ceteris Paribus: all other things equal Demand curve o A graph of the relationship between the prices on the demand schedule and the quantity demanded at those prices o Relationship between price and the quantity demanded produces a downward-sloping curve Test 2 Other Labor Market Indicators Labor Force Participation rate= labor force/ population x 100 Labor force participation rate o (D) the percentage of the population that is in the labor force o tells us the fraction of people in a country who are working or looking for work o two countries may have identical population but the labor Chapter 7 Unemployment Unemployment (D) occurs when a worker who is not currently employed is searching for a job without success o if you’re not looking for a job, you’re not counted as unemployed. If you start looing again, you’re unemployed Three Types of Unemployment Is it practical to have zero unemployment? o Generally, unemployment is a drain on society and very difficult for certain individual households o However, as our economy changes and progress certain jobs are destroyed Three Types of unemployment o Structural o Frictional o Cyclical Structural Unemployment (D) Unemployment caused by changes in the industrial makeup (structure) of the economy The introduction of new products and technologies leads to the end of industries and jobs New industries are created, and old ones are destroyed EXAMPLE o U.S steel industry 1980: 500,000 laborers 2010: 150,000 More automated equipment, safer and more efficient Frictional Unemployment (D) unemployment caused by time delays in matching available jobs and workers People don’t instantly take a new job, and they might not want to take the first available job Firms don’t always hire the first applicant EXAMPLE o A worker loses his job at burger king and at the same time Mc’Donalds needs to hire employees The unemployed worker will take some time to search for a new job Mc’Donalds will take some time deciding how many workers it needs and which applicants to hire Cyclical Unemployment (D) Unemployment caused by economic downturns The “worst” kind of unemployment because jobs are not available for many people who want to work Unhealthy economy Occurs for an unknown length of time 2008: 18 months, 10% unemployed Three Types of Unemployment We should aim for zero unemployment However, this aim is not attainable Structural and Frictional unemployment are natural, I.e are always present (even during periods of economic expansion) Cyclical unemployment is not natural, i.e present during recessions o During healthy economic periods, cyclical unemployment falls toward zero Unemployment Rate Unemployment rate (u) o (D) The percentage rate of the labor force that is unemployed o We measure this as follows By dividing the number of unemployed by the labor force Multiplying by 100 to convert to percentage Number unemployed/ labor force X 100 Labor force o (D) people who are employed or actively seeking work Who is not in the labor force? o Jobless people not actively seeking employment (no efforts made in four weeks) o Retirees, full time students, people in jail, children under the age of 16 Natural rate of unemployment Natural rate of unemployment (u*) o (D) The typical rate of unemployment that occurs when the economy is growing normally o In other words, the unemployment rate related with structural and frictional unemployment o Remember the unemployment rate denoted by (u), as seen above is related to the actual unemployment rate, i.e structural, frictional, and cyclical The natural rate of unemployment in US is near 5% Full employment output Full employment output o When the unemployment rate (u) is equal to the natural unemployment rate (u*), the output level produced in the economy is called the full employment output o (D) The output level produced in an economy when the unemployment rate (u) is equal to the natural rate of unemployment (u*) The actual employment output is denoted as Y o Real GDP = Y Shortcomings of the Unemployment Rate Discouraged workers o People who want a job but get discouraged and give up looking for work o Are not included in the labor force and not considered unemployed Underemployed workers o Part-time workers who want full-time jobs o Workers who are very overqualified at their jo o Considered employed Unemployment timeline o Unemployment rate lags behind economic activity o Recovery happens, people re-enter the labor force, and the unemployment rate can actually increase! Who is unemployed o Do not know who is unemployed o Do not know how long they have been out of work o Short-run unemployment may not be a big concern, but long- term unemployment is a big concern Other Labor Market Indicators Labor Force Participation rate= labor force/ population x 100 Labor force participation rate o (D) the percentage of the population that is in the labor force o tells us the fraction of people in a country who are working or looking for work o two countries may have identical population but the labor force may differ Chapter 8 Price Level and Inflation Inflation inflation o (D) the growth in the overall level of prices in an economy Deflation (opposite of inflation) o (D) Occurs when overall prices fall key = “overall” o prince do not all move together Clearly, most prices rise over time o Examples: Travel, Education However, some prices fall over time o Example: Consumer electronics Consumer Price Index Consumer Price Index (CPI) o The most common price level used to compute inflation o A measure of the price level based on the consumption pattern of a typical consumer o Essentially a basket of goods purchased by a representative consumer in the country o It included groceries, clothing, transportation, housing, medical care, education, many other goods and services o Goal: include everything a typical consumer buys in order to get realistic measure of the cost of living Bureau of Labor statistics o The government agency that reports inflation and unemployment data o Determines how much “weight” to put on certain consumer prices Computing CPI Finding the price index o Define the basket of goods and services and their appropriate weights o Determine the price of goods and across periods o Convert the index number for each period Price index = basket price/ basket price in base year x 100 Inflation Having found the price levels, we can find inflation by using a percentage change formula of the price level o Inflation rate (i)= Pt-Pt-1Pt-1 100 Historical Observations The historical average inflation is about 4% Since 1983, inflation has averaged less than 3% Using the CPI to Compare Dollar Values across Time Prices from different time periods can be confusing o To compare the prices of goods over time, we can convert all prices to today’s prices o Price Today = Price Earlier X price level today/ price level earlier Concerns about CPI Accuracy CPI needs to be accurate in order to calculate the accurate inflation Substitution o When the price of a good rises, consumers look to substitute to less expensive alternatives o Since the typical consumer basket changes, CPI calculations are difficult Quality changes o The quality of goods generally increases and the price increases too o Example flat-screen tv’s New products and locations o New goods are introduced and new buying options become available The Costs of Inflation Future price level uncertainty o Firms often make long-term agreements that involve paying salaries to workers and paying loans on capital goods o Uncertain inflation makes long-term contracts riskier o Reduction in purchase power Costs of inflation 1. Shoe-leather costs—time and resources are spent to guard against the effects of inflation a. Resources that are wasted when people change behavior to avoid holding money b. As prices go up, it becomes costlier to hold money c. Time, effort, and fuel costs that people bear when they try to use more money 2. Money illusion—consumers misinterpret nominal changes as real changes a. People interpreting nominal wage or price changes as real changes b. If prices and wages all go up by 2%, there is no real change in your purchasing power. People with money illusion think they are richer in this case Nominal wage o (D) the wage expressed in current dollars Real wage o (D) Nominal wage adjusted for inflation (changes in the price level) 3. Menu Costs—inflation means that firms must incur extra costs to change their output prices a. The costs of changing prices b. Some businesses can change prices easily; some can not! c. Example: a restaurant will have to print new menus for all price changes 4. Uncertainty about future price levels a. Wage and other input contracts often have a long-term commitment. Firms may have to borrow today and pay back the money later b. Uncertainty about prices may make borrowing riskier 5. Wealth redistribution a. Wealth can be redistributed between borrowers and lenders b. Example: i. you borrow 50,000 and expect to pay back 60,000 in five years c. If unexpected inflation occurs i. Wealth is redistributed from the bank to you ii. You are better off, bank is worse off 6. Price Confusion—inflation makes it difficult to read price signals, and this confusion can lead to a misallocation of resources a. Market prices are signals to consumers and firms b. Example: if demand increases, prices rise and firms have an incentive to increase the quantity supplied c. Difficulty analyzing price changes as a result of demand shifts or inflation 7. Tax distortions—inflation makes capital gains appear larger and thus increases tax burdens a. Capital gains taxes are taxes on the gains realized by selling an asset for more than its purchase price b. Problem: often, the price rises due to inflation rather than an increase in the value of the good Chapter 9 Savings, Interest Rates, and the Market for Loanable Funds The Loanable Funds Market Loanable funds market (banks, bonds, stocks) o (D) The market where savers supply funds for loans to borrowers o Includes places like stock exchanges, investment banks, mutual fund firms, and commercial banks o Borrowers get funds to use for businesses Firms, governments Firms need to borrow before production begins. That is why the loanable funds market is so important o Savers lend to these businesses Households Foreign entities Notes about Borrowing Chain of borrowing: o GDP (output, production) requires investment o Investment requires borrowing o Borrowing requires savings o The loanable funds market makes this process efficient Interest Rates Interest rate o (D) The price of loanable funds, quoted as a percentage of the original loan amount Savers: the reward for saving Borrowers: the cost of Borrowing o Like other prices, it rises and falls o Affected by supply and demand o We can examine this market like any other market Interest Rates as a Reward for Savings When you save money, you are supplying funds o The price you receive is the interest rate, which is a percentage (rather than dollars) Loanable funds “law of supply” o The higher the interest rate, the greater is the incentive to save. The interest rate is a reward for saving. Interest Rates as a Cost of Borrowing When you borrow money, you are demanding funds o Interest rate is the cost of borrowing o Higher interest rates mean a firm pays more to borrow Loanable funds “law of demand” o The higher the interest rate, the lower the incentive to borrow. The interest rate is a cost for borrowing o Borrow funds if and only if: expected return on investment > interest rate on the loan Inflation and Interest Rate Real interest rate o (D) The interest rate corrected for inflation Nominal interest rate o (D) the interest rate before it is corrected for inflation Fisher equation o Relates inflation to the real and nominal interest rate o Real interest rate = nominal interest rate – inflation rate o Nominal interest right = real interest rate + inflation rate What Factors Shift the Supply of Loanable Funds Recall that supply of loanable funds comes from savings Movement along the supply curve for loanable funds o Caused by a change in the interest rate, which is the price of saving Shift in the supply of loanable funds is caused by o Changes in income and wealth (same, increase= increase) Increases in income (wealth) generally increase savings This is a shift in the supply of loanable funds High-income people (and countries) save more than low-income people (and countries) at the same interest rate o Change in time preference (opposite, increase in time = decrease in loanable funds) People generally prefer goods and services sooner than later Loans are paid back at a later date Because people have time preferences, someone must pay them to save If time preferences change, the supply of loanable funds shifts Strongly prefer now to later: save less Weakly prefer now to later: Save more o Consumption smoothing Income changes over the course of the typical life Consumption smoothing—we don’t experience large changes in consumption with changes in income What Factors Shift the Demand of Loanable Funds? Demand of loanable funds comes from investment Movement along the demand curve for loanable funds o Caused by a change in the interest rate, which is the price of borrowing Shift in the demand of loanable funds is caused by o Changes in the productivity of capital If capital becomes more productive (in other words, the return is expected to increase), the demand for loans will increase o Changes in investor confidence Beliefs and expectations will shift the demand for loanable funds Equilibrium in the Market for Loanable Funds In Equilibrium, savings = investment Relationship between saving and borrowing o Every dollar borrowed requires a dollar saved Financial Markets and Securities How do Financial Markets Help the Economy? Financial intermediaries o (D) Firms that help channel funds from savers to borrowers banks Banks o (D) Private firms that accept deposits and extend loans Why are financial intermediaries important? o Help connect borrowers (demanders) with the savers (suppliers) o Businesses need funding to produce Direct and Indirect Financing Indirect finance o Occurs when savers deposit funds into financial intermediaries, which then loan these funds to borrowers Direct Finance o Occurs when borrowers go directly to savers for funds o Firms sell a security (stock or bond) directly to the public in exchange for funds o Security pays future income and/or gives part ownership of the firm Financial Tools What financial tools facilitate exchange between savers and borrowers? o Bonds, stocks, treasury securities, home mortgages, private sector securities (created by the process of securitization) Bond o (D) Contract between lender and a borrower by which the borrower promises to repay a loan with interest Bonds are used by large established firms when they are an infusion of money Securities are issued and sold to the public This is an example of direct finance Funds generated are used for investment Bond is a formal IOU – a contract specifying who owes how much, and a date for payment Name of Borrower, repayment date (maturity date), fixed among due at repayment (face value) Information on a Bond o Dollar price The price at inception. The dollar amount that the bond is originally bought and sold at o Maturity date The date on which the loan repayment is due o Face value (or par value) The value of the bond at maturity (the amount due at repayment) Maturity date and face value are set at the inception of the bond Interest Rate Bond buyers (lenders) o Look for the highest interest rate because they want the highest return on their money o In other words, they want to pay the lowest possible price at inception Bond sellers (borrowers) o Try to sell bonds at the lowest interest rate possible o In other words, they want to sell the bonds at an inception price that is as much as possible close to the face value The interest rate is computed as a growth rate: o IR(%) = Face Value- Price at Inception/ Price at Inception * 100 Bond Price Principles Give that the face value is fixed (printed on the contract), the dollar price of a bond determines its interest rate (and vice versa) The dollar price and interest rate of a bond move opposite each other Default Risk Since we focus on bonds that entail single payment when the bond matures, there are only two possible outcomes o The borrower pays maturity value of the bond to lender o The borrower defaults on the loan (lender gets $0 back) The risk that the borrower will not pay off the bond Default Risk o (D) The risk that the borrower will not pay the face value of a bond on the maturity date the greater the risk of default, the lower the price (and higher the interest rate) of the bond o bond interest rates rise with default risk how do lenders judge the default risk of companies? o It is difficult for a typical lender to assess the risk of any one company o Lenders look to rating agencies (Moody’s, Standard and Poor/s (S&P), Fitches) o The rating agencies evaluate the default risk of all borrowing entities and give a grade showing the likelihood of defaulting Stocks Stock shares o (D) ownership shares in the firm o Stock shares offer another option for firms that need funding to finance their production of output o Stocks are very different from bonds because owners of stocks are actual owners of the firm o Stock owners have some influence in the operations of the firm – if a shareholder owns more than 50% of the shares, they control more than 50% of the ownership votes Secondary Markets Secondary Markets o (D) markets in which securities are traded after their first sale o The buyer is not purchasing the security directly from the firm, but from the previous security owner o Often sold to investors through a broker (intermediary of the seller and the buyer) Stock markets are secondary markets Bonds vs. Stocks Stocks are only issued by firms. Bonds can be issued by firms or government Stocks pay investors dividends which are not guaranteed. Bonds pay interest which is guaranteed, unless the firm or government default Stockholders are owners thus; they have voting rights. Bondholders are just lenders Bondholders rank senior to stockholders and therefore bonds generally provide more safety than stocks. o In the case of default, all the assets of the defaulted firm or government are sold. Bondholders are the first in line to be repaid. Stockholders might receive some proceeds, only if there is anything left Treasury Securities Treasury securities o (D) The bonds sold by the U.S government to pay for the national debt o treasury securities are sold through auctions to large financial firms. The auction determines the interest rate o generally considered less risky (lower interest rate) than other bonds, since no one expects United States to default o rating agencies provide grades for countries Home Mortgages home mortgage loan o individuals use mortgages to pay for homes o (D) A contract that states the willingness to repay the loan over several years o A mortgage loan lasts many years from inception and is paid off with monthly payments Securitization (D) The creation of a new security as a combination of other securities and loan agreements The new security is available for resale in secondary markets This raises capital and gets the loans off the bank’s balance sheet, so it can issue new loans. This offers new opportunities for lenders The risk is spread to a larger number of parties which eventually leads to lower interest rates on loans Chapter 11 Economic Growth and the Wealth of Nations Economic Growth So Far Gross Domestic Product (GDP) o (D) The market value of all final goods and services produced within a country during a specific period. o GDP = Y = C + I + NX Per capita GDP o (D) GDP per person (GDP divided by population) o basic measure of living standards Economic Growth o (D) the percentage change in Real per capita GDP change in average person’s income, adjusting for price changes o Economic Growth = %^ Nominal GDP - %^ Prices - %^population = %^ per capita Real GDP o It is the annual growth rate of per capita real GDP o It is the measure of how an average person’s income changes over time, including an allowance for price changes Growth and Income Levels over Time Suppose annual growth is 2%, it will take less than 50 years fo us to grow by 100% o Compounding growth actually makes it occur faster than that. It takes about 35 years o “Rule of 70” shows why the growth rate is so important. Even a small change in the growth rate will significantly change the amount of time it shows for income to grow o if the annual growth rate is x%, the size of that variable doubles every 70/x years The Causes of Economic Growth economic growth affects income, life expectancy, and standards of living the sources of economic growth are o Resources (also know as factors of production) (D) the inputs used to produce goods and services economists divide resources into three major categories natural resources o physical land o inputs that occur naturally in or on the land (coal) o geography (physical location) o Natural resources not enough for growth physical capital o (D) tools and equipment used in the production of goods and services human capital o The resource represented by the quantity, knowledge, and skills of the workers in an economy o Technology (D) the knowledge that is available for use in production produce more for less o Institutions (D) Significant practice, relationship, or organization in a society conditions in which decisions are made include laws, regulations, and government also include work habits, expectations, and political behavior Chapter 12 Growth Theory Solow Growth Model This model still forms the basis of growth theory, but the theory has changed significantly over the past two decades Solow 1: Diminishing Returns, Aggregate Production Function Aggregate Production Function o Relationship between all the inputs used in the economy and the total output of the economy o For the macro economy, output is GDP Equation form o Y = F (physical capital, human capital, natural resources) Aggregate Production Function Marginal product (MP) o (D) the change in output divided by the change in input o the more we have of any given output, the higher GDP will be Increasing inputs will increase output Diminishing Marginal product (DMP) o (D) the marginal product of an input falls as the quantity of the input rises Two Theoretical Implications 1. Steady states o (D) the long-run equilibrium point of a macro economy when there is no new net investment o there is no change in capital stock or real income at this point o Since MPK decreases, there eventually will be no positive net return to more investment, even if the cost of capital is zero Investment Depreciation o (D) the fall in the value of a resource over time Net Investment o (D) Investment minus depreciation o to increase capital stock, net investment must be positive o in a steady state, there is no net investment… net investment = 0 o however, some positive investment is needed to offset depreciation 2. Convergence a. (D) the idea that per capita GDP levels across nations will equalize as nations approach the steady state b. just because one nation reaches steady state, doesn’t mean everyone one did Solow II: Technology Matters Solow II equation: Y = A X F (physical capital, human capital, natural resources) o Where “A” is a scalar (a numerical constant) (more technology will increase the value of “A”) accounting for technology change Exogenous Technological Change Assumption of exogenous technology shocks o The model assumes that technological change occurs exogenously (current economic situations can drive more technology growth to occur) o Technology increases just “happen” to hit, but there is nothing in the economy that produces the change. Developed nations won the technology lottery Two reasons for this assumption o Technological progress often is lucky and random o Made the theoretical models easier to solve mathematically Modern Growth Theory Powered by the intuition that some economies grow faster for reasons special to those economies o In other words, technological change is now considered endogenous (factors inside the economy) o Now, we can focus on creating an environment that encourages technological change Chapter 13 The Aggregate Demand—Aggregate Supply Model Aggregate demand Aggregate demand (AD) o (D) total demand for final goods and services in the economy o AD = C + I + G +NX Consumption, investment, government purchases, net exports The Aggregate Demand Curve Price Level (P) o Nominal variable that reflects current price changes without adjusting for inflation o Since we are looking at all final goods and services, the correct price index to use is the GDP deflator o Given the above, a rise in P indicates inflation in the economy Real GDP (Y) o Economy’s output of goods and services, corrects the growth in the economy for prices AD curve has a negative slope due to o Wealth effect, interest rate effect, international trade effect Wealth Effect Wealth o (D) the value of an individual’s accumulated assets o The total value of everything you own Wealth Effect o (D) The change in the quantity of aggregate demand that results from wealth changes due to price level changes o related with purchasing power o increasing overall price levels will decrease your purchasing power which reduces spending and decreases the quantity of goods demanded The Interest Rate Effect Interest rate effect o (D) Occurs when a change in the price level leads to a change in interest rates and, there for in the quantity of AD International Trade Effect International trade effect o (D) A change in the domestic price level leads to a change in the quantity of net exports demanded Shifts of the Aggregate Demand curve GDP = C + I + G + NX Domestic Factors That Can Shift AD Anything that changes major spending habits of individuals and firms will shift AD This includes changes in real wealth, expected income, and expected price levels o Stock market rises or falls o Widespread change in real estate values o General expectations about the future o Change in consumer confidence International Factors That Can Shift AD Foreign income and wealth o If foreign nations become wealthier, demand for U.S goods decreases (NX decreases) Exchange rate (value of the dollar) o If the value of the U.S dollar rises, U.S can buy more imports, but other countries can buy less U.S goods (decreasing exports), so NX falls, leading to a shift in AD Aggregate Supply Aggregate supply (AS) o (D) total supply of final goods and services in the economy short-run AS vs. Long-run AS o The slope of AS depends on the time horizon Short-run AS o Positively sloped, i.e depends on price level Long-run AS o Vertical (infinite) slope o Recall that prices have nothing to do with long-term output and growth of the economy Long-run Aggregate Supply Long run o A period of time sufficient for all prices to adjust Natural rate of output o The rate of production achieved by the economy in the long run when unemployment is at its natural rate o Y* = Natural rate of output when u=u* Shifts in the Long-run AS Occur when there is a change in an economy’s resources, technology, or institutions Short-Run Aggregate Supply Short run o Time period in which not all prices have adjusted to some macroeconomic change o Some prices adjust immediately, others don’t Three explanations for why the nominal price level affects real GDP in the in the short run leading to an upward-sloping SRAS o Sticky input prices Tend to be sticky (not as flexible). Set by contracts Fixed interest rates, yearly wage contracts o Menu cost o Money illusion Long-run shifts Whenever the long-run AS curve shifts, it takes the short-run AS curve with it Factors that shift only the short-run AS curve Temporary supply shocks o Drought, hurricane, oil shock Changes in expected future prices Adjustments to errors in past price expectations Shifts in Long Run AS Resources, institutions, technology Econ Exam 2 Review CHAPTER 15 FEDERAL BUDGETS: THE TOOLS OF FISCAL POLICY Government Budgets A budget must have plans for both incoming and outgoing funds Government budget is a plan for both spending and raising funds for the government o Sources of funds (income or revenue) o Uses of funds (spending or “outlays”) Government Outlays and Revenues Government outlays o The part of the government budget that includes both spending and transfer payments Government outlays = government spending + transfer payments Transfer payments o (D) payments made to individuals when no good or service is received in return o Transfer payments make a large (and growing) share of government outlays o Transfer payments are NOT included in GDP since no good or service is provided in exchange for the payments o Example: Social security payments to retired and disabled Total outlays represent the spending side of the government budget Difference between government spending and transfer payments? o Spending is when the government buys something in the marketplace o With transfer payments, the government transfers funds from one group to another Government revenues o Generally raised through taxes o Other small fees as well, i.e nation park admittance, museum admittance, etc. Major Categories of National Government Outlays Mandatory outlays (entitlement programs) o (D) Comprise government spending that is determined by ongoing long-term obligations o Examples: Social Security (bigger expense than defense spending) and Medicare o By far the largest portion of government outlays o Not generally altered during the budget process because they require changes to existing laws, which take time to accomplish Interest payments made to U.S. owners of Treasury bonds Discretionary outlays o (D) Comprise spending that can be altered when the government is setting its annual budget o Examples: Bridges, roads, payments to government workers, defense spending HOW TO COMPARE THIS TO INDIVIDUAL LIFE: o Mandatory outlays: monthly rent, monthly phone bill o Discretionary outlays: entertainment, groceries (yes, you have to eat, but there is flexibility in spending choices depending on your current money situation) Social Security and Medicare Social Security o Government-administered retirement program o Set up in 1935 by Franklin Roosevelt o Requires workers to contribute a portion of their earnings to the Social Security Trust Fund with the promise that they will receive these back upon retirement (including a modest growth rate). Goal? o Guarantee that no American worker retires without at least some retirement income Medicare Medicare o A mandated federal program that funds health care for retired people o Established in 1965 by Lyndon Johnson o Law requires current workers to pay Medicare taxes (with promise of insurance upon retirement Goal? o Ensure that all retired workers have some funding for their health care Social Security and Medicare Demographic changes are the main reason why Social Security and Medicare currently make up such a large portion of the budget Spending and the Current Fiscal Issues Increased government spending began recently, due to a number of events Increased defense spending in the wake of September 11, 2001 Defense spending was 16.5% of the budget by 2001 By 2010, defense spending comprised 19.1% of the federal budget The increased spending on Social Security and Medicare The government responses to the Great Recession, beginning with fiscal policy in 2008 (chapter 16) How do Federal Governments Raise Revenue? Generally, government revenue comes from taxes Most people probably don’t enjoy paying taxes but government activity must be paid for. Payroll taxes (deducted from paychecks) Income tax, Social Security tax, and Medicare tax combined for more than 80% of all federal tax revenue Other tax revenue sources Corporate taxes Estate/gift taxes (in the form of inheritance tax) Excise taxes on goods like cigarettes Custom taxes on imports Social Insurance Taxes Social and Medicare are paid for with taxes on employees’ pay. o Benefits received at retirement depend on taxes paid while in the labor force o Tax is 15.3% of the worker's pay o Typically, the worker and the firm split this tax bill, each paying 7.65% o Tax is applicable on first $110,100 a person earns o Revenue goes into the SSI and Medicare trust funds that serve to provide income and healthcare assistance to retirees Income Tax Progressive income tax system o (D) A system in which people with higher-incomes pay a larger portion of their incomes in taxes than people with lower incomes do Marginal tax rate o (D) The tax rate paid on the next dollar of income o marginal tax rates increase with higher earnings with a progressive tax system Average tax rate o (D) Total Tax paid divided by taxable income o Will be less than the marginal tax rate due to progressive tax system What are budget deficits and how bad are they? Budget deficit o Occurs when government outlays exceed revenues o More funds flowing out than in Budget surplus o Occurs when government revenues exceed outlays o More funds flowing in than out Outlays and Revenue Three general observations 1. Deficits grow when outlays increase, or revenues decrease (or both) 2. Deficits tend to grow during recessionary periods 3. Recent U.S budget deficits are large in a historic context Deficits VS. Debt Deficit vs. Debt Deficit: a shortfall in revenue for a particular year’s budget National debt: sum total of all accumulated and unpaid deficits The national debt Part of the debt is owed to the public Part of the debt is owed to government agencies (one branch of government can owe another branch). Chapter 16 Fiscal Policy How Does Fiscal Policy Work? Fiscal policy o The use of government spending and taxes to influence the economy o Spending and taxes changes must be legislated and approved by Congress and the president o Can be used in conjunction with (or instead of) monetary policy (Chapters 17&18) to steer economy Fiscal Policy Expansionary fiscal policy o Government increased spending or decreases taxes to stimulate the economy toward expansion o When the economy is slowing, the prescription is for expansionary fiscal policy Contractionary fiscal policy o Government decreases spending or increases taxes to attempt to slow economic expansion. o Used when the government wants to pay off debt, or slow down an “overheated” economy o Keep economy from expanding beyond long-run capabilities Expansionary Fiscal Policy Two ways to expand aggregate demand (AD) using fiscal policy The goal is to increase aggregate demand to move the economy to full-employment equilibrium, where real GDP is at its full-employment level, and the unemployment rate is equal to the natural rate 1. Increase government spending (G) a. Since G is one component of AD, increases in G directly increase AD b. If private spending (C, I, and NX) is low, then government can increase AD by increasing G. 2. Decrease taxes (T) a. Reducing the overall tax burden on private individuals, and gives them more to spend b. The focus here is on increasing consumption spending Debts and Deficits The bottom line is clear: o Expansionary fiscal policy leads to increases in deficit and debt during recessions. But why expansionary fiscal policy might work for the overall economy? o Spending by one person becomes income to another o Multipliers: money gets spent multiple times Contractionary Fiscal Policy Two reasons to decrease aggregate demand (AD) by decreasing (G) or increasing taxes (T): o Pay off debt that accrued due to expansionary fiscal policy during bad times o Slow down economy that is “overheated” from too much spending, which can lead to inflation Not sustainable in the long run Try to reduce upward pressure which is put on price level Side notes “overheated” economy o Real GDP greater than full-employment output Countercyclical Fiscal Policy Countercyclical fiscal policy o (D) The fiscal policy that seeks to counteract business-cycle fluctuations o It consists of using Expansionary policy during recessions Contractionary policies during expansions o Used to decrease “size” of expansion and recessions Remember, the natural path of the economy includes business cycles during which income and employment fluctuate. The hope is that countercyclical fiscal policy can reduce these fluctuations Goal is to smooth out the fluctuations in the business cycle Multipliers Two multiplier concepts: o Spending by one person becomes income to others; this is true for private and government spending. o Increase in income generally lead to increases in consumption Marginal propensity to consume (MPC) o (D) the portion of additional income that is spent on consumption i c osumption M CP i n icome When you see the word “marginal,” you’ll see the Greek letter delta (triangle) in the math. MPC of the Rich and Poor Lower-income people and countries have a higher MPC than their wealthier counterparts o Higher income usually means your basic needs have been met o Additional income is more likely to be saved for the future Relationship to multiplier o If a “stimulus package” is introduced in the form of tax breaks with the goal to boost AD, it will be more effective if it increases the income of people with higher MPC Spending Multiplier To determine the total impact on spending from any initial government expenditures, we need to use the spending multiplier formula Spending multiplier (m ) o (D) illustrates the total impact on spending from an initial change s 1 m 1 MPC of a given amount The multiplier depends on the MPC. The larger the MPC, the larger the multiplier Less taxes = more money into the multiplier Time Lags Recognition lag o It is difficult to determine when the economy is turning up or down o GDP data is released quarterly and the final estimate is not known until three months’ afterward o Unemployment rate data tends to lag even further o In addition, growth is not constant. One bad quarter or one good quarter might not mean anything Implementation lag o It takes time to implement fiscal policy o Changes in taxes and spending must pass through both houses of Congress and the president Impact lag o It takes time to materialize o Multiplier effect occur over time Effects of time lags o Time lags could exacerbate cycles rather than smoothing them out o Expansionary policy may hit when the economy is already expanding o Contractionary policy may hit when economy is shrinking Solutions of time lags Automatic stabilizers o Automatic s
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