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UGA / Economics / ECON 2105 / the five foundations of economics

the five foundations of economics

the five foundations of economics


School: University of Georgia
Department: Economics
Course: Macroeconomics
Professor: Mcwhite
Term: Summer 2016
Tags: Macroeconomics, supply, demand, aggregatedemand, pricecontrols, Fiscal, Monetary, markets, growth, unemployment, inlfation, CPI, and GDP
Cost: 50
Name: ECON 2105, FINAL Study Guide
Description: This study guide covers material from the entire semester. It includes lecture notes, notes from readings, and previous study guides. Good luck!
Uploaded: 12/07/2016
75 Pages 12 Views 11 Unlocks

Study Guide FINAL TEST

What are People respond to incentives?

ECON 2105 


Highlight = Important Concept Highlight = Key term 

Final Exam: What to know

Part I: Comparative Advantage

Opportunity Cost

Supply and Demand

Price Controls  

Part II:  Unemployment Rate



Financial Markets


Part III: Aggregate Supply and Aggregate Demand Fiscal Policy

Monetary Policy  

*Chapter 19: International Trade will not be on the exam

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Part I

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Chapter 1: The Five Foundations of Economics

• What is economics?

o Looking at human behavior, based on choices

o In other words, it is the study of making choices in the presence  limited resources and unlimited wants (scarcity)

o To study the economy you need:

▪ People with wants/needs

What is the benefit of getting an additional unit?

▪ Decisions about how to allocate resources

▪ Resources in limited supply

▪ Trade-offs

o Positive Economics: Don't forget about the age old question of what is Revocation of Edict of Nantes?

▪ Positive Economics consists of facts, not opinions

o Normative Economics: 

▪ Normative Economics is the opposite of Positive. It is opinion based.  

▪ People argue their viewpoints

2 Divisions of economics:

1. Microeconomics: focused on the decisions of individual units  (person/company/country)

⮚ Concepts like: externalities, Robert’s budget, a firm’s decisions 2. Macroeconomics: focused on interactions of the individuals as a whole  economy

⮚ Concepts like: GDP, inflation, tax policy, exchange rates

• What are the five foundations of economics?

1. People respond to incentives 

o Incentives are motivation factors in making decisions the way  we do – they can either be positive or negative

What is Ceteris paribus?

We also discuss several other topics like marketing strategy planners should recognize that

      *They change our behavior

⮚ Direct Incentive: hopefully causes the desired result

⮚ Indirect Incentive: Unexpected behavior

2. Trade-offs 

o Because we cannot do everything, we must consider our  

options (trade-offs)

  What are the other ways I could allocate my resources?

o We make trade-offs with our resources

3. Opportunity costs 

o The next best option that you had to give up

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o The highest value forgone alternative

o The trade-off of your next best choice for your resources

4. People make decisions at the margin 

o Marginal thinking is evaluating the cost/benefit of one  

more additional unit

o This is based off the assumption of the Principle of Self

Interest: People are rational and want to make the best  

decision on how to spend their resources

o Most decisions happen in incremental changes If you want to learn more check out glst

⮚ This means they are not “all or nothing.” People stop  

when the additional cost is greater than the additional  

benefit of an action.

o What is the benefit of getting an additional unit?  

⮚ For example: You are hungry and eat a piece of pizza. The  

first slice is great, and the second slice is also good. On the  

third slice, you get full. Is there any benefit in eating the  

fourth slice? After every slice of pizza, your satisfaction of  

the next unit, or your marginal benefit, started to  


o Your optimal decision point is where the Marginal benefit =  

the Marginal Cost  


5. Trade increases total value 

o Trade is beneficial to all parties involved!

o People decide who they want to compete with and who they  want to cooperate with  

o Trade makes us interdependent

o People are better off when they specialize in what  

they are best at and then trade that skill/product  

with others

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• What are markets? Don't forget about the age old question of kilegram

o A market is a place where buyers/sellers meet to buy/sell goods and  services 

o Markets make us better off because we end up with more stuff! ⮚ Everyone focuses on their comparative advantage

o Markets focus on the relationship between competition and  


o Law of Beneficial Specialization: 

▪ Workers do whatever involves the lowest opportunity cost  

compared with other tasks If you want to learn more check out cmsi inc

• Comparative advantage 

o Comparative advantage deals with the differences in opportunity  costs between producers. This is the basis for specialized production  and trade! If you want to learn more check out mat1330

o Who is the low-cost producer of a good?  

▪ Who has the lowest opportunity cost of producing a good?

• Absolute advantage 

o The ability to produce more of a good in comparison to someone else *Just because a producer may have absolute advantage, does not  mean they have comparative advantage!!!

For example:  









Sal has absolute advantage in the production of both hotdogs and buns because he can  produce the most. However, Murr has the comparative advantage in the production of  buns because he has the lowest opportunity cost. For every 1 bun he produces, he only  gives up producing 2 hamburgers, while Sal gives up 3:  

Murr: 20 Hamburgers = 10 Buns 1 Bun = 2 Hamburgers 10 10

Sal: 90 Hamburgers = 30 Buns 1 Bun = 3 Hamburgers 30 30

On the other hand, Sal has comparative advantage in the production of hamburgers.  For every hamburger he produces, he only gives up 1/3 of a bun, while Murr gives up  1/2 a bun:

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Murr: 20 Hamburgers = 10 Buns 1 Hamburger = 1/2 Bun 20 20

Sal: 90 Hamburgers = 30 Buns 1 Hamburger = 1/3 Bun

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Chapter 2: Model Building and Gains from Trade

• Ceteris paribus – “Other things the same” 

o This term is used to describe static analysis of markets

o In a theoretical/perfect market where everything holds constant,  

what will we observe?

• De qustibus non es disputandum – “To each his own” 

o This term means there is no accounting for tastes/preferences of  


o Every person has their own likes and dislikes

• Law of Increasing relative cost: 

o Opportunity cost of producing a good rises as a society produces more  of it


o Economist use the PPF to show combinations of outputs in an  

economy given the available factors of production and the production  


o The PPF demonstrates that the economy is constrained by the ability  

to produce

▪ One product must be given up in order to produce a different


• At Point A, more units of  

Good A are being produced  

than Good B.

• Point B is not on the PPF  

curve. There are not  

enough resources in this  

market to obtain this  


• Point C displays that the  

market is under producing  

and not maximizing their  


• At Point D, more of Good B  

is being produced.

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o A PPF shows:

▪ Efficiency: Optimal use of resources

▪ Trade-Offs: Constraints to what’s possible, forcing a  

substitution of one thing to attain another

▪ Opportunity cost: highest forgone alternative

▪ Economic growth: Increase in output

• Consumer good: 

o Any good that’s produced for present consumption

o Satisfies wants now

• Capital goods: 

o These goods help in the production of other valuable goods/services  in the future

o For example: roads/trucks/computers/factories/education

• Investment: 

o Investing is where someone uses their resources to create/buy new  capital

• Endogerious factors: 

o Factors that we can control

o Example: wind speed

• Exogenous factors: 

o Factors that are beyond our control

o Example: air pressure, wind

Graphs in Economics: 

• Casual variable: 

o Occurring when one variable influences the other

• Reverse causation: 

o Occurs when causation is incorrectly assigned among associated  events

o Occurs when relationships are not properly understood

o Example: Cars that mechanics work on regularly break down. People who visit the dentist are more likely to get a cavity.

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• Omitted Variable: 

o A model that incorrectly leaves out one or more important factors o Causes two variable to appear to be directly related when they are not o Example: People become tired when they wear athletic clothes. Drinking a lot of water leads to sunburn.

• One variable graphs:

⮚ Bar graph: compares size/quantity

⮚ Pie chart: displays proportions

⮚ Time series: displays single variables across time

• Two variable graphs

⮚ Scatter plots: shows correlation between variables

o Positive correlation: 

When two variables move together in the same  


o Negative correlation: 

When two variables move in opposite  


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Chapter 3: The Market at Work: Supply and Demand

• Monopoly: 

o Exists when a single company supplies the entire market for a  particular good or service

• Imperfect market: 

o Either the buyer or seller has an influence on the market price

• Competitive market: 

o There are so many buyers/sellers that each has a negligible impact on  the market

▪ This means that because there is such a large quantity of  

people in the market, if one person decides not to buy or sell a  

product, it’s not going to make a difference. The market will  

continue on unaffected

o There are little to non transaction costs

▪ Transaction costs are the time/money/effort spent before  

buying a good

o All information is known by both groups

• Equilibrium price: 

o The quantity supplied equals the quantity demanded

o No shortage or surplus exists

o Also known as the market clearing price

▪ Shortage: the quantity demanded exceeds the quantity supplied ▪ Surplus: the quantity supplied exceeds the quantity demanded

• Law of Demand: 

o Ceteris paribus

o As prices decrease, quantity demanded of a good will increase o As prices increase, quantity demanded of a good will decrease ▪ This is an inverse relationship!!

o ONLY a change in PRICE causes a change in QUANTITY DEMANDED

• Quantity Demanded: 

o The amount of a good buyers are willing and able to purchase ▪ You must be willing AND able to be apart of this market

▪ Quantity demanded is different from Demand!

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What causes a change in DEMAND?

Everything EXCPET the price of the product!

1. Consumer income 

• Normal Goods: 

When income increases, demand increases (shifts right)

• Example: You enjoy steak. When your income increased,  

you began to buy more steak.  

Market for Steak

• Inferior Goods: 

As income increases, demand for a good decreases (shifts left) • Example: You usually buy a lot of spam when you are  

tight on money. As your income increases, instead of  

buying spam, you choose to buy more steak.


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2. Prices of related goods (substitutes/compliments) 

o Compliments 

▪ A good that goes along with another good

▪ For example: You always eat peanut butter and jelly together.  If the price of peanut butter increases, then the demand for  

jelly decreases.  

               o Substitutes 

▪ These are goods that are pretty much the same and can be  


▪ As the price for one good increase, the demand for its  

substitute increase

▪ For example: As the price for Pepsi increases, the demand for  Coke increases

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3. Consumer tastes 

• Marketing can change consumer tastes. People may prefer one brand  over another.

4. Expectations of future events 

• If consumers expect the price to be lower in the future, they will wait  until later to by a good.

• If consumers expect prices to rise in the future, they will by the good  now

5. Number of buyers in the market 

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• Law of Supply: 

o The higher the price of a good, the greater will be the quantity  supplied

o This is a direct relationship


What causes a change in SUPPLY?

Everything EXCPET price of the product!


• What goes into creating the product?

• If input prices increase, less of the product is  

going to be made because it is now more  

expensive to produce. Supply will shift left


• What technology is used to create the product?

• If technology used to create a particular product  

improves, more or the product can be made.  

Supply will shift right



• Quantity Supplied: 

o The amount of a good that sellers are willing and able to sell o If a firm isn’t willing AND able, it is NOT part of the market

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Chapter 4: Price Controls

• Price controls: 

o Usually enacted to ease perceived burdens on society

o Usually do more harm than good

o Usually do not help the people they were intended too

o Binding price control: 

▪ Price floor/ceiling that impacts the market

o Black markets: 

▪ Illegal markets that can arise because of price controls

▪ There is no rule that black market prices rise/fall in the long run

Types of Price Controls:

• Price floor: 

o The price floor is the lowest allowed price that a product can be sold  at

o Price floor can be binding

▪ This means that the set price is above the equilibrium price  o An example of a price floor is the minimum wage

▪ Most minimum wages are non-binding



B C Price floorA



• This figure depicts a binding price floor… it is a price set above the  equilibrium point

• Point A was the original equilibrium point for the labor market without the  minimum wage price floor.

• There is now a surplus of labor in the market (unemployment) between  points B and C

• There are more people demanding jobs versus willing employers

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• Price ceiling: 

o A set price that the market cannot exceed

o An example is Rent control

▪ Rent control is ineffective for helping low-income residents ▪ It usually subsidizes higher-income residents’ living

▪ It does not incentivize land lords to keep their apartments in  good living condition

P Supply


B C Price ceiling



The figure above depicts a binding price ceiling in rent control

o The equilibrium price A is above the set price… the market cannot  obtain equilibrium

o The distance between point B and C represent the shortage in the  housing market

▪ The quantity demanded for housing in point C far exceeds the  quantity that is being supplied at point B

• Price gouging laws: 

o Temporary ceiling on prices that sellers can charge during times of  national emergency

▪ Typically happen after natural disasters

▪ In most states, this is illegal

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Chapter 5: The Efficiency of Markets and the Costs of Taxation

• Welfare economics: 

o How the allocation of resources affects economic well-being

• Equity: 

o The fairness of the distribution of benefits among the members of  society

• Willingness to pay 

o The value the consumer is willing to purchase a good/service for

• Willingness to sell: 

o The value that the seller is willing to sell their good/service for

• Total surplus 

o Also known as social welfare

o Economist use this to measure the benefits that markets create

• Consumer Surplus: 

o The difference between the willingness to pay for a good and the price that is paid to get it

• Producer surplus: 

o The difference between the willingness to sell a good and the price  that the seller receives

• Elasticity: 

o Measures how much one variable responds to changes in another  variable

o Is a numerical measure of the responsiveness of Quantity Demanded  or Quantity Supplied to one of its determinants

o Elastic good: 

▪ A good that is price sensitive  

▪ Absolute value of Elasticity of demand > 1

o Inelastic good: 

▪ A good that is not price sensitive

▪ Quantity demanded decreases slower with an increase in price • Example: cigarettes

▪ 1> Absolute value of Elasticity of demand > 0

Factors of Elasticity:

1. Number of substitutes 

• Goods with fewer substitutes tend to be more inelastic  

• Price elasticity is higher when close substitutes are available

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2. Time 

• Price elasticity is higher in the long run than in the short run 3. Budget share 

• Price elasticity is higher for luxuries than for necessities

• People can put off buying “wants” longer than “needs”

• Excise tax: 

o Taxes levied on one particular good/service

o The government favors excise taxes on goods that are highly inelastic ▪ There is less Dead Weight Loss on inelastic goods

▪ Dead Weight Loss: 

• A decrease in economic activity caused by market  

distortions, such as taxes  

• Taxes chase out demand and reallocate resources from  

their most productive use

• Incidence of taxation: 

o The burden of taxation

o Who does the tax affect the most? Consumer or seller?

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Part II

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Chapter 7: Unemployment

• A misconception is that an economy should aim for zero unemployment.  o A growing economy has some unemployment  

o Some unemployment is natural

o Natural rate of unemployment: 

▪ Typical rate of unemployment that occurs when the economy  is growing normally  

• Labor force: 

o Someone who is already employed OR actively seeking work Employed + Unemployed = LF

• Labor force participation rate: 

▪ The portion (percentage) of the population that is in the labor  force


• Discouraged workers: 

o Those who are not working

o Have looked for a job within the past year

o Are willing to work

o Have not sought employment in the past 4 weeks

• Underemployed workers: 

o Workers who have part-time jobs

o Want a full-time job

• Unemployed workers: 

o Someone not working but is actively looking for work

o Types:

▪ Structural

▪ Frictional

▪ Cyclical

Unemployment Rate:  


• Creative destruction: 

o Occurs when the introduction of new products and technologies leads  to the end of other industries and jobs

o Some jobs become obsolete

o This causes Structural Unemployment:

▪ Caused by changes in the industrial makeup of the economy

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▪ Tastes as well as technology change… so do jobs

▪ Learning new skills may take a long time or no time at all

▪ A natural disaster can also cause this

▪ Structural and Frictional unemployment will always exist to  

some degree in society

• Frictional Unemployment: 

o Caused by delays in matching available jobs and workers

o The time spent in between jobs for people who have a skill set that the  economy needs

o Another type of natural unemployment

o Causes:

▪ Information: Lack of information on what firms are hiring… it  can take time to find a job

▪ Government: Unemployment insurance programs and other  job security programs don’t always incentivize people to find  


• Cyclical Unemployment: 

o Changes in the economy will influence the number of workers hired o Caused by recessions

o This type generates the greatest concern among economists and  policymakers  

• Full employment output: 

o When the unemployment rate is equal to its natural rate

o There is no cyclical unemployment

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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 ⮚ You buying stuff is someone else’s income… add all of this up  for a nation

⮚ 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

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

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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 ???? mostly  manufactured goods ???? 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

• 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!

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• 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 ???? counts as USA GDP

2. When Ford builds a car in Europe ???? 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  


▪ 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

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

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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


• 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


• Nominal GDP  

o Take the market value of each good or service (Price X Quantity) o Add them all together

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• 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

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:

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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?

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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

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)

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• 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  


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 (Shoe-leather costs) 

o Shoe-leather 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

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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

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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

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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

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• 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

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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

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• 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  


Real Interest (r) = Nominal (i) – Inflation (π)

Also can be written as:  i = r +  π

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• Equilibrium of Loanable Funds Market

Plans of Savers = Plans of Borrowers

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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  


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

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• Effect on supply and demand of loanable funds market when inflation is  expected to increase






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.




Quantity of  

Loanable Funds

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• Effect on supply of loanable funds market if wealth increases o The amount of funds available is going to change






Quantity of  

Loanable Funds

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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%

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• Effect on supply of bond market when expectations of investors increase: o When supply of bonds is going up, it drives the price down






• Bond market when wealth increases:




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• 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

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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

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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


o The idea that per capita GDP levels across nations will equalize as  nations approach a steady state


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

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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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Part III

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Chapter 13: The Aggregate Demand-Aggregate Supply Model

Terms to Know 

Aggregate Demand

Aggregate Supply

Interest Rate Effect

International Trade Effect

Supply Shock


Wealth Effect

• Recessions are the results of irregular shifts in aggregate demand or  aggregate supply

o During recessions, real GDP growth slows and unemployment rises o Since the beginning of the 20th century, the US has experienced 22  recessions

• Aggregate Demand-Aggregate Supply model

o Used to study the business cycle

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• Aggregate Demand 

o The demand for all goods and services in the economy  

o The total of everything consumed

o To determine this, we sum up spending from different sources of the  economy

Aggregate Demand = Consumer (C) + Investment (I) + Government (G) + Net Exports (NX) • Consumption is the largest component of GDP

o On the AD graph, Real GDP (quantitates of all final goods/services)  are placed on the X axis

o On the Y axis, overall price level (P) is measured


o Movement along the AD Curve results from price level changes

Reasons for inverse relationship (slope) between Price Level and AD: 1. Wealth Effect

2. Interest Rate Effect

3. International Trade (Relative Price Levels)

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1. Wealth Effect 

• The change in the quantity of aggregate demand that results from  wealth changes due to price-level changes

• Wealth 

o Wealth is the total value of everything you own

o If prices fall:

▪ The real value of income increases, and nominal  

remains constant  

▪ Consumers now buy more goods and services with  

the same amount of income

▪ This is a shift on the AD curve right from P1 to P2







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2. Interest Rate Effect 

• This occurs when a change in the price level leads to a change in  interest rates and in the quantity of aggregate demand

• When prices rise you cut back on savings because you have to  spend more, this leads to the interest rate effect

o When you cut back on savings, the quantity of investment  

declines, which affects AD

o This results in movement along the AD curve to the left

• If prices fall, you consider yourself “wealthier”

o The funds in the Loanable Funds Market increases

o Investment increases in the LF Market

o This drives Interest Rates down

o This causes movement along the AD curve to the right

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3. International Trade 

• This occurs when a change in price level leads to a change in the  quantity of net exports demanded  

• If prices fall in the US (and we assume prices are held constant  around the world), world consumers will buy more US goods

o This causes an increase in Net Exports for the US

o This causes movement along the AD curve to the right


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Shift in Aggregate Demand: 

1. Changes in Real Wealth 

• When real wealth increases, people consume more

• This causes the AD curve to shift right

• Example: Technological advances generate wealth in a broad range of industries… shift in AD to the right

• US Real Estate values rise… decrease in unemployment  

2. Changes in Expected Income 

• When people expect that their future income will increase, they  will consume more today because they believe they can pay for it  later

• AD will shift right… short-run unemployment decreases  

3. Changes in Future Prices 

• When people expect higher prices in the future, they will spend  more today

• AD increases and shifts right… short-run unemployment  decreases

4. Changes in Foreign Income 

• Foreign Income affects US exports

• When income of foreign nations increases, their demand for US  goods increases

• This shifts AD to the right… short-run unemployment also  decreases  

5. Changes in Dollar Value (Exchange Rate)  

• US imports go up when the value of the dollar increases

o The makes AD shift left because foreigners consume  

less of our products… short-run unemployment will  


• If the dollar is weak, a foreign dollar is worth more

o More foreign countries will consume US products

o This makes the AD shift right because foreign  

companies consume more of our products

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Aggregate Supply 

o The supply of all goods and services produced in the country

o Long-run (LR) 

o In the LR, all prices adjust to conditions and changes in the  


o Short-run (SR) 

o SR prices are often referred to as “sticky” prices, meaning  

some prices are slow to change

o Sometimes prices change in the LR, but sometimes they  

stay the same in the SR (not all prices change at the same  


Aggregate Supply    



• All Long-Run shifts cause a shift in the Short-Run as well

• We reach the long run when all prices adjust

o Y* represents the full employment output

▪ At Y*, the unemployment rate is equal to the natural  

rate of unemployment:

U = U*

• The output produced in the Long-Run doesn’t have anything to do  with nominal prices

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• LRAS output depends on resources, technology, and institutions ▪ Technological advances would cause a shift right of  

the curve

• If LRAS shifts right, it means workers are  

becoming more productive

▪ If there is a permanent decline in the economy’s

resources (such as massive death of  

population) or with the adoption of

inefficient institutions, LRAS can shift left

• A shift of LRAS to the left does not change the  

unemployment rate… workers become less  


• Example: A new law prohibits people under  

the age of 21 to be hired

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• SRAS has a positive relationship between price level and quantity of AS o This is because of inflexible input prices, menu costs, and the money  illusion

1. Input Prices

• Input prices are sticky, they take time to change

o On the other hand, output prices are more flexible

2. Menu Costs

• Menu costs are the costs to a firm resulting from changing its  prices

• If general price level is rising, but a firm decides not to adjust its  prices because of menu costs, customers will want more of its  


• If firms decide to increase output, the quantity of aggregate supply  increases

3. Money Illusion

• This occurs when people interpret nominal values as real values • If output prices are decreasing but workers do not want to accept  nominal pay decreases, they reinforce the stickiness of input  


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• Shifts in Short-Run Aggregate Supply: 

1. Supply Shocks 

• Surprise events that change’s a firm’s production costs

• A temporary change in production costs

o Positive Effect: shifts curve right

o Negative Effect: shifts curve left

2. Expected Future Prices 

• Higher expected future prices lead to a lower quantity of  

aggregate supply

3. Corrections of Past Errors in Expectations 

• Adjustments to higher price expectations cause a shift to  

the left in SRAS

• Example: When workers renegotiate their wages upward,  

this reduces SRAS (shift left)

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• Aggregate Demand and Aggregate Supply Equilibrium 

o We can produce more in the SR than in the LR

o If consumers want to buy more goods/services, the Price Level will go  up in the LR

o In the Long-Run equilibrium, U = U*





Y* (Q)

Adjustments to Shifts in Long-Run Aggregate Supply (LRAS) • Technological advancements increase full employment output and shift LRAS  to the right

o When LRAS shifts, SRAS shifts in the same direction as well

Adjustments to Shifts in Short-Run Aggregate Supply (SRAS) • A negative supply shock causes SRAS to shift left

o Lower output means increased unemployment in the short-run U > U*

Adjustments to Shifts in Aggregate Demand (AD)

• Consumer expect prices to rise in the future

o Aggregate Demand will shift right because more people are buying  now

o This causes and increase in prices

o The unemployment rate drops

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Chapter 15: Federal Budgets: The Tools of Fiscal Policy

Terms to Know 


Average Tax Rate

Budget Deficit

Budget Surplus


Discretionary Outlays

Government Outlays

Marginal Tax Rate


Progressive Income Tax System

Social Security

Transfer Payments

• Us Government now spends over $3.5 trillion a year

o Government spending is represented by (G)

▪ Roads, bridges, military equipment, salaries of government  employees are examples of government spending

• Transfer Payments 

o Payments made to individuals/groups from the government, and no  good/service is given to the government in return  

o Example: Welfare, Medicare (Mandated healthcare for retirees),  Medicaid (Mandated healthcare for those with low income)

*The main reason for rising Medicare costs is the changing demographics • The population is getting older

• Spending: 

o Spending happens when the government receives goods and services

• Government Outlays 

o Part of the government budget that includes both spending and  transfer payments

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Types of Outlays: 

2. Interest

• Interest payments are made to current owners of US  

Treasury bonds

• These payments are not easy to alter

3. Discretionary

• Government spending that can be altered when the  

government is setting its annual budget

• Example: Monies for bridges/roads, payment to government  

workers, defense spending, international aid, research

4. Mandatory

• This is the biggest portion of the federal budget

• Mandatory outlays are also known as Entitlements

o Citizens who meet certain requirements are entitled  

to benefits under current laws

• Laws mandate government funding for these programs

o The laws must be changed to change spending on  

Mandatory outlays

• Example: Medicare, Food Stamps, Income Assistance,  

Unemployment Benefits, Social Security (retirement funding  


*Social Security now begins at 67

Way to Fix Social Security/Medicare Funding problem:

1. Increasing the retirement age

2. Adjusting the benefits computation to the consumer price index 3. Means-testing for Medicare/Social Security benefits

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Government Taxes 

• The two largest sources for government revenue are individual income  taxes and social insurance (these are both known as payroll taxes) o 80% of US tax revenue comes from payroll taxes

• Payroll Taxes:

o Social Insurance Taxes 

▪ Dollars from your income go towards paying for other people’s  Social Security and Medicare

o Income Tax 

▪ Income tax is tax on your working wages

▪ Income Taxes are set according to a scale that increases with  income levels… this is known as the Progressive Income Tax  


o The higher the income, the more you get taxed

▪ Marginal Tax Rates

o The tax rate paid on an individual’s next dollar of  


▪ Average Tax Rate

o The total tax paid, divided by the amount of taxable  


o The average tax rate is below the marginal tax rate

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• Money Supply 

o Currency in circulation

• Government Budget 

o It is a plan for spending government funds

o It is a plan for raising funds for the government

• Earning revenues and spending money result in a deficit or surplus o Budget Deficit 

▪ Occurs when government outlays exceed revenue

o Budget Surplus 

This occurs when revenue exceeds outlays

o Debt 

▪ Accumulation of all unpaid deficits

▪ Debt can be held internally or publicly

o Publicly held debt is debt not owned by the government

▪ Foreign Ownership of the US Federal Debt

o Many people are concerned with this topic

o In 2011, about 70% of US debt was held domestically

o 30% of US debt was held internationally by mainly  

China, Japan, and UK

▪ Debt-to-GDP ratio = Total Debt / Nominal GDP

o Can also be calculated by finding the deficit, dividing  

deficit by GDP, then multiply by 100 to get percentage

• Some European nations struggle with government debt problems o Austerity 

▪ Involves strict budget regulations aimed at debt reduction

▪ Greece implemented this, and it resulted in riots

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Chapter 16: Fiscal Policy

Terms to Know 

Automatic Stabilizers

Contractionary Fiscal Policy

Countercyclical Fiscal Policy


Expansionary Fiscal Policy

Laffer Curve

Marginal Propensity to Consume (MPC)

New Classical Critique

Spending Multiplier

Supply-Side Fiscal Policy

• Fiscal Policy 

o Government use of spending and taxes to influence the economy  o President and Congress control Fiscal Policy

▪ They would do this to try to control inflation

o Fiscal policy is generally used to try to shift aggregate demand, but it  can affect aggregate supply in the long-run


▪ Expansionary

▪ Contractionary

▪ Countercyclical

▪ Supply-Side

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• Expansionary Fiscal Policy 

o Occurs when the government increases spending or decreases taxes  in order to stimulate the economy toward expansion

o We use the aggregate demand—aggregate supply model to analyze  expansionary policy effects







AD1 Real GDP

o Expansionary Fiscal Policy focuses on shifting the aggregate demand  from AD2 back to AD1, so the economy can return to full employment  o Expansionary policy leads to increases in budget deficits • Government increases their borrowing

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• Contractionary Fiscal Policy 

o Occurs when the government decreases spending or increases taxes  to slow economic expansion

o Contractionary Fiscal Policy focuses on shifting aggregate demand from  AD1, back to AD2

Why would the government want to slow down the economy? 1. Expansionary fiscal policy creates deficits during recessions

• An increase in taxes helps to pay off government debt

2. Government might want to reduce aggregate demand if it believes  that the economy is expanding beyond its long-run capabilities

• This could lead to inflation because aggregate demand is  

high enough to dive unemployment below the natural rate,  

and this puts upward pressure on the price level

• Countercyclical Fiscal Policy 

o The use of fiscal policy to counteract business-cycle fluctuations o The goal of countercyclical policy is to smooth out the fluctuations in  the business cycle

▪ Uses Expansionary policy during economic downturns

▪ Uses Contractionary policy during economic expansions

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• Automatic Stabilizers 

o Government programs that automatically implement countercyclical  fiscal policy in response to economic conditions

▪ Examples: Progressive income tax rates, taxes on corporate  

profits, unemployment compensation, welfare programs

• Marginal Propensity to Consume (MPC) 

o The portion of additional income that is spent on consumption o MPC is a fraction between 0 and 1

MPC = Change in Consumption / Change in Income

• Spending Multiplier 

o Tells us the total impact on spending from an initial change of a given  amount  

o It depends on the marginal propensity to consume

The greater the MPC, the greater the spending multiplier

▪ The multiplier is generally larger than 1

o Sometimes referred to as the Keynesian or Fiscal Multiplier Spending Multiplier = 1 / (1 - MPC)

• Multiplier Effect 

o Multiplier Effect is when you spend money, someone else gets paid,  and then they spend that money

▪ When you put money in the economy, it multiplies

Issues with Fiscal Policy

1) Time lags

• It takes time to implement fiscal policy. When the affects of the  policy finally hit the economy, the economy may no longer need it o Recognition lag

o Implementation lag

o Impact lag

2) Crowding out

o Occurs when private spending falls in response to increases  

in government spending

o This affects the loanable funds market because the  

government borrows money to pay for their spending

• When the government borrows, the demand for  

loans increases, changing the equilibrium point and  

driving up interest rates

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3) Savings Shift

• In response to increases in government spending or lower taxes,  people may increase their current savings to help pay for  

inevitably higher future taxes

• Spending in the economy today must be paid for someday

• New Classical Critique:

o Increases in government spending and decreases in taxes are  

largely offset by increases in savings because people know  

they will have to pay higher taxes eventually

• Supply-Side Fiscal Policy 

o Involves the use of government spending and taxes to affect the  supply/production side of the economy  

o Supply-Side is focused on moving LRAS1 to LRAS2

Price Level



Y* Y**

Real GDP

o Shifts in LRAS are caused by changes in resources, technology, and  institutions

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Fiscal Policy Incentives Focusing on Supply-Side:

1. Research and development tax credits

2. Policies that focus on education

3. Lower corporate profit tax rates

4. Lower marginal income tax rates

*All of these increase incentives for productive activities, and each incentive takes time  to affect aggregate supply  

• The Laffer Curve 

o Illustrates the relationship between tax rates and tax revenue o It models tax revenue as a function of a single tax rate

▪ Increasing the tax rate increases government revenue to a  

certain point

▪ When tax rates are too high, tax revenue starts to decline

▪ The point at which optimal revenue is achieved is debated

Income Tax Revenue = Tax Rate X Income



Tax Rate

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Chapter 17: Money and the Federal Reserve

Terms to Know 


Balance Sheet

Bank run


Checkable deposits

Commodity money

Commodity-backed money


Discount loan

Discount rate

Double coincidence of wants

Excess reserves

Federal funds

Federal funds rate




Medium of exchange

Open market operations

Owner’s equity

Quantitative easing

Required reserve ratio


Simple money multiplier

Store of value

Unit of account

• Currency 

o Paper bills and coins that are used to buy foods and services

• Money 

o An asset, used as currency, generally accepted as payment for goods  and services or repayment of debt

3 Useful Functions of Money

1. Medium of Exchange

2. Unit of Account

3. Store of Value

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1. Medium of Exchange 

• What people trade for goods and services

• People used to barter:

▪ Individuals traded a good or service that they already had, for  something that they wanted. There were issues with this:  

▪ Double Coincidence of Wants:

• Each party in an exchange transaction must have what  

the other party desires

2. Unit of Account 

• A measure in which prices are quoted

• A standard measure that’s easily understood by those in  

an economy

• Money can be used as a recording device (a way to  

measure accounts and transactions)

3. Store of Value 

• A means for holding wealth

• Used to save purchasing power

• In the past, this was more important… today, we have  

other options for holding wealth

Types of Money

1. Commodity money

• Involves the use of an actual good in place of money

• Oldest form of money

• Usually precious metal (silver/gold) or other valuable  


• Problem: Commodity money was heavy and inconvenient  

2. Commodity – backed money

• Money that can be exchanged for a commodity at a fixed rate • Until 1971, US dollars were backed by the ability to be converted  into coins or other precious metals (Gold Standard)

3. Fiat Money

• Money that has no value except as the medium of exchange

• Our currency is now fiat, back by the US government  

*Counterfeit money causes inflation

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Money must be:

1. Easily standardized

2. Widely accepted

3. Divisible

4. Easy to carry

5. Slow to deteriorate  

Measuring the Quantity of Money:

• Checkable Deposits  

o Deposits in bank accounts from which depositors may make  withdrawals by writing checks

o These deposits represent purchasing power that is very similar to  currency  

o Adding checkable deposits to currency gives us a money supply  measure known as M1

▪ M1

• The money supply measure that is composed of currency  

and checkable deposits

• Includes traveler’s checks

• It is the most liquid

M1 = Cash + Checkable Deposits

▪ M2

• A broader measure of the money supply

• Includes everything in M1, plus savings deposits and CD’s

• Also includes money market mutual funds and small

denomination time deposits

o The money supply in an economy includes both currency and bank  deposits:

▪ Credit cards are not part of the money supply

Money Supply (M) = Currency + Deposits

o Checks eliminate the need for large exchanges of currency

o It gives the ability to assign payment and provide receipts

▪ A downside is that payment is delayed in transfer between  


Study Guide FINAL TEST

Financial Statements:

• Balance Sheet 

o An accounting statement that summarizes a firm’s key financial  information

o The left side of the balance statement display assets (What the firm  owns)

o The right side of the balance sheet show liabilities (what the firm  owes)  

o Owner’s Equity is the difference between the firm’s assets and its  liabilities  

Federal Reserve 

• The Fed was founded in 1913 as the central bank of the United States o It was created in response to nationwide bank failures

• There are 12 Federal Reserve banks

o There are 9 directors

o It is a semi-private institution


1. Monetary Policy

• The Fed controls the US money supply

• Regulates money supply to offset  

macroeconomic fluctuations

2. Central Banking

• The Fed is a bank for other banks

• It holds other bank’s deposits and extends  

loans to them

3. Bank Regulation

• Helps ensure the financial stability of banks

• Federal Funds 

o Deposits that private banks hold on reserve at the Fed

o These deposits are part of the reserves that banks set aside, along  with physical currency in their vaults

• Federal Funds Rate 

o Rate on interbank loans

Study Guide FINAL TEST

• Discount Loans 

o Loans from the Fed to private banks

o Don’t often figure prominently in macroeconomics, but in  

extremely turbulent times they reassure financial market  


• Discount Rate 

o Interest rate on the discount loans made from the Fed to private  banks

• Adjustments to the reserve requirement and the discount rate are no longer  relevant tools used by the Fed to implement monetary policy  

Monetary Policy Tools:

• Federal Open Market Committee (FOMC) 

o Another part of the Federal Reserve

o Uses Open Market Operations as the main method of affecting the  money supply

• Open Market Operations 

o Involves the purchase or sale of bonds by central bank

o When the Fed wants to increase the money supply, it buys securities o When the Fed wants to decrease supply, it sells securities

• Quantitative Easing 

o The targeted use of open market operations in which the central bank  buys securities specifically targeted in certain markets

o The FED buys long-term Treasuries and mortgage-backed securities  on the open market


o Banks fund their activities primarily by taking in deposits

o Fractional Reserve Banking 

▪ This is our modern system of banking

▪ It occurs when banks hold only a fraction of deposits on  


o Banks can borrow directly from the Federal Reserve at a Discount  Rate

o Banks borrow from each other at the Federal Funds Rate

Study Guide FINAL TEST

• Commercial Banks 

o Take in deposits and extend loans

o Banks make profit by charging a higher interest rate on loans than the  interest rate they pay on deposits

• Reserves 

o The portion of bank deposits that are set aside and not lent out o Includes currency in the bank’s vault  

o Also includes funds that the bank holds in deposit at its bank, the  Federal Reserve

Reasons why banks hold reserves:

1. They must accommodate withdrawals by their depositors

• Bank Run: occurs when many depositors attempt to  

withdraw their funds at the same time

2. Banks are legally bound to hold a fraction of their deposits  

on reserve

• Required Reserve Ratio (rr): The portion of  

deposits that banks are required to keep on reserve.  

The current rr is 10%

rr = Required Reserves / Total Deposits

Required Reserves = rr X deposits

• Excess Reserves 

o Any reserves above the required level

Excess reserves = total reserves – required reserves  

• Simple Money Multiplier 

o The rate at which banks multiply money when all currency is  deposited into banks, and they hold no excess reserves


• Federal Deposit Insurance Corporation (FDIC) 

o Makes sure depositors get their money back if an insured bank fails o Implemented during the Great Depression

o Originally, the FDIC helped decrease the frequency of bank runs ▪ Now, there is an increased potential for moral hazard

Study Guide FINAL TEST

• Moral Hazard 

o Occurs when a party that is protected from risk behaves differently  from the way it would behave if it were fully exposed to the risk ▪ FDIC insurance means that neither banks nor depositors have  an incentive to monitor risk because no matter what happens,  

they are protected

• Certified Deposits (CD) 

o CDs are amounts of money that the depositor made an agreement  with the bank to not touch for a certain amount time

US Money Supply:

• US Dollars are printed at the Treasury

Study Guide FINAL TEST

Chapter 18: Monetary Policy

• Keynesian economics predicts that macroeconomic adjustments happen  slowly because prices are downward sticky

• Classical economists expect quick adjustments to the economy

• Expansionary Monetary Policy 

o Occurs when a central banks acts to increase the money supply in an  effort to stimulate the economy

o The Federal Reserve buys bonds, increasing the money supply ▪ Investment increases and aggregate demand increases

• The Great Recession

o Many economist believe that a decline in aggregate demand was one  cause

• Unexpected Inflation 

o Can hurt people:

▪ New workers that just signed a contact that cannot be adjusted ▪ Input suppliers

o Because unexpected inflation can hurt people, there is an incentive to  predict it and account for it in contracts

▪ When inflation is predicted, it diminishes the affect of  

monetary policy

▪ In the Long-Run, monetary policy has real effects only when  some prices are sticky

▪ In the Long-Run, monetary policy just leads to an increase in  price level

• Contractionary Monetary Policy 

o Occurs when a central bank takes action that reduces the money  supply in the economy

o The Federal Reserve sells bonds, taking funds out of the loanable  market

▪ Investment falls and aggregate demand falls

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