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TULANE / OTHER / ECON 1020 / cost benefit principle

cost benefit principle

cost benefit principle

Description

School: Tulane University
Department: OTHER
Course: Intro to Macroeconomics
Professor: Toni weiss
Term: Spring 2017
Tags: Macroeconomics
Cost: 50
Name: Macroeconomics Final Study Guide
Description: Notes from class and the textbook
Uploaded: 04/27/2017
54 Pages 7 Views 10 Unlocks
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What is Economic Surplus?



CHAPTER 1: THINKING LIKE AN ECONOMIST  

Economics

∙ the study of how people make choices under conditions of scarcity and  of the results of those choices for society  

∙ the scarcity principle  

o although we have boundless wants and needs, the resources  available to us are limited  

 having more of one good thing means having less of  

another  

 trade offs  

∙ the cost benefit principle  

o an individual (or a firm or society) should take an action if, and  only if, the extra benefits from taking the action are at least as  great as the extra costs  

applying the cost-benefit principle  

∙ rational person  

o someone with well-defined goals who tries to fulfill those goals as best he or she can  

∙ an analysis for how rational people make choices  

economic surplus  

∙ the benefit of taking an action minus its cost  


What is Opportunity Cost?



∙ as a decision maker you want to choose those actions that result in the highest economic surplus  

opportunity cost  

∙ the value of what must be forgone to undertake an activity  

SUMMARY  

∙ scarcity is a basic fact of economic life. because of it, having more of  one good thing almost always means having less of another (the  scarcity principle). the cost - benefit principle holds that an individual  (or a firm or a society) should take an action if, and only if, the extra  benefit from taking the action is at least as great as the extra cost. the  benefit of taking any action minus the cost of taking the action is  called the economic surplus from that action. since, the cost - benefit  principle suggests that we take only those actions that create  additional economic surplus.  If you want to learn more check out gmu bus 100 midterm

three important decision pitfalls  

∙ knowing that rational people tend to compare costs and benefits  enables economists to predict likely behavior  


What is Marginal Benefit?



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o however, it is not always applied consistently so in these  situations the cost benefit principle may not predict behavior  accurately  

∙ pitfall 1:  

o measuring costs and benefits as proportions rather than absolute dollar amounts may not have a clear way to measure relevant  costs and benefits  

∙ pitfall 2:  

o ignoring implicit costs

 need to take into count the value of forgone opportunities   the value that must be forgone in order to participle in that activity  

∙ pitfall 3:  

o failure to think at the margin  

 the only costs that should influence a decision about  

wether to take an action are those we can avoid by not  

taking an action. similarly, the only benefits we should  

consider are those that would not occur unless the action  

were taken  

 sunk costs  

∙ a cost that is beyond recovery at the moment a  

decision must be made  

marginal cost  

∙ the increase in total cost that results from carrying out one additional  unit of an activity  

marginal benefit

∙ the increase in total benefit that results from carrying out one  additional unit of an activity  

average cost  

∙ the total cost of undertaking n units of an activity divided by n  average benefit  

∙ the total benefit of undertaking n units of an activity divided by n  

normative economics versus positive economics  

∙ normative economic principle  Don't forget about the age old question of this manipulator forces cout to print digits in fixed-point notation:

o one that provides guidance for how people should behave  ∙ positive economic principle  

o describes how we actually will behave  

the incentive principle  

∙ a person (or a firm or a society) is more likely to take an action if its  benefit rises, and less likely to take it if its cost rises

o in short, incentives matter  

∙ positive economics principle  

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o relevant costs and benefits usually help us predict behavior  

economics: micro and macro  

∙ microeconomics  

o to describe the study of individual choices and of group behavior  in individual markets  

∙ macroeconomics  

o the study of the performance of nation economies and of the  policies that governments use to try to improve that performance  understand the determinate of such things such as the  national employment rate, the overall price level, and the  total value of nation output  

economic naturalist  

∙ someone who uses insights from economies to help make sense of  observations from everyday life  

Summary

∙ economics is the study of how people make choices under conditions  of scarcity and of the results of those choices for society. economic  analysis of human behavior begins with the assumption that people  are rational — that they have well-defined goals and try to achieve  them as best they can. in trying to achieve their goals, people normally face trade-offs: because material and human resources are limited,  having more of one good thing meaning making do with less of another good thing  We also discuss several other topics like gary shoats

∙ our focus in this chapter has been on how rational people make  choices among alternative courses of action. our basic tool for  analyzing these decisions is cost- benefit analysis. the cost-benefit  principle says that a person should take an action if, and only if, the  benefit of that action is as least as great as the cost.  We also discuss several other topics like bsu fight song

∙ the benefit of an action is defined as the largest dollar amount the  person would be willing to pay in order to take the action  

∙ the cost of an action is defined as the dollar value of everything the  person must give up in order to take the action  

∙ in using the cost-benefit framework, we need not presume that people  choose rationally all the time. indeed, we identified three common  pitfalls that plague decision makers in all walks of life: a tendency to  treat small proportional changes as insignificant, a tendency to ignore  implicit costs, and a tendency to fail to think at the margin  

o for example, by failing to ignore sunk costs or by failing to  compare marginal costs and benefits  Don't forget about the age old question of global issues exam 1
Don't forget about the age old question of asi 102

∙ often the question is not whether to pursue an activity but rather how  many units of it to pursue. in these cases, the rational person pursues  additional units as long as the marginal benefit of the activity (the  

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benefit from pursuing as addition unit of it) exceeds its marginal cost  (the cost of pursing an additional unit)  

∙ microeconomics is the study of individual choices and of group  behavior in individual markets while macroeconomics is the study of  the performance of national economics and of the policies that  governments use to try to improve economic performance  

Core Principles

∙ the scarcity principle (also called the no-free-lunch principle)  o although we have boundless needs and wants, the resources  available to us are limited. so having more of one good thing  usually means having less of another  

∙ cost benefit principle

o an individual (or a firm or a society) should take an action if, and  only if, the extra benefits from taking the action are at least as  great as the extra costs  

∙ incentive principle  

o a person (or a firm or a society) is more likely to take an action if  its benefit rises, and less likely to take it if its cost rises

 in short, incentives matter

CHAPTER 2: COMPARATIVE ADVANTAGE  

comparative advantage  

∙ the alternative to a system in which everyone is a jake-of-all-trades is  one in which people specialize in particular goods and services and  then satisfy their needs by trading among themselves  

o economies that specialize and trade a more production than  those with little specialization  

absolute advantage  

∙ one person has an absolute advantage over another if he or she takes  fewer hours to perform a task than the other person  

comparative advantage  

∙ one person has a comparative advantage over another if his or her  opportunity cost of performing a task is lower than the other persons  opportunity cost  

the principles of comparative advantage  

∙ when two people (or countries) have different opportunity costs of  preforming various tasks, they can always increase the total value of  available goods and services by trading with one and other  

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∙ the principle of comparative advantage:

o everyone does best when each person (or each country)  concentrates on the activities for which his or her opportunity  cost is lowest  

sources of comparative advantage  

∙ at the individual level: comparative advantage often appears to be the  result of inborn talent but more often the result of education, training,  experience  

∙ at the national level: may derive from differences in natural resources  or differences in societies/cultures  

recap: exchange and opportunity cost  

∙ gains from exchange are possible if trading partners have comparative  advantage in producing different goods and services. you have a  comparative advantage in producing, say, web pages if your  opportunity cost of producing a web page - measured in terms of other  production opportunities forgone- is smaller than the corresponding  opportunity costs of your trading partners. maximum production is  achieved if each person specializes in producing the good or service in  which he or she has the lowest opportunity cost (the principle of  comparative advantage). comparative advantage makes specialization  worthwhile even if one trading partner is more productive than others,  in absolute terms, in every activity  

comparative advantage and production possibilities  

∙ comparative advantage and specialization allow an economy to  produce more than if each person tries to produce a little bit of  everything  

the production possibilities curve  

∙ a graph that describes the maximum amount of one good that can be  produced for every possible level of production of the other good  ∙ attainable point

o any combination of goods that can be produced using currently  available resources  

∙ unattainable point  

o any combination of goods that cannot be produced using  currently available resources  

∙ inefficient point

o any combination of goods for which currently available resources enable an increase in the production of one good without  

reduction in the production of the other  

∙ efficient point  

o any combination of goods for which currently available resources

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do not allow an increase in the production of one good without a  reduction in the production of the other  

the principle of increasing opportunity cost (also called the “low-hanging-fruit principle”)  

∙ in expanding the production of any good, first employ those resources  with the lowest opportunity cost, and only afterward turn to resources  with higher opportunity costs  

recap: comparative advantage and production possibilities  ∙ for an economy that produces two goods, the production possibility  curve describes the maximum about of one good that can be produced for every possible level of production of the other good. attainable  points are those that lie on or within the curve and efficient points are  those that lie along the curve. the slope of the production possibilities  curve tells us the opportunity cost of producing an additional unit of  the good measured along the horizontal axis

∙ the principle of increasing opportunity cost, or the low-hanging-fruit  principle, tells us that the slope of the production possibilities curve  becomes steeper as we move downward to the right. the greater the  differences among individual opportunity costs, the more bow-shaped  the production possibilities curve with be; and the more bow-shaped  the production possibilities curve, the greater the potential gains from  specialization with be  

factors that shift the economy’s production possibilities curve  ∙ production possibilities curve provides a summary of the production  options open to any society  

∙ economic growth: an increase in productive resources (labor, capital  equipment) or improvements in knowledge and technology with cause  the PPC to shift outward  

outsourcing  

∙ a term increasingly used to connote having services performed by low wage workers overseas  

recap: comparative advantage and international trade  

∙ nations, like individuals, can benefit from exchange, even though one  trading partner may be more productive than the other in absolute  terms. the greater the difference between domestic opportunity cost  and world opportunity costs, the more a nation benefits from exchange with other nations. but expansions of exchange do not guarantee that  each individual citizen will do better. in particular, unskilled workers in  high-wage countries may be hurt in the short run by the reduction of  barriers to trade with low-wage nations

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SUMMARY  

∙ one person has an absolute advantage over another in the production  of a good if she can produce more of that good than the other person.  ∙ one person has a comparative advantage over another in the  production of a good if she is relatively more efficient than the other  person at producing that good, meaning that her opportunity cost of  producing it is lower than her counterparts  

∙ specialization based on comparative advantage is the basis for  economic exchange. when each person specializes in the task at which he or she is relatively most efficient, the economic pie is maximized,  making possible the largest slice for everyone  

∙ at the individual level, comparative advantage may spring from  differences in talent or ability or form differences in education, training, and experience. at the national level, sources of comparative  advantage include those innate and learned differences, as well as  differences in language, culture, institutions, climate, natural  resources, and a host of other factors  

∙ the production possibilities curve is a simple device for summarizing  the possible combinations of output that a society can produce if it  employs its resources efficiently. in a simple economy that produces  only coffee and nuts, the PPC shows the maximum quantity of coffee  production (vertical axis) possible at each level of nut production  (horizontal axis). the slope of the PPC at any point represents the  opportunity cost of nuts at that point, expressed in pounds of coffee.  (LO2)

∙ all production possibility curves slope downward because of the  scarcity principle, which states that the only way a consumer can get  more of one good is to settle for less of another. in economies whose  workers have different opportunity costs of producing each good, the  slope of the PPC becomes steeper as consumers move downward  along the curve. the change in slope illustrates the principle of  increasing opportunity cost (or the low-hanging-fruit principle), which  states that in expanding the production of any good, a society should  first employ those resources that are relatively efficient at producing  that good, only afterward turning to those that are less efficient (LO2)

∙ factors that cause a country’s PPC to shift outward over time include  investment in new factories and equipment, population growth, and  improvements in knowledge and technology  

∙ the same logic that prompts individuals to specialize in their production and exchange goods with one another also leads nations to specialize  and trade with one another. on both levels, each trading partner can  benefit from and exchange, even though one may be more productive  than the other, in absolute terms, for each good. for both individuals  

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and nations, the benefits of exchange tend to be larger the larger the  differences are between the trading partners’ opportunity cost  

core principles

∙ the principle of comparative advantage  

o everyone does best when each person (or each country)  concentrates on the activities for which his or her opportunity  cost is lowest  

o the principle of increasing opportunity cost (also called the low hanging-fruit principle)

 in expanding the production of any good, first employ  

those resources with the lowest opportunity cost, and only  afterward turn to resources with higher opportunity costs  

CHAPTER 3: SUPPLY AND DEMAND  

supply and demand  

∙ when there’s excess demand for a product, its price tends to rise  

buyers and sellers in markets

∙ market: the market for any good consists of all buyers and sellers of  that good  

∙ smith  

o cost of a good was determined by cost of production

∙ Stanley Jevons  

o explain price by focusing on the value people derive from  consuming different goods and services  

∙ *both matter

o Alfred Marshall

o show how cost and value interact to determine both the  prevailing market price for a good and the amount of it that is  bought or sold  

the demand curve  

∙ demand curve  

o a schedule or graph showing the quantity of a good that buyers  wish to buy at each price  

o downward sloping with respect to price  

 ex. if the price of pizza falls, people will buy more slices  ∙ substitution effect  

o the change in the quantity demanded of a good that results  because buyers switch to or from substitutions when the price of  the good changes  

o ex. if pizza becomes more expensive, consumers may switch to  other things that substitute for pizza

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∙ income effect

o the change in the quantity demanded of a good that results  because a change in price of a good changes the buyers  purchasing power

o ex. a consumer cannot afford to buy as many slices of pizza at  higher prices as at lower prices  

∙ buyer’s reservation effect  

o the highest dollar amount the buyer would be willing to pay for a  good  

o consumers differ in how much they are willing to pay  

the supply curve  

∙ a graph or schedule showing the quantity of a good that sellers which  to sell at each price  

∙ ex. for each possible price, the total number of slices that all pizza  vendors would be willing to sell at that price  

∙ sellers differ in their opportunity cost of suppling pizza  

∙ seller’s reservation price

o the smallest dollar amount for which a seller would be willing to  sell a additional unit, generally equal to marginal cost  

recap: demand and supply curves

∙ the market for a good consists of the actual and potential buyers and  sellers of that good. for any given price, the demand curve shows the  quantity that demanders would be willing to buy and the supply curve shows the quantity that suppliers of the good would be willing to sell.  suppliers are willing to sell more at higher prices (supply curves slope  upward) and demanders are willing to buy less at higher prices  

(demand curves slop downward)  

market equilibrium  

∙ equilibrium  

o a balanced or unchanging situation in which all forces at work  within a system ate canceled by others  

∙ equilibrium price and equilibrium quantity  

o the price and quantity at the intersection of the supply and  demand curves for the good  

∙ market equilibrium  

o occurs in a market when all buyers and sellers are satisfied with  their respective quantities at the market price  

∙ excess supply

o the amount by which quantity supplied exceeds quantity  demanded when the price of a good exceeds the equilibrium  price  

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o difference between quantity supplied and quantity demanded  ∙ excess demand  

o the amount by which quantity demanded exceeds quantity  supplied when the price of a good lies below the equilibrium  price  

o the difference between quantity demanded and quantity supplies

price ceiling

∙ a maximum allowable price, specified by law  

recap: market equilibrium  

∙ market equilibrium, the situation in which all buyers and sellers are  satisfied with their respective quantities at the market price, occurs at  the intersection of the supply and demand curves. the corresponding  price and quantity are called the equilibrium price and equilibrium  quantity

∙ unless prevented by regulation, prices and quantities are driven toward their equilibrium values by actions of buyers and sellers. if the price is  entitle too high, so that there is an excess supply, frustrated sellers will cut their price in order to sell more. if the price is initially too low, so  that there is excess demand, competition among buyers drives the  price upward. this process continues until equilibrium is reached  

predicting and explaining changes in prices and quantities  ∙ change in the quantity demanded  

o a movement along the demand curve that occurs in response to  a change in price  

∙ change in demand  

o a shift of the entire demand curve  

∙ change in the quantity suppled  

o a movement along the supply curve that occurs in response to a  change in price

∙ change in supply

o a shift in the entire supply curve  

shifts in demand  

∙ complements  

o two goods are complements in consumption if an increase in the  price of one causes a leftward shift in the demand curve for the  other (or if a decrease causes a rightward shift)

∙ substitutes  

o two goods are substitutes in consumption if an increase in the  price of one causes a rightward shits in the demand curve for the other (or if a decrease causes a leftward shift)  

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normal good  

∙ a good whose demand curve shifts rightward when the income of  buyers increase and leftward when the incomes of buyers decrease inferior good

∙ a good whose demand curve shifts leftward when the incomes of  

buyers increase and rightward when the incomes of buyers decrease  

shifts in the supply curve  

∙ increasing opportunity cost  

∙ reduction of marginal cost  

recap: factors that shift supply and demand  

∙ factors that cause an increase (rightward or upward shift) in demand  o a decrease in the price of complements to the good or service o an increase in the price of substitutes for the good or service o an increase in income (for a normal good)

o an increased preference by demanders for the good or service o an increase in the population of potential buyers  

o an expectation of higher prices in the future  

 when these factors move in the opposite direction, demand will shift left  

∙ factors that cause an increase (rightward or downward shift) in supply o a decrease in the cost of materials, labor, or other puts used in  the production of the good or service

o an improvement in technology that reduces the cost of producing the good or service

o an improvement in the weather (specifically for agricultural  products)

o an increase in the number or suppliers

o an expectation of lower prices in the future  

 when these factors more in the opposite direction, supply  will shift left  

cash on the table  

∙ buyer’s surplus  

o the difference between the buyer’s reservation price and the  price he or she actually pays  

∙ seller’s surplus

o the difference between the price received by the seller and his or her reservation price  

∙ total surplus  

o the difference between the buyer’s reservation price and the  sellers reservation price  

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∙ “cash on the table”

o an economic metaphor for unexploited gains from exchange  o when people fail to take advantage of all mutually beneficial  exchanges  

smart for one, dumb for all  

∙ socially optimal quantity  

o the quantity of a good that results in the maximum possible  economic surplus from producing and consuming the good ∙ efficiency (or economic efficiency)

o a condition that occurs when all goods and services are produced and consumer at their respective socially optimal levels  

the efficiency principle

∙ efficiency is an important social goal because when the economic pie  grows larger, everyone can have a larger slice  

the equilibrium principle (also called the “no-cash-on-the-table principle”)  ∙ a market in equilibrium leaves no unexploited opportunities for  individuals but may not exploit all gains achievable through collective  actions  

recap: markets and social welfare

∙ when the supply and demand curves for a good reflect all significant  costs and benefits associated with the production and consumption of  that good. but if people other than buyers benefit from the good, or if  people other than sellers bear costs because of it, market equilibrium  need not to result in the largest possible economic surplus  

summary

∙ the demand curve is a downward-sloping line that tells what the  quantity buyers will demand at any given price. the supply curve is an  upward-sloping line that tells what quantity sellers will offer at any  given price  

∙ Alfred Marshall’s model of supply and demand explains why neither  cost of production nor value to the purchaser (as measured by  willingness to pay) is, by itself, sufficient to explain why some goods  are cheap and others are expensive. to explain variations in price, we  must examine the interaction of cost and willingness to pay. as we've  seen in this chapter, goods differ in price because of differences in  their respective supply and demand curves.  

∙ market equilibrium occurs when the quantity buyers demand at the  market price is exactly the same as the quantity that sellers offer. the  equilibrium price-quantity pair is the one at which the demand and  supply curves intersect. in equilibrium, market price measures both the

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value of the last unit sold to the buyers and the cost of resources  required to produce it  

∙ when the price of a good lies above its equilibrium value, there is an  

excess supply of that good. excess supply motivates sellers to cut their prices and price continues to fall until equilibrium price is reached.  ∙ when price lies below the equilibrium value, there is excess demand.  with excess demand, frustrated buyers are motivated to offer higher  prices and the upward pressure on prices persists until equilibrium is  reached

∙ a remarkable feature of the market system is that, relying only on the  tendency of people to respond in self-interested way to market price  signals, it some how manages to coordinate the actions of literally  billions of buyers and sellers worldwide. when excess demand or  excess supply occurs, it tends to be small and brief, except in markets  where regulations prevent full adjustment of prices  

∙ the basic supply and demand model is a primary tool of the economic  naturalist. changes in the equilibrium price of a good, and in the  amount of it traded in the market-place, can be predicted on the basis  of shifts in its supply or demand curves. the following four rules hold  for any good with a downward-sloping demand curve and an upward  sloping supply curve:

o an increase in demand will lead to an increase in the equilibrium  price and quantity  

o a reduction in demand will lead to a reduction in equilibrium  price and quantity

o an increase in supply will lead to a reduction in equilibrium price  and an increase in equilibrium quantity  

o a decrease in supply will lead to an increase in equilibrium price  and a reduction in equilibrium quantity  

∙ incomes, tastes, population, expectations, and the prices of substitutes and complements are among the factors that shift demand schedules.  ∙ supply schedules, in turn, are primarily governed by such factors as  technology, input prices, expectations, the number of sellers, and,  especially for agricultural products, the weather  

∙ the efficiency of markets in allocating resources does not eliminate  social concerns about how goods and services are distributed among  different people. for example, we often laminate the fact many buyers  either the market with too little income to buy even the most basic  goods and services. concern for the well-being of the poor has  motivated many governments to intervene in a variety of ways to alter  the outcomes of market forces. sometimes these interventions take the form of laws that peg prices below their equilibrium levels. such laws  almost variably generate harmful, if unintended, consequences.  programs like rent-controlled laws, for example, lead to severe housing shortages, black marketeering, and a rapid deterioration of the  

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relationship between land lords and tenants

∙ if the difficulty is that the poor have too little money, the best solution  is to discover ways of boosting their income directly. the law of supply  and demand cannot be repealed by the legislator. but legislators do  have the capacity to alter the underlying forces that govern the shape  and position of the supply and demand schedules  

∙ when the supply and demand curves for a good reflect all significant  costs and benefits associated with the production and consumption of  that good, the market equilibrium price will guide people to produce  and consume the quantity of the good that results in the largest  possible economic surplus. this conclusion, however, does not apply if  others, besides buyers, benefit from the good (as when someone  benefits from his neighbors purchase of a vacation against measles) or  if others besides sellers bear costs because of the good (as when in  production generates pollution). in such cases, market equilibrium does not result in the greatest gain for all

CHAPTER 4: SPENDING, INCOME, AND GDP

Gross domestic product: measuring the nation’s output  

∙ GDP is the market value of the final goods and services produced in a  country during a given period  

Market value  

∙ The selling price of goods and services in the open market  ∙ Economists need to aggregate the quantities of the many different  goods and services into a single number  

o They do so by adding up the market values of the different goods and services the economy produces  

Final goods and services

∙ Goods or services consumed by the ultimate user; because they are  the end products of the production process, they are counted as a part  of GDP  

∙ Intermediate goods or services

o Goods or services used up in the production of final goods and  services and therefore not counted as part of GDP  

∙ A capital good  

o A long-lived good that is used in the production of other goods  and services  

 Ex. Factories and machines  

∙ Value added

o For any firm, the market value of its product or service minus the cost of inputs purchased from other firms  

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Produced within a country during a given period  

∙ Domestic in GDP is the measure of economic activity within a given  country  

o Only production that takes please within country borders  Recap: measuring GDP  

∙ Gross domestic product (GDP) equals the market value of final goods  and services produced within a country during a given period  o GDP is an aggregate of the market values of the many goods and services produced in the economy  

o Goods and services that are not sold in markets, such as unpaid  housework, are not counted in GDP. An important exception is  goods and services provided by the government, which are  included in GDP at the governments cost of providing them  

o Final goods and services – goods and services consumed by the  ultimate user – are counted in GDP. By convention, newly  

produced capital goods, such as factories and machines, are also treated as final goods and are counted in GDP. Intermediate  goods and services, which are used up in the production of final  good and services, are not counted  

o In practice, the value of final goods and services is determined  by the value-added method. The value added by any firm equals  the firm’s revenue from selling its product minus the cost of  inputs purchased from other firms. Summing the value added by  all firms in the production process yields the value of the final  good or service  

o Only goods and services produced within a nation’s borders are  included in GDP

o Only goods and services produced during the current year (or the portion of the value produced during the current year) are  counted as part of the current-year GDP  

The expenditure method for measuring GDP  

∙ Economists divide the users of final goods and services that make up  the GDP for any given year into four categories  

o Consumption expenditure (or consumption)

 Spending by households on goods and services such as  food, clothing, and entertainment  

 Subdivided into three categories:  

∙ Consumer durable goods: long-lived consumer goods

such as cars and furniture  

∙ Consumer nondurable goods: shorter-lived goods like

food and clothing  

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∙ Services: the largest single component of consumer  

spending and includes everything from haircuts and  

taxi rides to legal, financial, and educational services

o Investment  

 Spending by firms on final goods and services, primarily  capital goods

 Divided into three subcategories:

∙ Business fixed investment: purchase by firms of new  

capital such as machinery, factories, and office  

buildings – bought by firms to increase their capacity  

to produce  

∙ Residential investment: construction of new homes  

and apartment buildings – also capital goods

∙ Inventory investment: the addition of unsold goods  

to company inventories. In other words, the goods  

that a firm produces but doesn’t sell during the  

current period are treated, for accounting purposes,  

as if the firm had bought those goods from itself  

(guarantees that production = expenditure)

o Government purchases  

 Final goods and services bought by federal, state, and local governments – do not include transfer payments which are  payments made by the government in return for which no  current goods or services are received, nor do they include  interest paid on the government debt  

o Net exports  

 Equals exports minus imports  

 Exports are domestically produced final goods and services that are sold abroad  

 Imports are purchases by domestic buyers of goods and  services that were produced abroad

GDP and the incomes of capital and labor  

∙ GDP can be thought of as a measure of total production or as a  measure of total expenditure – either method gives the same final  answer  

∙ Can also be thought of as the incomes of capital and labor  o Whenever a good or service is produced and sold, the revenue  from the sale is distributed to the workers and the owners of the  capital involved in the production of the good or service  

o Labor income  

 Compromises wages, salaries, and the incomes of the self employed  

∙ Equal to about two-thirds of GDP  

o Capital income  

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 Made up of payments to owners of physical capital (such  as factories, machines, and office buildings) and intangible  capital (such as copy rights and patents).  

 The components of capital income include items such as  profits earned by business owners, the rents paid to  

owners of land or buildings, interest received by  

bondholders, and the royalties received by the holders of  

the copyrights or patents  

o Measured prior to payment on taxes  

Recap: expenditure components of GDP

∙ GDP can be expressed as the sum of expenditures on domestically  produced final goods and services. The four types of expenditures that  are counted in the GDP, and the economic groups that make up each  type of expenditure, are as follows:

o Consumption  households  food, clothes, haircuts, new cars o Investment  business firms  new factories and equipment, new houses, increases in inventory stock  

o Government purchases  government  new school buildings,  new military hardware, salaries of soldiers and government  officials  

o Net exports, or exports minus imports  foreign sector  exported manufactured goods, legal or financial services provided by  domestic residents to foreigners  

 (type of expenditure  who makes the expenditure 

examples)

nominal GDP versus real GDP  

∙ real GDP  

o a measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices; real GDP  measures the actual physical volume of production  

∙ nominal GDP

o a measure of GDP in which the quantities produced are valued at current-year prices; nominal GDP measures the current dollar  value of production  

recap: nominal GDP versus real GDP

∙ real GDP is calculated using prices of goods and services that prevailed in a base year rather than in the current year. Nominal GDP is  calculated using current-year prices. Real GDP is GDP adjusted for  inflation; it may be thought of as measuring the physical volume of  production. Comparisons of economic activity at different times should  always be done using real GDP, not nominal GDP  

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real GDP and economic well-being  

∙ GDP is an imperfect measure of economic well-being because, for the  most part, it captures only those goods and services that are priced  and sold in markets  

∙ Factors that are not included in GDP but affect weather people are  better off:

o Leisure time  

 The increased leisure time available to workers in the US  and other industrialized countries – which allows them to  

pursue many worthwhile activities, including being with  

family and friends, participating in sports and hobbies, and  pursing cultural and educational activities – is a major  

benefit of living in a healthy society

∙ These extra hours of leisure are not priced in markets

of reflected in GDP  

o Nonmarket economic activities  

 Not all economically important activities are bought and  sold in markets  

∙ Housekeeping, volunteer services  

o Environmental quality and resource depletion  

o Quality of life  

 What makes a town a desirable place to live? Spacious,  well-constructed homes, good restaurants and stores  

 Not included in GDP – low crime rate, minimal traffic  

congestion, active civic organizations ...  

o Poverty and economic inequality  

 Distribution of economic welfare across the nation  

∙ Factors of GDP that are related to economic well being  

o Availability of goods and services  

 Citizens of a country with high GDP are likely to possess  more and better goods and services  

o Health and education  

Recap: real GDP and economic well-being  

∙ Real GDP is an imperfect measure of economic well-being. Among the  factors affecting well-being omitted from real GDP are the availability  of leisure time, nonmarket services such as unpaid homemaking and  volunteer services, environmental quality and resource conservation,  and quality-of-life indicators such as a low crime rate. The GDP also  does not reflect the degree of economic inequality in a country.  Because real GDP is not the same as economic well-being, proposed  policies should not be evaluated strictly in terms of whether or not they increase the GDP  

∙ Although GDP is not the same as economic well-being, it is positively  associated with many things that people value, including higher  

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material standard of living, better health, longer life expectancies, and  higher rates of literacy and education attainment. This relationship  between real GDP and economic well-being has led many people to  emigrate from poor nations in search of a better life and has motivated policy makers in low human development countries to try to increase  their nations’ economic growth  

Summary  

∙ The basic measure of an economy’s output is gross domestic product (GDP), the market value if the final goods and services produced in a  country during a given period. Expressing output in terms of market  values allows economists to aggregate the millions of goods and  services produced in a modern economy

∙ Only final goods and services (which include capital goods) are  counted in GDP, since they are the only goods and services that  directly benefit final users. Intermediate goods and services, which are  used up in the production of final goods and services, are not counted  in GDP, nor are sales of existing assets. Summing the value added by  each firm in the production process is a useful method of determining  the value of final goods and services  

∙ GDP also can be expressed as the sum of four types of expenditure:  consumption, investment, government purchases, and net exports. These four types of expenditures correspond to the spending of house holds, firms, the government, and the foreign sector, respectively  

∙ To compare levels of GDP over time, economists must eliminate the  effects of inflation. They do so by measuring the market value of goods and services in terms of the prices in the base year. GDP measured in  this way is called real GDP, while GDP measured in terms of current years prices is called nominal GDP. Real GDP should always be used in  making comparisons of economic activity over time  

∙ Real GDP per person is an imperfect measure of economic well-being.  With a few exceptions, notably government purchases of goods and  services (which are included in GDP at their cost of production), GDP  includes only those goods and services sold in markets. It excludes  important factors that affect people’s well-being, such as the amount  of leisure time available to them, the value of unpaid or volunteer  services, the quality of the environment, the quality-of-life indicators  such as the crime rate, and the degree of economic inequality  

∙ Real GDP is still a useful indicator of economic well-being, however.  Countries with a high real GDP per person not only enjoy high average  standards of living; they also tend to have higher life expectations, low  rates of infant and child mortality and high rates of school enrollment  and literacy  

CHAPTER 5: INFLATION AND THE PRICE LEVEL

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The consumer price index and inflation  

∙ The basic tool economists use to measure the price level in the U.S.  

economy is the consumer price index – it is a measure of the “cost of  living”  

∙ The consumer price index (CPI) for any period measures the cost in  that period of a standard set, or basket, of goods and services relative  to the cost of the same basket of goods and services in a fixer year,  called the base year  

o CPI = cost of base year basket of goods and services in current  year 

 cost of base year basket of goods and services in base  year  

∙ Price index = a measure of the average price of a given quality of  goods or services relative to the price of the same goods or services in  a base year  

Inflation  

∙ The CPI provides a measure of the average level of price relative to  prices in the base year  

∙ Inflation, in contrast, is a measure of how fast the average price level is changing over time  

∙ The rate of inflation is the annual percentage rate of change in the  price level, as measured, for example, by the CPI  

o Inflation rate = (x year CPI – base year CPI) / base year CPI  ∙ Deflation  

o A situation in which the prices of most goods and services are  falling over time so that inflation is negative  

∙ The core rate of inflation  

o The rate of increase of all prices except energy and food  

Adjusting for inflation  

∙ CPI allows us to measure changes in the cost of living; it also can be  used to adjust economic data to eliminate the effects of inflation  ∙ Deflating  

o Using the CPI to convert quantities measured at current dollar  values into real terms  

Deflating a normal quantity

∙ Normal quantities  

o a quantity that is measured in terms of its current dollar value  ∙ Real quantity  

o A quantity that is measured in physical terms – for example, in  terms of quantities of goods and services  

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∙ Deflating the normal quantity  

o The process of dividing a normal quantity by a price index (such  as the CPI) to express the quantity in real terms  

Real wage

∙ The wage paid to workers measured in terms of purchasing power  ∙ The real wage for any given period is calculated by:  

o Normal dollar wage/ CPI for that period  

Indexing to maintain buying power  

∙ Indexing = the practice of increasing a nominal quantity each period  by an amount equal to the percentage increase in a specified price  index

o Prevents the purchasing power of the nominal quantity from  being eroded by inflation  

Recap: methods to adjust for inflation  

∙ Deflating. To correct a nominal quantity, such as a family’s dollar  income, for changes in the price level, divide it by a price index such as the CPI. This process expresses the nominal quantity in terms of real  purchasing power. If nominal quantities from two different years are  deflated by a price index with the same base year, the purchasing  power of the two deflated quantities can be prepared  

∙ Indexing. To ensure that a nominal payment, such as a Social Security  benefit, represents a constant level of real purchasing power, increase  the nominal quantity each year by a percentage equal to the rate of  inflation for that year  

Does the CPI measure “true” inflation?

∙ CPI is calculated for a fixed basket of goods and services  ∙ The indexing of government benefits of the CPI could be costing the  federal government money  

Price level  

∙ A measure of the overall level of prices at a particular point in time as  measured by a price index such as the CPI  

Relative price

∙ The price of a specific good or service in comparison to the prices of  other goods and services  

The true costs of inflation  

∙ Confusion in inflation and relative price changes  

∙ True economic costs of inflation  

o “noise” in the price system  

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 when inflation is high, the subtle signals that are  

transmitted though the price system become more difficult to interoperate  

o distortions of the tax system  

 people with higher incomes pay a higher percentage of  their income in taxes. Without indexing, an inflation that  

raises people nominal incomes would force them to pay an  increasing percentage of their income in taxes, which is  

known as bracket creep, congress has indexed income tax  brackets to the CPI. The effect of this indexation is that a  

family whose nominal income is rising at the same rate as  inflation does not have to pay a higher percentage of  

income in taxes  

o “shoe-leather” costs  

 having plenty of cash on hand facilitates transactions with  customers and reduces the need for frequent deposits and  withdrawals from the bank  

 currency is debt owned by government to currency  

holders  

 when faced with inflation, people are not likely to accept a  loss in purchasing power but instead will take actions to try and “economize” on their cash holding  

o unexpected redistributions of wealth  

 when inflation is unexpected, it may arbitrarily redistribute  wealth from one group to another  

o interference with long-term planning  

 high and erratic inflation can make long-term planning  

difficult  

hyperinflation  

∙ a situation in which the inflation rate is extremely high  

recap: the true costs of inflation  

∙ the public sometimes confuses changes in relative prices (such as the  price of oil) with inflation, which is a change in the overall level of  prices. This confusion can cause problems because the remedies for  undesired changes in relative prices for inflation are different  

∙ there are a number of true costs of inflation, which together tend to  reduce economic growth and efficiency. These include:

o “noise” in the price system, which occurs when general inflation  makes it difficult for the market participants to interpret the  information conveyed by prices

o distortions of the tax system, for example, when provisions of the tax code are not indexed  

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o “shoe-leather” costs, or the costs of economizing on cash (for  

example, by making more frequent trips to the bank or installing  a computerized cash management system)

o unexpected redistribution of wealth, as when higher-than expected inflation hurts wage earnings to the benefit of the  employers or hurts creditors to the benefit of the debtors

o interference with long-term planning, arising because people  find it difficult to forecast prices over long periods  

inflation and interest rates

∙ during periods of high inflation, interest rates tend to be high as well  

inflation and the real interest rate  

∙ inflation tends to hurt creditors and help debtors by reducing the value  of the dollars with which debt is repaid  

∙ real interest rate  

o the annual percentage increase in the purchasing power of a  financial asset; the real interest rate on any asset equals the  nominal interest rate on the asset minus the inflation rate  ∙ nominal interest rate (or market interest rate)

o the annual percentage increase in the nominal value of a  financial asset  

∙ inflation-protected bonds  

o bonds that pay a nominal interest rate each year equal to a fixed real rate plus the actual rate of inflation during that year  

the fisher effect  

∙ the tendency for nominal interest rates to be high when inflation is  high and low when inflation is low  

summary  

∙ the basic tool for measuring inflation is the consumer price index (CPI). The CPI measures the cost of purchasing a fixed basket of goods and  services in any period relative to the cost of the same basket of goods  and services in a base year. The inflation rate is the annual percentage  rate of change in the price level as measured by a price index such as  the CPI  

∙ a nominal quantity is a quantity that is measured in terms of its current dollar value. Dividing a nominal quantity such as a family’s income or a worker’s wage in dollars by a price index such as the CPI expresses  that quantity in terms of real purchasing power. This procedure is  called deflating the nominal quantity. If nominal quantities from two  different years are deflated by a common price index, the purchasing  power of the two quantities can be compared. To ensure that a nominal payment such as a Social Security benefit represents a constant level  

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of real purchasing power, the nominal payment should be increased  

each year by a percentage equal to the inflation rate. This method of  adjusting nominal payments to maintain their purchasing power called  indexing

∙ the official U.S. inflation rate, based on the CPI, may overstate the true  inflation for two reasons: first, it may not adequately reflect  improvements in the quality of goods and services. Second, the  method of calculating the CPI ignored the fact that consumers can  substitute cheaper goods and services for more expensive ones  

∙ the public sometimes confuses increases in the relative prices for  specific goods or services with inflation, which is an increase in the  general price level. Since the remedies for a change in relative prices  are different from the remedies for inflation, this confusion can cause  problems  

∙ inflation imposes a number of true costs on the economy, including  “noise” in the price system; distortions of the tax system; “shoe leather” costs, which are the real resources that are wasted as people  try to economize on cash holdings; unexpected redistribution of  wealth; and interference with long-term planning. Because of these  costs, most economists agree that sustained economic growth is more  likely if inflation is low and stable. Hyperinflation, a situation in which  the inflation rate is extremely high, greatly magnifies the costs of  inflation and is highly disruptive to the economy  

∙ the real interest rate is the annual percentage increase in the  purchasing power of the financial asset. It is equal to the nominal, or  market, interest rate minus the inflation rate. When inflation is  unexpectedly high, the real interest rate is lower than anticipated,  which hurts lenders but benefits borrowers. When inflation is  unexpectedly low, lenders benefit and borrowers hurt. To obtain a  given real rate of return, lenders must charge a high nominal interest  rate when inflation is high and a low nominal interest rate when  inflation is low. The tendency for nominal interest rates to be high  when inflation is high and low when inflation is low is called the fisher  effect.  

CHAPTER 6: WAGES AND UNEMPLOYMENT  

Three important labor market trends  

∙ over a long period, average real wages have risen substantially both in  the United States and in other industrialized countries

∙ despite the long-term upward trend in real wages, real wage growth  has been stagnant in the united states since the early 1970’s.  employment also grew substantially from the 1970’s through the  1990’s. however, over the last decade the share of the working-age  

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population either employed or actively looking for work has  dramatically decreased from its peak in 2000

∙ in the united states, wage inequality has increased dramatically in  recent decades. The real wages of most unskilled workers have  

actually declined. While the real wages of skilled and educated workers have continued to rise  

supply and demand in the labor market  

∙ the “price” is the real wage paid to workers in exchange for their  services  

∙ the “quantity” is the amount of labor firms use (number of workers  employed)  

wages and the demand for labor

∙ the demand for labor  

o the number of worker’s employers want to hire at any given  wage

∙ the more productive workers are, or the more valuable the goods and  services they produce, the greater the number of workers an employer  will want to hire at any given wage  

∙ diminishing returns to labor  

o if the amount of capital and other inputs in use is held constant,  then the greater the quantity of labor already employed, the less  each additional worker adds to production  

shifts in the demand for labor  

∙ increase labor demand:

o an increase in the price of the company’s output  

o an increase in the productivity of workers  

the supply of labor  

∙ the total number of people willing to work at each real wage  

shifts in the supply of labor  

∙ size of the working age population  

recap: supply and demand in the labor market  

∙ the demand for labor  

o the extra production gained by adding one more worker is the  marginal product of that worker. The value of the marginal  product of a worker is that worker’s marginal product times the  price of the firms output. A firm will employ a worker only if the  workers value of marginal product, which is the same as the  extra revenue the worker generates for the firm, exceeds the real wage that the firm must pay. The lower the real wage, the more  

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workers the firm will find it profitable to employ. Thus, the  demand labor curve, like most demand curves, is downward sloping  

o for a given real wage, any change that increases the value of  workers’ marginal products will increase the demand for labor  and shift the labor demand curve to the right. Examples of  

factors that increase labor demand are an increase in the price of workers’ output and an increase in productivity  

∙ the supply of labor  

o an individual is willing to supply labor if the real wage that is  offered is greater than the opportunity cost of the individual’s  time. Generally, the higher the real wage, the more people are  willing to work. Thus, the labor supply curve, like most supply  curves, is upward-sloping  

o for a given real wage, any factor that increases the number of  people available and willing to work increases the supply of labor and shifts the labor supply curve to the right. Examples of factors that increase labor supply include an increase in the working-age population or an increase in the share of the working-age  

population seeking employment  

the trends in real wages and employment  

∙ why real wages have increased so much in industrialized countries  o the dramatic technological progress that occurred during the 12th century  

o large increases in capital, which provided workers with more and  better tools with which to work  

∙ since the 1970’s, real wage growth in the united states has stagnated,  while employment growth has been rapid  

∙ increasing wage inequality: the effects of globalization

o worker mobility = the movement of workers between jobs, firms,  and industries  

∙ increasing wage inequality: technological change  

o skill- biased technological change = technological change that  affects the marginal products of higher-skilled workers differently from those of lower-skilled workers  

recap: explaining the trends in real wages and employment  ∙ the long-term increase in real wages enjoyed by workers in  industrialized countries results primarily from large productivity gains,  which have raised the demand for labor. Technological progress and an expanded and modernized capital stock are two important reasons for  these long-term increases in productivity

∙ the stagnation in real wage growth that began in the 1970s resulted in  part from the slowdown in productivity growth (and, hence, the slower  

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growth in labor demand) that occurred at about the same time.  Increased labor supply, arising from such factors as the increased  participation of women and the coming of age of the baby-boom  generation, depressed real wages further while also expanding  

employment. In the latter part of the 1990s, resurgence in productivity  growth was accomplished by an increase in real wage growth.  However, real wages remained exactly the same in 2010 as in 1970

∙ both globalization and skill-biased technological change contribute to  wage inequality. Globalization raises the wages of workers in exporting  industries by raising the demand for those workers, while reducing the  wages of workers in importing industries. Technological change that  favors more-skilled workers increases the demand for such workers,  and hence their wages, relative to the wages of less-skilled workers

∙ attempting to block either globalization or technological change is not  the best response to the problem of wage inequality. To some extent,  worker mobility (movement of workers from low-wage to high-wage  industries) will offset the inequality created by these forces. Where  mobility is not practical, transition aid – government assistance to  workers whose employment prospects have worsened- may be the  best solution  

unemployment and the unemployment rate  

∙ the unemployment rate is a sensitive indicator of conditions in the  labor market

o when the unemployment rate is low, jobs are secure and  relatively easier to find  

o low unemployment is often associated with improving wages and working conditions as well, as employers compete to attract and  retain workers  

measuring unemployment  

∙ employed

o a person is employed if he or she worked full-time or part-time  (even for a few hours) during the past week or is on vacation or  sick leave from a regular job  

∙ unemployed  

o a person is unemployed if he or she did not work during the  preceding week but made some effort to find work in the past  four weeks  

∙ out of the labor force  

o a person is considered to be out of the labor force is he or she  did not work in the past week and did not look for work in the  past four weeks.  

Labor force  

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∙ the total number of employed and unemployed people in the economy  unemployment rate

∙ the number of unemployed people divided by the labor force  participation rate

∙ the percentage of the working-age population in the labor force (that  is, the percentage that is either employed or looking for work)  

the costs of unemployment  

∙ economic:  

o output is lost because the workforce is not fully utilized  ∙ psychological  

o felt primarily by unemployed workers: loss of self-esteem,  feelings of loss of control over one’s life, depression, economic  difficulties created by loss of income  

∙ social  

o if unemployed for a while – severe financial difficulties  

the duration of unemployment  

∙ unemployment spell

o a period during which an individual is continuously unemployed  ∙ duration  

o the length of an unemployment spell  

the unemployment rate versus “true” unemployment  

∙ unemployment rate misses two groups of people who are not counted  among the unemployed:

o discouraged workers  

 people who say they would like to have a job but have not  made an effort to find one in the past four weeks because  they believe there are no jobs available for them  

o involuntary part-time workers

 people who say they would like to work full-time but are  able to find only part-time work  

∙ since they do have jobs, they are counted as  

employed  

types of unemployment:  

∙ frictional unemployment  

o the short-term unemployment associated with the process of  matching workers with jobs  

∙ structural unemployment  

o the long-term and chronic unemployment that exists even when  the economy is producing at a normal rate  

∙ cyclical unemployment  

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o the extra unemployment that occurs during periods of recession  

impediments to full employment:

∙ minimum wage laws

∙ labor unions  

∙ unemployment insurance

∙ other government regulations  

o healthy and safety  

o non racial or gender discrimination  

recap: unemployment and the unemployment rate

∙ defining and measuring unemployment involves distinguishing among  the employed, unemployed, and those not in the labor force. We can  then use these concepts to calculate measures such as the  unemployment rate, which is the number of people unemployed  divided by the labor force, and the participation rate, which is the labor force divided by the working-age population  

∙ economists distinguish among three broad types of unemployment.  Frictional unemployment is the short-term unemployment that is  associated with the process of matching workers with jobs. Structural  unemployment is the long-term or chronic unemployment that occurs  even when the economy is producing at a normal rate. Cyclical  unemployment is the extra unemployment that occurs during periods  of recession. Frictional unemployment may be economically beneficial,  as improved matching of workers and jobs may increase output in the  long run. Structural unemployment and cyclical unemployment impose heavy economic costs on workers and society, as well as psychological  costs on workers and their families

∙ structural features of the labor market may cause structural  unemployment. Examples of such features are legal minimum wages  or union contracts that set wages about market-clearing levels;  unemployment insurance, which allows unemployed workers to search  longer or less intensively for a job; and government regulations that  impose extra costs on employers. Regulation of the labor market is not  necessarily undesirable, but it should be subject to the cost-benefit  criterion  

summary: page 171  

CHAPTER 7: ECONOMIC GROWTH  

Compound interest  

∙ the payment of interest not only on the original deposit but on all  previously accumulated interest  

∙ simple interest  

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o interest paid only in the deposit  

why nations become rich  

∙ real GDP per person = average labor productivity X the share of the  population that is working  

∙ average labor productivity  

o average labor per employed worker  

∙ Real GDP person tells us:  

o The quantity of goods and services that each person can  consume depends on  

 How much each worker can produce  

 How many people (as a fractional of the total population)  are working  

Recap: economic growth and productivity  

∙ Real GDP per person, a basic indicator of living standards, has grown  dramatically in the industrialized countries. This growth reflects the  power of compound interest: even a modest growth rate, if sustained  over a long period of time, can lead to large increases in the size of the economy  

∙ Output per person equals average labor productivity times the share of the population that is employed. Since 1960 the share of the U.S.  population with jobs has risen significantly, but this variable has  started to decline in recent years. In the long run, increases in output  per person and hence living standards arise primarily from increases in average labor productivity  

The determinates of average labor productivity  

∙ Human capital  

o An amalgam of factors such as education, training, experience,  intelligence, energy, work habits, trustworthiness, and initiative  that affects the value of a worker’s marginal product  

∙ Physical capital  

o Tools workers have to work with  

 Ex. Factories and machines  

o More and better capital allows workers to produce more  efficiently  

o Diminishing returns in capital  

 If the amount of labor and other inputs employed is held  constant, then the greater the amount of capital already in  use, the less an additional unit of capital adds to  

production  

∙ Land and other natural resources  

o Land, energy, and raw materials  

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o An abundance of natural resources increases the productivity of  the workers who use them  

∙ Technology  

o A company’s ability to develop and apply new, more productive  technologies will help to determine its productivity  

o Most economists would probably agree that new technologies are the single most important source of productivity improvement ∙ Entrepreneurship and management  

o The productivity of workers depends in part on the people who  help to decide what to produce and how to produce it  

o Entrepreneurs  

 People who create new economic enterprises  

∙ The political and legal environment  

o Key contributions government can make is to provide a political  and legal environment that encourages people to behave in  economically productive ways  

 Work hard, save and invest wisely, acquire useful  

information and skills, and provide the goods and services  that the public demands  

Recap: determinates of average labor productivity  

∙ Key factors determining average labor productivity in a country  include:

o The skills and training of workers, called human capital  o The quantity and quality of physical capital – machines,  equipment, and buildings

o The availability of land and other natural resources  

o The sophistication of technologies applied in production  o The effectiveness of management and entrepreneurship  o The broad social and legal environment  

Promoting economic growth  

∙ Measures policymakers can take to raise rate of economic growth: o Policies to increase human capital  

 Supporting education and training programs because well  educated workers are more productive than unskilled labor o Policies that promote saving and investment  

 Support the creation of new capital because labor  

productivity increases when workers can utilize a sizable  

and modern capital stock  

∙ To support creation of new capital, government can  

encourage high rates of saving and investment in  

the private sector  

o Policies that support research and investment  

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 Productivity is enhanced by technological progress which  in turn requires investment in research and development  

o The legal and political framework  

 Government creates framework in which the private sector can operate productively  

Thinking about the costs of economic growth  

∙ Societies should not strive for the highest rate of economic growth  o To increase capital stock, we must divert resources that could  otherwise be used to increase the supply of consumer goods  

Recap: economic growth: benefits and costs  

∙ Policies for promoting economic growth include policies to increase  human capital (education and training); policies that promote saving  and capital formation; policies that support research and development; and the provision of legal and political framework within which the  private sector can operate productively. Deficiencies in the legal and  political framework (for example, official corruption or poorly defined  property rights) are a special problem for many developing countries  

∙ Economic growth has substantial costs, notably the sacrifice of current  consumption that is required to free resources for creating new capital  and new technologies. Higher rates of growth should be pursued only if the benefits outweigh the costs  

∙ Some have argued that finite resources imply ultimate limits to  economic growth. This view overlooks that facts that growth can take  the form of better, rather than more, goods and services; that  increases wealth frees resources to safeguard the environment; and  that political and economic mechanisms exist to address many of the  problems associated with growth. However, these mechanisms may  not work well when environmental or other problems arising from  economic growth are global in scope  

CHAPTER 8: SAVING, CAPITAL FORMATION, AND FINANCIAL MARKETS

Saving and wealth  

∙ Saving  

o Current income minus spending on current needs

∙ Saving rate

o Saving divided by income  

∙ Wealth

o The value of assets minus liabilities

∙ Assets

o Anything of value that one owns  

∙ Liabilities

o The debt one owes

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∙ Balance sheet

o A list of an economic unit’s assets and liabilities on a specific  date  

Stocks and flows  

∙ Saving is an example of a flow  

o Flow = a measure that is defined per unit of time  

∙ Wealth is a stock  

o Stock = a measure that is defined at a point in time  

Capital gains and losses  

∙ Capital gains  

o Increases in the value of existing assets  

∙ Capital losses

o Decreases in the value of existing assets  

Recap: saving and wealth  

∙ In general, saving is current income minus spending on current needs.  Wealth is the value of assets – anything of value that one owns – minus liabilities – the debt one owes. Saving is measured per unit of time (for  example, dollars per week) and thus is a flow. Wealth is measured at a  point in time and thus is a stock. In the same way the flow of water  

through the faucet increases with stock of water in a bathtub, the flow  of saving increases the stock of wealth. Wealth can also be increased  by capital gains (increases in the value of existing assets) or reduced  by capital losses (decreases in asset values)  

National savings and its components  

∙ Aggregate saving of the economy  

∙ National savings includes savings of business firms and the  government as well as that of households  

The measurement of national savings  

∙ Production must equal total expenditure  

∙ Y = C + I + G + NX

o Y = production of aggregate income  

o C = consumption expenditure  

o I = investment spending  

o G = government purchases of goods and services  

o NX = net exports  

∙ National savings  

o The saving of the entire economy, equal to GDP less  

consumption expenditures and government purchases of goods  and services  

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o S = Y – C – G  

Private and public components of national savings  

∙ Private saving  

o The saving of the private sector of the economy is equal to the  after-tax income of the private sector minus consumption  expenditures (Y – T – C)  

 private saving can be further broken down into household  saving and business saving  

o Amount households and business save from private-sector  income  

∙ Public saving

o The saving of the government sector is equal to net tax  payments minus government purchases (T – G)  

o Amount governments save from public-sector income  

o Amount of public sectors income that is not spent on current  needs

∙ Transfer payments  

o Payments the government makes to the public in which it  receives no current goods or services in return  

 Social security benefits, welfare payments, pensions to  government  

Public saving and the government budget  

∙ Government budget surplus  

o The excess of government tax collections over government  spending (T – G)  

 The government budget surplus equals public saving  

 T = net taxes (total taxes – transfer payments –  

government interest payments)  

∙ Government budget deficit  

o The excess of government spending over tax collections (G – T)  

Recap: national savings and its components  

∙ National saving, the saving of the nation as a whole, is defined by S =  Y – C – G, where Y is GDP, C is consumption spending, and G is  government purchases of goods and services. National saving is the  sum of public saving and private saving

∙ Private saving, the saving of the private sector, is defined by Sprivate  = Y – T – C, where T is net tax payments. Private saving can be broken  down further into household saving and business saving  

∙ Public Saving, the saving of the government, is defined by Spublic = T  – G. public saving equals the government budget surplus, T – G. when  the government budget is in surplus, government saving is positive;  when the government budget is in deficit, public saving is negative  

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Why do people save?

∙ Life-cycle saving

o Saving to meet long-term objectives such as retirement, college  attendance, or the purchase of a home  

∙ Precautionary saving

o Saving for protection against unexpected setbacks such as the  loss of a job or a medical surgery  

∙ Bequest saving  

o Saving done for the purpose of leaving an inheritance  

Saving and the real interest rate

∙ People make financial investments that they hope will provide a good  return on their savings  

∙ Higher the return, the faster their savings will grow  

∙ Real interest rate is relevant to savers because it is their reward for  saving

Saving, self-control, and demonstration effects  

∙ Peoples saving behavior is based as much on psychological as on  economic factors  

o Many people lack the self-control to do what they know is in their own best interest  

Recap: why do people save?

∙ Motivations for saving include saving to meet long-term objectives  such as retirement (life-cycle saving), saving for emergencies  (precautionary saving), and saving to leave an inheritance or bequest  (bequest saving). The amount that people save also depends on  macroeconomic factors such as the real interest rate. A higher real  interest rate stimulates saving by increasing the reward for saving, but  it also can depress saving by making it easier for savers to reach a  specific savings target. On net, a higher real interest rate appears to  lead to modest increases in savings  

∙ Psychological factors also may affect savings rates. If people have self control problems, then financial arrangements (such as automatic  payroll deductions) that make it more difficult to spend will increase  their saving. People’s saving decisions also may be influenced by  demonstration effects, as when people feel compelled to spend at the  same rate as their neighbors, even though they may not be able to  afford to do so  

Investment and capital information  

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∙ National savings provide the funds needed for investment and is  critical to increasing average labor productivity and improving  standards of living  

o Investment = the creation of new capital goods and housing  

Factors that increase the willingness of firms to invest in new capital  ∙ A decline in the price of new capital goods  

∙ A decline in the real interest rate  

∙ Technological improvements that raises the marginal product of capital ∙ Lower taxes on the revenue generated by capital  

∙ A higher relative price for the firm’s output  

bonds  

∙ Bond = a legal promise to repay a debt, usually including both  principle amount and regular interest, or coupon, payments  o Principle amount  

 The amount originally lent  

o Maturation date  

 The date at which the principle of the bond will be repaid  o Coupon payments  

 Regular interest payments made to the bondholder  

o Coupon rate

 The interest rate promised when a bond is issued

 The annual coupon payments are equal to the coupon rate  times the principle amount of the bond  

Stocks  

∙ Stock (or equity) = a claim to a partial ownership of a firm  o Dividend  

 A regular payment received by stockholders for each share that they own

∙ Risk premium  

o The rate of return that financial investors require to hold risky  assets minus the rate of return on safe assets  

Diversification  

∙ The practice of spreading one’s wealth over a variety of different  financial investments to reduce overall risk  

Mutual fund  

∙ A financial intermediary that sells shares in itself to the public and then uses the finds raised to buy a wide variety of financial assets  

Recap

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∙ Financial markets, such as bond and stock markets, improve the  allocation of saving in two ways  

o The provide information to savers about which possible uses of  their funds and likely to prove most productive and hence pay  the highest return  

o Financial markers help savers share the risks of lending by  permitting them to diversify their financial investments  

Saving, investment, and financial markets  

∙ Any of the following factors will shift the demand for savings (I) to the  right  

o A decline in the price of new capital goods  

o Technological improvements that raises the marginal product of  capital  

o Low taxes on the revenues generated by capital  

o A higher relative price for the firm’s output  

∙ The supply of savings will shift fight is national saving private and/or  public saving, is increased  

∙ Crowding out  

o The tendency of increased government deficits to reduce  investment spending  

CHAPTER 9: MONEY, PRICES, AND FINANCIAL INTERMEDIARIES  

The banking system and the allocation of saving to productive uses  ∙ A successful economy not only saves but also uses its saving wisely by  applying these limited funds to the investment projects that seem  likely to be the most productive  

∙ Financial intermediaries  

o Firms that extend credit to borrowers using funds raised from  savers  

Money and its uses  

∙ Money = any asset that can be used in making purchases  ∙ Why do people use money?  

o Medium of exchange: an asset used in purchasing goods and  services

 Barter = the direct trade of goods and services for other  goods and services

o Unit of account: a basic measure of economic value  

o Store of value: as asset that serves as a means of holding wealth

Measuring money  

∙ M1 = the sum of currency outstanding and balances held in checking  accounts  

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∙ M2 = all the assets in M1 plus some additional assets that are usable in making payments but as greater cost or inconvenience than currency  or checks  

Recap: money and its uses  

∙ Money is any asset that can be used in making purchases, such as  currency or a checking account. Money serves as a medium of  exchange when it is used to purchase goods or services. The use of  money as a medium of exchange eliminates the need for barter and  the difficulties of finding a “double coincidence of wants.” Money also  serves as a unit of account and a store of value  

∙ In practice, two basic measures of money are M1 and M2. M1, a  narrower measure, is made up primarily of currency and balances held in checking accounts. The broader measure, M2, includes all the assets in M1 plus some additional assets usable in making payments

∙ Credit card balances are never counted as or even considered money,  as credit card balances are merely obligations to pay others  

Commercial banks and the creation of money  

∙ Bank reserves  

o Cash or similar assets held by commercial banks for the purpose  of meeting depositor withdrawals and payments  

∙ 100 percent reserve banking  

o a situation in which banks’ reserves equal 100 percent of their  deposits  

∙ reserve- deposit ratio  

o bank reserves divided by deposits  

∙ fractional-reserve banking system  

o a banking system in which bank reserves are less than deposits  so that the reserve-deposit ratio is less than 100 percent  

recap: commercial banks and the creation of money  

∙ part of the money supply consists of deposits in private commercial  banks. Hence, the behavior of commercial banks and their depositors  helps to determine the money supply  

∙ cash or similar assets held by banks are called bank reserves. In  modern economies, banks’ reserves are less than their deposits, a  situation called fractional-reserve banking. The ratio of bank reserves  to deposits is called reserve- deposit ratio; in a fractional-reserve  banking system, this ratio is less than 1

∙ the portion of bank reserves that is in excess of what is desired to  support the banks’ deposits can be lent out by the banks to earn  interest. Banks will continue to make loans and accept deposits as long as the reserve-deposit ratio exceeds its desired level. This process  

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stops only when the actual and desired reserve-deposit ratios are  

equal. At that point, total banks deposits equal bank reserves divided  by the desired reserve-deposit ratio, and the money supply equals the  currency held by the public plus bank deposits  

central banks, the money supply, and prices  

∙ federal reserve system (the Fed) = the central bank of the united  states  

o two main responsibilities:  

 monetary policy – determination of the nation’s money  supply  

 oversight and regulation of financial markets  

controlling the money supply with open-market operations  ∙ control the money supply indirectly  

∙ open-market purchases  

o the purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the  money supply  

∙ open-market sales  

o the sale by the Fed of government bonds to the public for the  purpose of reducing bank reserves and the money supply  ∙ open-market operations  

o open-market purchases and open-market sales  

money and prices  

∙ in the long run, the amount of money circulating in an economy and  the general level of prices are closely linked  

velocity  

∙ a measure of the speed at which money changes hands in transactions involving final goods and services

∙ = nominal GDP divided by the stock of money  

money and inflation in the long run  

∙ quantity equation  

o money times velocity = nominal GDP  

recap: central banks, the money supply, and prices  

∙ central banks control the money supply through open-market  operations. Open-market purchases increase the money supply while  open-market sales decrease the money supply  

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∙ a high rate of money growth generally leads to inflation. The larger the  amount of money in circulation, the higher the public will bid up the  prices of available goods and services  

∙ velocity measures the speed at which money circulates in payments  for final goods and services; equivalently it is equal to nominal GDP  divided by the stock of money. A numerical value for velocity can be  obtained from the equation V = (P * Y)/ M, where v is velocity, P * Y is  nominal GDP, and M is the money supply  

∙ the quantity equation states that money times velocity equals nominal  GDP, or, in symbols, M * V = P * Y. the quantity equation is a  restatement of the definition of velocity and thus always holds. If  velocity and output are approximately constant, the quantity equation  implies that a given percentage increases in the money supply leads to the same percentage increases in the price level. In other words, the  rate of growth of the money supply equals the rate of inflation  

CHAPTER 10: SHORT-TERM ECONOMIC FLUCTUATIONS  

Recessions and expansions  

∙ business cycles  

o short-term fluctuations in GDP and other variables  

∙ recession (or contraction)

o a period in which the economy is growing at a rate significantly  below normal  

∙ depression  

o a particularly severe or protracted recession  

∙ peak

o the beginning of an economic recession

o the high point of economic activity prior to a downturn  

∙ trough  

o the end of a recession

o the low point of economic activity prior to a recovery  

∙ expansion  

o a period in which the economy is growing at a rate significantly  above normal  

∙ boom  

o a particularly strong and protracted expansion  

recap: some facts about short-term economic fluctuations  ∙ a recession is a period in which output is growing more slowly than  normal. An expansion, or boom, is a period in which output is growing  more quickly than normal  

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∙ the beginning of a recession is called the peak, and its end (which  corresponds to the beginning of the subsequent expansion) is called  the trough

∙ the sharpest recession is history of the United States was the initial  phase of the Great Depression in 1929-1933

∙ short-term economic fluctuations (recessions and expansions) are  irregular in length and severity, and thus are difficult to predict  ∙ expansions and recessions have widespread (and sometimes global)  impacts, affecting most regions and industries  

∙ unemployment rises sharply during recession and falls, usually more  slowly, during an expansion  

∙ durable goods industries are more affected by expansions and  recessions than other industries. Services and non-durable goods  industries are3 less sensitive to ups and downs in the economy  

∙ recessions tend to be followed by a decline in inflation and often  preceded by an increase in inflation  

potential output (Y*, potential GDP, or full employment output) ∙ the maximum sustainable amount of output (real GDP) that an  economy can produce  

the output gap  

∙ the difference between the economy’s actual output and its potential  output, relative to potential output, at a point in time  

∙ recessionary gap  

o a negative output gap, which occurs when potential output  exceeds actual output (Y < Y*)

∙ expansionary gap  

o a positive output gap, which occurs when actual output is higher  than potential output (Y < Y*)

the natural rate of unemployment and cyclical unemployment  ∙ natural rate of unemployment, u*  

o the part of the total unemployment rate that is attributable to  frictional and structural unemployment; equivalently, the  

unemployment rate that prevails when cyclical unemployment is  zero, so that the economy has neither a recessionary not  

expansionary gap  

o cyclical unemployment  

 the difference between the total unemployment rate and  the natural rate  

okun’s law  

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∙ each extra percentage point of cyclical unemployment is associated  

with about a 2 percent widening of a negative output gap, measured in relation to potential output  

recap: output gaps and clinical unemployment  

∙ potential output is the maximum sustainable amount of output (real  GDP) that an economy can produce. The output gap is the difference  between the economy’s actual output and its potential output, relative  to potential output, at a point in time. When actual output is below  potential, the resulting output gap is called a recessionary gap. When  actual output is above potential, the difference is called an  expansionary gap. A recessionary gap reflects a waste of resources,  while an expansionary gap threatens to ignite inflation; hence,  policymakers have an incentive to try and eliminate both types of  output gaps  

∙ the natural rate of unemployment u* is the sum of the frictional and  structural unemployment rates. It is the rate of unemployment that is  observes when the economy is operating at a normal level, with no  output gaps  

∙ cyclical unemployment, u – u*, is the difference between the actual  unemployment rate u and the natural rate of unemployment u*.  cyclical unemployment is positive when there is a recessionary gap,  negative when there is an expansionary gap, and zero when there is no output gap  

∙ okun’s law relates cyclical unemployment and the output gap.  According to this rule of thumb, each percentage point increases in  cyclical unemployment is associated with about a 2 percent widening  of a negative output gap, measured in relation to potential output  

CHAPTER 11: SPENDING, OUTPUT, AND FISCAL POLICY  

Menu costs  

∙ the costs of changing prices  

planned aggregate expenditure  

∙ total planned spending on final goods and services  

o four types of spending  

 consumption, planned investment, government purchases,  net exports  

consumer spending and the economy  

∙ consumers’ willingness to spend effects sales and profitability  ∙ consumption function  

o the relationship between consumption spending and its  determinates, in particular, disposable income  

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∙ autonomous consumption  

o consumption spending that is not related to the level of  disposable income  

∙ wealth effect  

o the tendency of changes in asset prices to affect households’  wealth and thus their consumption spending  

∙ marginal propensity to consume (mpc)

o the amount by which consumption rises when disposable income rises by $1; we assume that 0 < mpc < 1  

planned aggregate expenditure and output  

∙ autonomous expenditure  

o the portion of planned aggregate expenditure that is  

independent of output  

∙ induced expenditure  

o the portion of planned aggregate expenditure that depends on  output Y  

∙ expenditure line  

o a line showing the relationship between planned aggregate  expenditure and output  

recap: planned aggregate expenditure  

∙ planned aggregate expenditure (PAE) is the total planned spending on  final goods and services. The four components of planned spending are consumer expenditure (C), planned investment (Ip), government  purchases (G), and net exports (NX). Planned investment differs from  actual investment when firms’ sales are different from what they  expected, so that additions to inventory (a component of investment)  are different from what firms anticipated  

∙ the largest component of aggregate expenditure is consumer  expenditure, or simply consumption. Consumption depends on  disposable, or after- tax income, according to a relationship known as  the consumption function, stated algebraically as C = Ć + (mpc)(Y-T)

∙ the constant term in the consumption function, Ć, captures factors  other than disposable income that affect consumer spending. For  example, an increase in housing or stock prices that makes households wealthier and thus more willing to spend – an affect called the wealth  effect – could be captured by an increase in Ć. The slope of the  consumption function equals the marginal propensity to consume,  mpc, where 0 < mpc < 1. This is the amount by which consumption  rises when disposable income ruses by one dollar  

∙ increases in output Y, which imply equal increases in income, cause  consumption to rise. As consumption is part of planned aggregate  expenditure, planned spending depends on output as well. The portion  of planned aggregate expenditure that depends on output it called  

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induced expenditure. The portion of planned aggregate expenditure  that is independent of output is autonomous expenditure  

short-run equilibrium output  

∙ the level of output as which output Y equals planned aggregate  

expenditure PAE; the level of output that prevails during the period in  which prices are predetermined  

o Y = PAE  

o Can be solved either numerically or graphically  

 The graphical solution is based on a diagram called the  Keynesian cross. The Keynesian-cross diagram includes two lines: a 45-degree line that represents the condition Y =  

PAE and the expenditure line, which shows the relationship  of planned aggregate expenditure to output.  

∙ Short-run equilibrium output is determined at the  

intersection of the two lines.  

o If short-run equilibrium output differs from  

potential output, an output gap exists  

Income-expenditure multiplier  

∙ The effect of a one-unit increase in autonomous expenditure on short run equilibrium output  

Planned spending and the output gap  

∙ Increases in autonomous expenditure shift the expenditure line  upward, increasing short-run equilibrium; decreases in autonomous  expenditure shift the expenditure line downward, leading the declines  in short – run equilibrium output. Decreases in autonomous  expenditure that drive actual output below potential output are a  source of recessions  

∙ Generally, a one-unit change in autonomous expenditure leads to a  larger change in short-run equilibrium output, reflecting the working of  the income-expenditure multiplier. The multiplier arises because a  given initial increase in spending raises the incomes of producers,  which leads them to spend more, raising the incomes and spending of  other producers, and so on  

Fiscal policy and recessions  

∙ Stabilization policies  

o Government policies that are used to affect planned aggregate  expenditure, with the objective of eliminating output gaps  ∙ Expansionary policies  

o Government policy actions intended to increase planned  spending and output  

∙ Contractionary policies  

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o Government policy actions designed to reduce planned spending  and output  

∙ Fiscal policy  

o Decisions about how much the government spends and how  much tax revenue it collects  

Automatic stabilizers  

∙ Provisions in the law that imply automatic increases in government  spending or decreases in taxes when real output declines

Recap: fiscal policy and planned spending  

∙ Fiscal policy consists of two tools for affecting total spending and  eliminating output gaps  

o (1) changes in government purchases  

o (2) changes in taxed or transfer payments  

∙ an increase in government purchases increases autonomous  expenditure by an equal amount. A reduction in taxes or an increase in transfer payments increases autonomous expenditure by an amount  equal to marginal propensity to consume times the reduction in taxes  or increase in transfers. The ultimate effect of a fiscal policy change on short-run equilibrium output equals the change in autonomous  expenditure times the multiplier. Accordingly, if the economy is in  recession, an increase in government purchases, a cut in taxes, or an  increase in transfers can be used to simulate spending and eliminate  the recessionary gap  

∙ three important qualifications regarding fiscal policy  

o changes in taxed and transfer programs may affect the  incentives and economic behavior or households and firms  o governments must weigh the short-run effects of fiscal policy  against the possibility of large and persistent budget deficits  o changes ins pending and taxation take time and thus fiscal policy can be relatively slow and inflexible  

CHAPTER 12: MONETARY POLICY AND THE FEDERAL RESERVE  

Structure of the federal reserve system  

∙ board of governors

o the leadership of the Fed

o consists of 7 governors appointed by the president to staggered  14- year terms  

∙ federal open market committee (FOMC)

o the committee that makes decisions concerning monetary policy  banking panic  

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∙ a situation in which news or rumors of the imminent bankruptcy of  one or more banks leads bank depositors to rush to withdraw their  finds  

deposit insurance  

∙ a system under which the government guarantees that depositors will not lose any money even if their bank goes bankrupt  

federal funds rate  

∙ the interest rate that commercial banks charge each other for very  short-term (usually overnight) loans; because the fed frequently sets  its policy in terms of the federal funds rate, this rate is closely  watched in financial markets  

the fed fights are recessions  

∙ there is a recessionary gap (output less than Y*)  

∙ the fed reduces the real interest rate which shifts the expenditure line  up so now output = potential output and the gap has been eliminated  the fed fights inflation  

∙ there is an expansionary gap (output greater than potential output) ∙ the fed increases the real interest rate which shifts the expenditure line down so now output = potential output and the gap has been  eliminated  

recap: monetary policy and the economy  

∙ an increase in the real interest rate reduces both consumption  spending and planned investment spending. Through its control of the  real interest rate, the Fed is able to influence planned spending and  short-run equilibrium output

o to fight a recession (a recessionary output gap), the fed lowers  the real interest rate, stimulating planned spending and output o to fight the threat of inflation (an expansionary output gap), the  fed raises the real interest rate, reducing planned spending and  output  

∙ the federal reserve has not typically used monetary policy to affect  asset prices. Rather, the fed has focused on keeping prices stable and  output near potential. The experience of shock market bubble of the  late 1990s tends to support this course of action, but the hosing bubble of the 2000s provides evidence against it  

the demand for money  

∙ portfolio allocation decision  

o the decision about the forms in which to hold one’s wealth  ∙ demand for money  

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o the amount of wealth an individual or firm chooses to hold in the  form of money  

the money demand curve  

∙ a curve that shows the relationship between the aggregate quantity of  money demanded M and the nominal interest rate i  

∙ because an increase in the nominal interest rate increases the  opportunity cost of holding money, which reduces the quantity of  money demanded, the money demand curve slopes down  

o for a given nominal interest rate, any change that makes people  want to hold more money will shift the curve to the right  

equilibrium in the market for money  

∙ equilibrium in the market for money occurs where the quantity of  money demanded equals the quantity of money supplied by the  federal reserve

recap: money demand and supply  

∙ for the economy as a whole, the demand for money is the amount of  wealth that individuals, households, and businesses choose to hold in  the form of money. The opportunity cost for holding money is  measured by the nominal interest rate i, which is the return that could  be earned on alternative assets such as bonds. The benefit of holding  money is its usefulness in transactions  

∙ increases in real GDP (Y) or the price level (P) raise the nominal volume of transactions and thus the economy wide demand for money. The  demand for money also is affected by technological and financial  innovations, such as the introduction of ATM machines, that effect the  costs or benefits of holding money  

∙ the money demand curve relates the economy wide demand for  money to the nominal interest rate. Because an increase in the  nominal interest rate raises the opportunity cost of holding money, the  money demand curve slopes downward  

∙ changes in factors other than the nominal interest rate that affect the  demand for money can shift the money demand curve. For example,  increases in real GDP or the price level raise the demand for money,  shifting the money demand curve to the right, whereas decreased shift the money demand curve to the left

∙ in the market for money, the money demand curve slopes downward,  reflecting the fact that a higher nominal interest rate increases the  opportunity cost of holding money and thus reduces the amount of  

money people want to hold. The money supply curve is vertical at the  quantity of money that the fed chooses to supply. The equilibrium  nominal interest rate i is the interest rate at which the quantity of  

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money demanded by the public equals the fixed supple of money  made available by the fed  

how the fed controls the nominal interest rate  

∙ open-market operations

∙ discount window lending  

o the lending of federal reserves by the federal reserve to  commercial banks  

o discount rate (or primary credit rate)

 the interest rate that the fed charges commercial banks to  borrow reserves  

∙ reserve requirements  

o set by the fed, the minimum values of the ratio of bank reserves  to bank deposits that commercial banks are allowed to maintain  ∙ interest paid on reserves  

o the fed began paying interest on required reserve balances and  on excess reserve balances  

∙ unconventional monetary policy  

o quantitative easing (QE)

 an expansionary monetary policy in which a central bank  buys financial assets from private financial institutions,  

thereby lowering the yield or return of those assets while  

increasing the money supply  

recap: the federal reserve and interest rates  

∙ the federal reserve controls the nominal interest rate by changing the  supply of money. An open-market purchase of government bonds  increases the money supply and lowers the equilibrium nominal  interest rate. An increase in discount window lending, a reduction in  reserve requirements, a decrease in the interest rate paid on required  reserves, or quantitative easing will all have the same effect

∙ Conversely, an open-market sale of government bonds reduces the  money supply and increases the nominal interest rate, as will a  decrease un discount window lending, an increase in the interest rate  paid on required reserves, or an increase in reserve requirements

∙ The fed can prevent changes in the demand for money from affecting  the nominal interest rate by adjusting the quantity of money supplied  appropriately  

CHAPTER 13: AGGREGATE DEMAND, AGGREGATE SUPPLY, AND  BUSINESS CYCLES  

The aggregate demand-aggregate supply model  

∙ The aggregate demand (AD) curve slopes downward because a fall in  the inflation rate causes an increase in planned spending and output

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∙ The aggregate supply (AS) curve is upward sloping because an  increase in the quantity of output supplied causes an increase in the  inflation rate

∙ The economy us in long-run equilibrium because the AD and AS curves  intersect at the level of potential GDP Y*  

∙ Long-run equilibrium  

o A situation in which the AD and AS curves intersect at potential  output Y*

∙ Short-run equilibrium  

o A situation where the AD and AS curves intersect at a level of  real GDP that is above or below potential  

The aggregate demand (AD) curve  

∙ a curve that shows the amount of output consumers, firms,  government, and customers abroad want to purchase at each inflation  rate, holding all other factors constant  

∙ why does the AD curve slope downward?

o An increase in the inflation rate causes planned consumption,  investment, and net exports to fall  

o Monetary policy rule  

 A rule that describes how a central bank, like the fed, takes action in response to changes in the state of the economy  ∙ What factors shift the AD curve?

o Changes in aggregate demand  

 A shift of the AD curve  

o Demand shocks  

 Changes in planned spending that are not caused by  

changes in output or the inflation rate  

 Called shocks because they are not anticipated

o Stabilization policy  

 Fiscal policy  

∙ Changes in government spending and taxes  

 Monetary policy  

∙ Changes in the real interest rate without changes in  

inflation  

 To increase aggregate demand  

∙ Increase government spending  

∙ Cut taxes  

∙ Decrease the real interest rate  

 To decrease aggregate demand  

∙ Decrease government spending  

∙ Raise taxes

∙ Increase the real interest rate  

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Recap: the aggregate demand (AD) curve  

∙ The aggregate demand (AD) curve shows the amount of output  consumers, firms, government, and customers abroad want to  purchase at each inflation rate, holding all other factors constant  

∙ The AD curve slopes downward because of the Fed’s monetary policy  rule:

o Higher inflation leads the fed to raise the real interest rate, which reduces spending and thus short-run equilibrium output  

∙ Demand shocks (changes in planned spending that are not caused by  changes in output or the inflation rate) shift the AD curve

o Positive demand shocks shift the AD curve to the right, while  negative demand shocks shift the AD curve to the left  

∙ Stabilization policy, that is, the use of fiscal and monetary policy to  close output gaps, shifts the AD curve. Higher levels of government  spending, lower taxes, and lower interest rates all increase aggregate  demand, while decreased government spending, higher taxes, and  higher interest rates all decrease aggregate demand  

The aggregate supply (AS) curve  

∙ A curve that shows the relationship between the amount of output  firms want to produce and the inflation rate, holding all other factors  constant

∙ Why does the AS curve slope upward?

o Inflation inertia  

 Inflation expectations  

 Long-term wage and price contracts  

o Output gaps and inflation  

 No output gap: Y = Y*

 Expansionary gap: Y >Y*

 Recessionary gap: Y<Y*

∙ What causes the AS curve to shift?

o Change in aggregate supply  

 A shift of the AS curve  

o Changes in available resources and technology  

o Changes in inflation expectations  

o Inflation shocks  

 A sudden change in the normal behavior of inflation,  

unrelated to the nation’s output gap  

Recap: the aggregate supply (AS) curve

∙ The aggregate supply (AS) curve shows the relationship between the  amount of output firms want to produce and the inflation rate, holding  all other factors constant  

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∙ The AS curve slopes upward because actual inflation is related to  expected inflation and also to the gap between actual output and  potential output: when output is below potential, actual inflation is  

below expected inflation, and when output is above potential, actual  inflation is above expected inflation  

∙ Changes in available resources and technology and changes in  expected inflation shift the AS curve  

∙ Inflation shocks also shift the AS curve. Adverse inflation shocks shift  the AS curve to the left and favorable shocks shift the AS curve to the  right  

Business cycles  

∙ Business cycles are caused by shifts in aggregate demand and  aggregate supply  

∙ The primary causes of aggregate demand shifts are demand shocks,  while the most frequent causes of aggregate supply shifts are inflation shocks  

∙ The AD-AS model can be used to study business cycles by applying a  5 step process  

o Show the economy in long run equilibrium  

o Identify how the AD and/or AS curves are affected  

o Shift the AD and/or AS curves in the appropriate fashion  o Find the economy’s new short-run equilibrium  

o Compare the new short-run equilibrium with the initial long-run  equilibrium to show how output and the inflation rate were  affected  

∙ The great recession was the result of two negative demand shocks;  declining house prices and the 2008 financial panic  

The self- correcting economy  

∙ Self-correcting property  

o The fact that output gaps will not last indefinitely, but will be  closed by rising of falling inflation  

Recap: AD-AS and the self-correcting economy  

∙ Inflation adjusts gradually to bring the economy into long-run  equilibrium (a phenomenon called the economy’s self-correcting  tendency). Inflation rises to eliminate an expansionary gap and falls to  eliminate a recessionary gap  

∙ The more rapid the self-correction process, the less need for active  stabilization policies to eliminate output gaps. In practice,  policymakers’ attempts eliminate output gaps are more likely to be  helpful when the output gap is large then when it is small  

CHAPTER 14: MACROECONOMIC POLICY  

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Stabilization policy and inflation shocks  

∙ Accommodating policy  

o A policy that allows the effects of a shock to occur  

∙ Anchored inflationary expectations  

o When people’s expectations of future inflation do not change  even if inflation ruses temporarily  

Recap: the role of stabilization policy  

∙ In response to changes in spending that create shocks in aggregate  

demand, fiscal and monetary policy can be applied to return output to  potential and inflation to its long-run expected rate. Shocks to  aggregate supply (such as inflation shocks), however, force the fed the choose between maintaining inflation and stabilizing output. If  inflationary expectations are anchored, however, the return to  potential output following an inflations hock will occur more rapidly. By  monitoring the core rate of inflation, the Fed can determine whether an inflation shock has led to any second-round effects on inflation and can act accordingly

Inflation expectations and credibility  

∙ What determines if inflation expectations are anchored? o The credibility of monetary policy  

 The degree to which the public believes the central bank’s  promises to keep inflation low, ever if doing so may impose short-run economic costs  

∙ Central bank independence  

o When central bankers are insulated from short-term political  considerations and are allowed to take a long term view of the  economy  

∙ Announcing a numerical inflation target  

∙ Central bank reputation  

o Inflation hawk  

 Someone who is committed to achieving and maintaining  low inflation, even at some short-run cost in reduced  

output and employment  

o Inflation dove  

 Someone who is not strongly committed to achieving and  maintaining low inflation  

Recap: inflationary expectations and credibility  

∙ Macroeconomic performance may be improved if expectations of  inflation are anchored, anchored expectations, in turn, depend on the  extent to which a central bank’s anti-inflation pronouncements are  viewed at credible. Several institutional characteristics may help to  

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enhance a central bank’s credibility: the extent to which the central  

bank is independent from the executive and legislative branches of the government, the announcement of a numerical inflation target, and the reputation of the central bank as an “inflation hawk”

Fiscal policy and the supply side  

∙ Supply-side policy  

o A policy that affects potential output  

∙ Marginal tax rate  

o The amount by which taxes rise when before-tax income rises by  one dollar  

∙ Average tax rate  

o Total taxes divided by total before-tax income  

Recap: fiscal policy and the supply side  

∙ A supply-side policy is a policy that affects potential output. Fiscal  policies affect aggregate demand, but they also may be supply-side  policies  

∙ Government expenditures on public capital – such as roads, airports,  and schools – increase aggregate expenditure but also may increase  potential output  

∙ Government tax and transfer programs affect the incentives, and thus  the economic behavior, of households and firms  

∙ People may respond to reductions in their marginal tax rates by  working more hours, investing more in education, and taking more  entrepreneurial risks, all of which contribute to greater potential  output. The size of the effect of tax changes on labor supply remains  somewhat controversial  

∙ Fiscal policymakers should take into account the effects of spending  and tax decisions on potential output as well as on aggregate demand  

Inside lag (of macroeconomic policy)

∙ The delay between the date a policy change is needed and the date is  implemented  

Outside lag (of macroeconomic policy)

∙ The delay between the date a policy change is implemented and the  date by which most of its effects on the economy have occurred  

Recap: policy making: art or science?

∙ Macroeconomic policymaking is a difficult and inexact science.  Policymakers do not know the precise state of the economy, the future  path of the economy if no policy changes are implanted, or the precise  level of potential output. They also have imperfect control over policy  instruments and imprecise knowledge of the effects of any policy  

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changes. The existence of inside and outside lags makes policy making even more difficult. Consequently, macroeconomic policymaking is an  art as well as a science  

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