ECON 2105, Study Guide Test 2
ECON 2105, Study Guide Test 2 ECON 2105
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This 24 page Study Guide was uploaded by Randi on Thursday October 13, 2016. The Study Guide belongs to ECON 2105 at University of Georgia taught by McWhite in Summer 2016. Since its upload, it has received 125 views. For similar materials see Macroeconomics in Macro Economics at University of Georgia.
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Date Created: 10/13/16
ECON 2105 Study Guide Test 2 ECON 2105 PROF. MCWHITE Highlight = Important Concept Highlight = Key term Chapter 6: Understanding GDP, Spending, and Income • Gross Domestic Product o The market value of all final goods and services produced in a country during a given period o It measures a nation’s production and income at the same time Ø You buying stuff is someone else’s income… add all of this up for a nation Ø If GDP decreases, the economy s producing less and total national income falls • GDP is used to compare countries o It is also used to measure business cycles o Long-‐Term economic growth o Living Standard • Low GDP is not always an indicator of an economy with poor health o It may be a small country with a high GDP per capita o It may have a strong real GDP growth rate • How do we measure how the economy is doing? o We look at if the economy is in a recession and its real GDP o Recession: § A fall in GDP over 2 quarters § Don’t always prevent a Long-‐Run increase in GDP • Usually balanced out with economic growth o Real GDP § Value of the goods and services produced by the nation’s economy minus the value of the goods and services used up in production, adjusted for price changes • Graphs of dollars values over time need to be adjusted because of inflation • Inflation o An increase in the overall price level o There is also hyperinflation ECON 2105 Study Guide Test 2 o Related to the money supply in the economy relative to the quantity of goods and services o Governments can cause it on purpose • Deflation o Decrease in overall price level o Deflation is not necessarily a good thing • Real vs. Nominal GDP o Nominal: Prices and other values in those years o Real: Prices and other values adjusted for inflation § Adjusted to prices in the base year** § How much stuff can I buy with these dollars? § When prices go up, GDP goes up as well **This is why we are more concerned with real GDP • A home may have cost $7000 in 1945. However, it may cost $62,000 in 2016. Nominally speaking, it costs more now… in real terms, it may not • Purchasing Power Parity (PPP) o The idea that a unit of currency should be able to buy the sane quantity of goods and services in any country o China has the largest economy based on PPP as of last year o USA has the largest economy based on Real GDP (stuff produced) • GDP per capita o GDP is a good measure to compare economies, but GDP per capita is a better comparison to use between individuals in the same economy o GDP per capita is how much stuff per person in the country GDP / Population • What countries produce over time changes o For example: The US has gone from mostly agriculture à mostly manufactured goods à to now mostly services • Market value o Many countries produce a lot of similar and different things, so we use market value to count it o The more valuable items have heavier weight Price X the Quantity of Good Produced ECON 2105 Study Guide Test 2 • Final goods and service o When it gets to the consumer that is a final good or service, or when it is in inventory to be used later o Make sure to avoid double counting o A majority (about 70%) of US GDP comes from services! • Goods/services produced in the US by foreign countries count towards US GDP o US goods produced abroad count towards Gross National Product (not GDP) • Intermediate good o Goods that firms repackage/bundle with other goods for sale at a later stage Example: Cellphone keyboard • Increased commercial travel adds directly to GDP • What is made and sold this year adds to GDP 1. When BMW makes care in the USA à counts as USA GDP 2. When Ford builds a car in Europe à does not count as USA GDP • What makes up GDP? o The Expenditure Method: § Consumption (C) § Investment (I) § Government Purchases (G) § Net Exports (NX) Total = GDP 1. Consumption o Spending by household makes up Consumption o Purchase of final (not intermediate) goods and services o Most people spend a majority of their income on consumption goods/services o Durable goods: § Things that are expected to last more than a year (roughly speaking) § Example: furniture, automobile o Nondurable goods: § Things that will be consumed immediately or not last very long § Example: Happy Meal o Services: § When you pay people to do something ECON 2105 Study Guide Test 2 2. Investment o Spending by firms o Spending on tools/equipment to produce future output (capital goods) o A share of stock is not considered part of GDP o Example: Business: A corporation fixed one of its machines Residential: Buying a home Inventory: What is not sold to consumers 3. Government Purchases o Purchases by local, state, and federal government o Does not include transfer payments (example: social security) o Doesn’t include interest on debt o Government spending has increased over the years • Example goods: tanks, street signs, missiles, buildings Example services: teachers, trash services, police 4. Next Exports Exports – Imports o Exports: o Goods produced domestically, sold abroad o Imports: o Goods produced abroad, sold domestically o Our net exports have been negative for a long time o A good has to be produced/sold in the same year to count towards the year’s GDP PRACTICE: • A 1973 corvette sold in 2016 is not counted in this year’s GDP • A vacuum cleaner made and sold in 2016 counts towards this year’s GDP • Price Level and GDP Deflator o Comparing different years is more accurate using real GDP o Nominal GDP: GDP in the current year’s prices o Price level: Index values of prices in the economy • GDP Deflator: o A measure of price level o Calculated value used to determine real GDP ECON 2105 Study Guide Test 2 CALCULATIONS: • Nominal GDP o Take the market value of each good or service (Price X Quantity) o Add them all together • Real GDP o Determine the base year (this will be given) o (Nominal GDP/ Price Level) X 100 • GDP Deflator (Price Level) (Nominal GDP / Real GDP) X 100 *base year will always be 100 • We use growth rates to determine where the economy is going o This changes from year to year • Example: Nominal GDP Growth Rate for 2014 = (GDP2014 – GDP2013) / GDP2013 X 100 • Price Level Changes (GDP.Deflator 2014 – GDPDeflator2013) / GDPDeflator2013 X 100 • With the changes in the price level and the Nominal GDP, we can determine the change in real GDP Growth in Nominal GDP = Growth in Real GDP = Growth in Price Level • Issues with GDP: 1. Non-‐market goods/services 2. Underground/illegal markets 3. No value for standard of living • Environmental quality • Leisure time • Higher per capita GDP correlates with higher standard of living 1. Non-‐Market Activities Example 1: o You go to Lowes and buy tiles to fix your kitchen… this is included in GDP o You hire someone to fix the kitchen for you… this is included in GDP ECON 2105 Study Guide Test 2 o You watch videos online and fix the kitchen yourself… Not included in GDP Example 2: o Your house is a mess, so you hire a maid… this is included in GDP o You clean the house yourself… Not included in GDP Example 3: o You hire a professional lawn care company to cut your grass… this is included in GDP o You pay your neighbor’s kid to do it for you… probably not included in GDP (cash exchange) • Cash exchanges may not be documented and sent into the IRS • In countries where governments are more corrupt, there is usually a higher cash economy 2. Illegal markets • Exchanges on black markets are not counted in GDP • Illegal markets can’t be prevented and are hard to keep track of 3. No value for standard of living • Standard of living is subjective • Environmental quality: o Less environmental regulation could improve GDP o Would this be a good thing? • More spending to prevent crime/treat cancer could increase GDP • Leisure time: o Are we better off if we spend a lot of time at work? ECON 2105 Study Guide Test 2 Chapter 8: The Price Level and Inflation • Consumer Price Index (CPI) o For a given period, a measure of costs of a standard basket of goods/services, relative to the cost of said basket in a base year o CPI is a basic tool for economists to measure the price level and inflation in the economy for consumers o Also known as a measure of the cost of living • What’s in a “basket” of goods/services? o Goods consumers would buy on a regular basis o Examples: food, housing, medical care, transportation • What is not in the “basket”? o CPI does not include stocks, bonds, real estate, life insurance, investments, or taxes o These goods are savings goods and consumption expenses • Bureau of Labor Statistics (BLS) is in charge of CPI o They determine what is important to consumers o The basket should reflect where consumers put their resources s CPI = (Price of Basket in the current year) X Quantity of Base Year (Price of Basket in the base year) X Quantity of Base Year *the Q stays the same from the base year *the basket is not GDP • Price Index= (Basket Price in Current Year/ Basket Price in Previous Year) X 100 • Price in an earlier period’s dollars= (Price Today) X (Price Level of Earlier Time/ Price Level Today) ECON 2105 Study Guide Test 2 • CPI vs. GDP Deflator o Real GDP holds Price constant § CPI holds goods/services constant o GDP and Deflator consider all goods/services in the US § CPI considers a basket of goods/services relevant to consumers o GDP is not affected by changes in the price of foreign goods § CPI can be if it is part of the basket • Inflation Rate = [(Price 2 – Price 1)/ Price 1] X 100 • Issues with Inflation 1. Uncertainty about the future decisions 2. Price Confusion 3. The cost of holding money (“shoe leather costs”) 4. Money Illusion 5. Menu Costs 6. Wealth Redistribution and Tax Distribution 1. Uncertainty o Not knowing what to expect from the price levels in the future changes behavior of individuals and firms 2. Price Confusion o What is causing prices to change? o You may mistake inflation with changes in demand or changes in the markets for your inputs 3. Holding Money (Shoeleather costs) o Shoeleather costs are the resources that are wasted when people change their behavior to avoid holding money o If inflation is increasing, the value of money decreases o This is not as big an issue in countries with stable credit and updated banking systems o This was a bigger issue in the past ECON 2105 Study Guide Test 2 4. Money Illusion o Money illusion occurs when people interpret nominal changes in wages/prices as real changes. o As inflation increases, real values of money become more difficult to determine 5. Menu Costs o Menu costs are the costs of changing prices o Less informed customers think you’re just raising prices and shop elsewhere… until they realize it’s increasing every where else as well 6. Wealth/Taxes o Wealth distribution: § Borrowers are made better off by inflation § The real value of money paid back is less o Taxes: § Taxes don’t account for inflation § If you’re wages rise to maintain the real value of your pay, what happens? • The IRS actually changes tax rate margins yearly • Capital Gain taxes o Taxes on the gains realized for selling an asset for more than its purchase price ECON 2105 Study Guide Test 2 Limitations with CPI: 1. Substitution Effect 2. Changes in Quality 3. New Products in the Economy • The estimate from CPI may over or underestimate the true change • It is important that CPI is accurate because employers use it to adjust for wages o As CPI increases, so do wages 1. Substitution Effect o Consumers respond to price changes o When price rises, Quantity Demanded falls and consumers will buy other goods if it’s an option o CPI assumes no change in the amount bought which exaggerates the price effect 2. Quality Changes o CPI makes no distinction about quality of goods o If you’re paying a higher price for a better product, that is not an inflation effect § Advances in technology usually cause prices of some goods to decrease overtime o CPI will be biased upward § Upward bias: prices are estimated to have gone up more than what they really have 3. New Products o The CPI is updated, but not quickly o New goods tend to decrease in price at first, so that’s not captured in the delay o The surveys are done in stores, which misses online sales o The solution is a chained CPI § Chained CPI is a measure of the CPI in which the typical consumer’s basket of goods is updated monthly § It keeps track of upward bias • Billion Prices Project (BPP) o This is an independent index that tracks prices across the internet o Many prices can be monitored daily ECON 2105 Study Guide Test 2 4. Substitution Effect o Substitution causes the basket of goods the typical consumer buys to change. o As price increases, quantity demanded decreases o Consumers will buy other goods if its an option ECON 2105 Study Guide Test 2 • Social Security is adjusted based on the CPI o Cost of Living Adjustment (COLA) o COLA keeps real Purchasing Power from going down • CPI assumes you buy the same amount of goods every year… this is why the base year is constant ECON 2105 Study Guide Test 2 Chapter 9: Savings, Interest Rates, and the Market for Loanable Funds • For a company to have long term growth, there must be an adequate level of investment • 2 groups in the financial markets: 1. Those that have funds that they choose no to use at the present (lenders) 2. Those who have an immediate need for capital to invest in an idea/project (borrowers) • A financial market is a means to bring the above two groups together • Loanable funds market § Savers supply funds to borrowers § Future production depends on present investment which needs funding • When people start retiring, they draw money out of the global funds market o This causes interest rates to go up o This means the loans you qualify for gets smaller • 2 ways to get funds 1. Direct Finance • Occurs when borrowers go directly to savers for funds • Example: stocks and bonds 2. Indirect • Occurs when savers lend funds to financial intermediaries, which loan these funds to borrowers • Example: banks (and others) *most of us deal within the indirect method • Stocks o Ownership shares in a firm • The stock market is borrowing/lending by selling rights to potential profits • Generally speaking in the stock market: o Stock or equity in the company is sold o There is no guarantee of payment o Only select groups of people receive dividends ECON 2105 Study Guide Test 2 • Large corporations can issue stock o Corporations receive funds at the initial price offering (IPO), not as share prices rise o You buy shares from brokers (not directly from the company) § Brokers are examples of a Secondary Market • Place where securities are traded after their first sale Example: New York Stock Exchange • Most of our dealings with financial markets are through Indirect funding o The US banking system is the most common example • Bank o Maintain deposits of customers o Also give out loans § Banks consolidate small individual savings and lend those to investors • Demand: Those looking to spend money now • Supply: Those saving now • Like any market, there’s a price to borrow money o In the loanable funds market, this is called the interest rate • The interest rate is 1. An incentive to save instead of spend 2. The cost of spending money you don’t have • Increasing interest rates cause individuals to spend less and save more o Also causes firms/individuals to borrow less • Real Interest Rate o Interest rate that is corrected for inflation o It is the rate of return in terms of real purchasing power • Nominal Interest Rate o Interest rate before it is corrected for inflation o It is the stated interest rate • FISHER EQUATION Real Interest (r) = Nominal (i) – Inflation (π) Also can be written as: i = r + π ECON 2105 Study Guide Test 2 • Equilibrium of Loanable Funds Market Plans of Savers = Plans of Borrowers ECON 2105 Study Guide Test 2 Factors that shift the DEMAND for funds: 1. Productivity of capital • Firms borrow in order to finance capital purchases • If capital is more productive, the demand for loans will increase 2. Expectations of investors • Investor Confidence: A measure of what firms expect for future economic activity • If a firm believes its sales will increase in the future, it invests more today to build for future sales 3. Expectations of inflation rate Factors that shift the SUPPLY of funds: 1. Discount rate of investors (also known as time preferences) o People prefer to receive goods and services sooner rather than later o People with the strongest time preferences are the least patient § They want funds now o If someone saves money, it is said they have a low discount rate 2. Income/wealth changes o As nations gain wealth, they save more 3. Consumption patterns (smoothing) o Consumption smoothing is accomplished with the help of the loanable funds market o It is being able to spread out income/spending in a way that is consistent and balanced way throughout the consumer’s lifetime o Dissaving: People withdraw funds from their previously accumulated savings 4. Relative saving options 5. Expectations of inflation rate o Inflation makes the real value of your debt go back down ECON 2105 Study Guide Test 2 Examples: • Effect on supply and demand of loanable funds market when inflation is expected to increase Inflation S’ S D’ D Quantity of Loanable Funds • Effect on demand of loanable funds market when expectations of investors increase Example: Apple predicts that the economy is going to pick up. Inflation S D’ D Quantity of Loanable Funds ECON 2105 Study Guide Test 2 • Effect on supply of loanable funds market if wealth increases o The amount of funds available is going to change Inflation S S’ D Quantity of Loanable Funds ECON 2105 Study Guide Test 2 Chapter 10: Financial Markets and Securities • Saving vs. Investing o If you put $200 in the bank this is saving o A company takes out a loan… this is investing • A decrease in income causes interest rates to increase • Bond prices and interest rates are inversely related • Bond o A bond is a debt instrument with a fixed interest payment o Bonds are less risky than stocks o Bonds can be wither long-‐term or short-‐term *Long-‐term bonds have higher rates of interest • Interest Rate: (Face Value – Initial Price) / Initial Price • Face value o Also known as par value o This is the value of the bond at the maturity date (when the loan repayment is due) • Discount bond o Bond is sold for less than what it’s face value is o The face value is still due at maturity though Example: A bond is $1,000. It is sold for $900. Interest Rate: (1000-‐900)/(900) = 11.1% ECON 2105 Study Guide Test 2 • Effect on supply of bond market when expectations of investors increase: o When supply of bonds is going up, it drives the price down Price S S’ D Quantity • Bond market when wealth increases: S D’ D ECON 2105 Study Guide Test 2 • Default Risk o The chance that the borrower will not pay back the funds owed pay back their bonds) o Default risk (ρ) I = r + π + ρ *California and Illinois have the worst credit rating in the United States • The government spends more than it takes in • Deficit o Yearly difference between taxes and costs • Debt o The total of all deficits • Security o A tradable contract that entitles its owner to certain rights o A bond is a security that represents debt unpaid • Treasury Securities o Bonds sold by the federal government o T-‐Bills § Short-‐term bonds, less than 52 weeks until maturity o T-‐Notes § 1-‐10 years until maturity o T-‐Bonds § Longer than 10 years until maturity • Securitization o The creation of new security by combining otherwise separate loan agreements o Combining different assets (like mortgages) and then selling them to investors o Taking things that aren’t usually considered assets and making them tradable ECON 2105 Study Guide Test 2 Chapter 11: Economic Growth and the Wealth of Nations • In wealthy countries there is a presence of stable legal, banking, and political systems • Economic Growth: Percent Change in Q = (%Change in Y − %Change in P − %Change in Population) • Human Capital o The resource represented by the quantity, knowledge, and skills of the workers in an economy • Institution o A significant practice, relationship, or organization in a society o The official and unofficial conditions that shape the environment in which decisions are made • Private Property Rights o Individuals can own property (houses, land, and other resources) o When their property is used in production, they own the resulting output • Resources o Also known as factors of production o Inputs used to produce goods/services • Rule of 70 o If the annual growth rate of a variable is x% the size of that variable doubles every 70/x years o This is an approximation o Shows that small/consistent growth rates that are sustained can greatly improve the living standards • Technological Advancement o Introduces new techniques or methods so that firms can produce more valuable outputs per unit of input • Technology o The knowledge that is available for use in production • When markets aren’t competitive, people face barriers to entry • International Trade barriers reduce the benefits from specialization and trade ECON 2105 Study Guide Test 2 Chapter 12: Growth Theory Production function o Relationship between the inputs a firm uses and the output it creates q = output of the firm o The production function for a single firm = q = f (human capital, physical capital) k = human capital L = labor NR= Natural Resources Aggregate Production Function o Relationship among all the inputs used in the macroeconomy and the total output of that economy, where GDP is output GDP = Y = F (physical capital, human capital, natural resources) Marginal Product (MP) o The MP of an input is the change in output divided by the change in input o Economist use this to quantify how helpful an additional resource may be MP of Input x = Change in output/ Change in input x Diminishing Marginal Product o The marginal product of an input falls as the quantity of the input rises Convergence o The idea that per capita GDP levels across nations will equalize as nations approach a steady state Depreciation o A fall in the value of a resource over time o This is natural with capital Endogenous Growth o Growth driven by factors inside the economy Exogenous Growth o Growth that is independent of any factors in the economy Net Investment Investment – Depreciation ECON 2105 Study Guide Test 2 Steady State o The condition of a macroeconomy when there is no investment § Voluntary investment and production occurs only if: Expected payoff ≥ costs .
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