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ECO 105 Goel Final Exam Study Guide

by: Daniel Hemenway

ECO 105 Goel Final Exam Study Guide ECO 105

Marketplace > Illinois State University > Economcs > ECO 105 > ECO 105 Goel Final Exam Study Guide
Daniel Hemenway
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This is a compilation of all of the study guides for all of the exams in ECO 105 with Goel. He did not give an official study guide for the final, but said to look back on them all. I believe this...
Principles Economics
Rajeev Goel
Study Guide
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This 30 page Study Guide was uploaded by Daniel Hemenway on Wednesday December 2, 2015. The Study Guide belongs to ECO 105 at Illinois State University taught by Rajeev Goel in Fall 2015. Since its upload, it has received 64 views. For similar materials see Principles Economics in Economcs at Illinois State University.


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Date Created: 12/02/15
EXAM 1 STUDY GUIDE • Definition of Economics − The study of how scarce resources are allocated among competing ends/uses • Micro and Macro Economincs − Micro: Analysis of small − Macro: Analysis of large Economics _______________|_______________ | | Micro Macro |______________________________| _______________|_______________ | | Positive Statements Normative Statements • Scarce and Free Goods −Scarce goods have positive opportunity costs • Resources are SCARCE when DEMAND EXCEEDS SUPPLY −Free goods have zero opportunity costs • Positive and Normative Economics $ 5 −Positive Statements: Fact based, “what is?” −Normative Statements: More opinion based, “what should be?” −See chart under micro/macro • Fallacies in Economics −False-Cause: Caution about cause and effect 0 Q $ $ −Composition: Caution about generalization 5 • Positive and Negative relationships − Positive: Both variables move in same direction − Negative: Variables move in opposition • Independent and Dependent Variables 0 Q Q $ −Independent Variable: Changes by itself • On horizontal (X) axis −Dependent Variable: Changes as a result of a change in the independent variable • On vertical (Y) axis • Area and Slope −Area • Area of a Rectangle = Length x Width − Example: The total sales of a Business (P x Q) can be expressed as the area of a rectangle Q P H Cost Profit W Sales • Area of a Triangle = (1/2)Base x Height −Slope • Rise/Run • Positive relation, positive slope • Negative relation, negative slope • Cannot talk about slope of a curve, it changes as you move along it • Resources: Land, Labor, Capital, Entrepreneurship −Land (Rent), Labor (Wages), Capital (Interest….Technology), Entrepreneurship (Profits = Sales – Costs) −Land and Capital: have one distinguishing characteristic • Unlike capital, total aggregate supply of land is fixed −Labor (Characteristics) • Cannot be bought or sold • Ability to form unions • Cares about the kind of work it does −Entrepreneurship (Characteristics) • Risk taking ability • Profits are residual rewards: gets paid after factors (costs) have been paid • Scarcity, Choice, Specialization, Exchange − Scarcity (PPF) —> Choice —> Specialization (LCA) —> Exchange • PPF: Production Possibilities Frontier • LCA: Law of Comparative Advantage • Opportunity Costs −Cost of the Next Best Alternative forgone • Scarce goods have positive opportunity costs • Free goods have zero opportunity costs • The Economic Problem − Three Economic Questions • What to Produce? − Necessities vs. Luxuries • Luxuries are more responsive to income that is free (available) • How to Produce? − Labor Intensive vs. Capital Intensive • Labor Intensive: more workers, fewer machines • Capital Intensive: more machines, fewer workers • For Whom to Produce? − If a business focuses on necessities, they are catering to a bigger population − If a business focuses on luxuries, they are catering to a smaller population − Prices give the business signal; businesses will focus more on where they believe the most money can be made • PPF: Production Possibilities Frontier − Shows Maximum Combinations of goods and services that an economy can produce with the Given Resources (i.e.: Land, Labor, Capital, Entrepreneurship) and Current Technology − Talks about production possibilities, NOT what should (or must) be produced − Points on the PPF are attainable and efficient, points beyond the Frontier are unattainable, and points inside the Frontier are attainable, but inefficient − When Resources and/or technology changes, the PPF either shifts or rotates Good B Z Point A is on the PPF and is A A PPF attainable and efficient Point Z is beyond the PPF and is unattainable M Point M is inside the PPF and is attainable, but it is inefficient 0 Good A Representation of a SHIFT in the PPF Representation of a ROTATION in the PPF Good B Good B 0 Good A 0 Good A • Shape of PPF − A PPF has a negative slope (due to the positive opportunity cost of producing a good or service) and is bowed outward (due to the Law of Increasing Cost) • Law of Increasing Costs − Law of Increasing Cost: As you produce more of a good (or service) its Opportunity Cost per unit goes up • This is the economic reason for the PPF being Bowed Outward • Law of Diminishing Returns − Law of Diminishing Returns: As one input (land, labor, capital, entrepreneurship) is increased in equal increments, holding all other inputs the same, the additions to output will eventually decrease • Markets − Markets are established arrangements where buying and selling of goods (and services) takes place • Eliminates once in a lifetime transactions (example: garage sales) − Local vs. National Markets − Daily and Monthly Markets − Goods Markets • Walmart − Factor Markets • Bank • Real-estate − How has the internet changed markets? • Allows buyers and sellers to come together that wouldn’t normally have the opportunity to − Isolated transaction is not a market • Circular Flow of Economic Activity • Relative and Money Prices − Money Prices: Price of a good (or service) in the unit of currency − Relative Prices: Price of a good (or service) in terms of another good (or service) • Can be seen as a Frame of Reference • Can also be relative to some other good at another time − Microeconomics focuses on Relative Price: Frame of Refer ence − Macroeconomics focuses on Money Price: Rate of Inflation − Example: MP1 MP2 RP1 RP2 Car $8,000 $20,000 10 Bikes 20 Bikes Bike $800 $1,000 1/10 C 1/20 Car • While both Money Prices have increased from period 1 to 2 only the Relative Price of cars has increased. The Relative Price of bikes, on the other hand, has decreased over the same period • Money Price and Relative Price do not necessarily move in the same direction • ** Marginal Analysis − “What happens when one more?” − Rational Economic Agents make decisions at the margin: undertake those activities whose Marginal Benefits EXCEEDS Marginal Costs − Think about economic “irrationality” • The Principle of Substitution − Principle of Substitution: nearly every good (or service) has a substitute • Example: Coke and Pepsi, Air and Car Travel • Specialization/The Law of Comparative Advantage − Law of Comparative Advantage (LCA) • REVIEW: Scarcity(PPF) —> Choice —> Specialization (LCA) —> Exchange • Focuses on specialization • It is better for individuals to specialize in those activities in which their Comparative Advantage over other activities is the greatest, or their comparative disadvantage is the least • Distinction between Comparative vs. Absolute Advantage • REMEMBER Opportunity Cost is always in terms of something else • Example: Opp. Cost Lawns Opp. Cost Pages Lawn/Day Pages/Day (in pages) (in lawns) Jack 2 20 2/20 = .1^ Jill 8 50 50/8 = 6.25^ 8/25 = .16 _ = Higher opportunity cost ^ = Lower opportunity cost • Although, Jill has an absolute advantage in both, her comparative advantage is in mowing lawns • Jill should mow, and Jack should type because it is his least disadvantage • Doctrine of Invisible Hand: Adam Smith (Father of Modern Economics, 1700s) − When economic agents (buyers and sellers) act in their self interest, without any interference by the government, they end up promoting well being of society − Invisible hand emphasizes “Hands-off” Government − It has less relevance in the modern world as all governments interfere to varying degrees in their economies − Limitations of Invisible Hand (case for government intervention) • Income Distribution: reveals what percentage of individuals are at different wage levels • Role of Government: − Public Goods: nonrivalry in consumption, nonexclusion • Many people can use these at the same time − Example: Mt. Rushmore, National Defense − Externalities: private costs/benefits ≠ social costs/benefits • Example: Congestion/pollution; pollution from oil company effecting people living around it and if the government steps in to regulate it • Monopoly: in general, is not a bad thing − Example of how a monopoly can be bad: If there is only one producer of a life saving drug they cannot charge an outrageous price • Macroeconomic Instability: The government steps in to help out • Demand − Demand: The amount people are prepared to buy under specified circumstances during a specified time period − Law of Demand: There is a negative (inverse) relationship between the price of a good and its Quantity Demanded, Holding other factors constant − Demand Curve: Shows the various Quantities Demanded at different prices, Holding other factors constant − Real world behavior is not necessarily a straight line (Example: D1) ($/Unit) P D1 D 0 Q (Units) − A negative price and negative quantity don’t have economic meaning • Individual and Market Demand − The Market Demand curve is the Horizontal Sum(adding QD) of Individual Demand Individual Market Market Demand $/Meal $/Meal $/Meal A B D A+B + = 5 5 5 A A 3 3 3 D A D B 2 3 Q 3 4 Q 5 7 Q 3 #/Week 3 #/Week 3 3 #/Week • Individual and Market Demand (cont.) − Principle of Substitution: nearly every good (or service) has a substitute • Example: Coke and Pepsi, Air and Car Travel • Factors that Shift the Demand Curve (other than price) − Price of Related Goods • Substitutes or Complements − Substitutes example: Coke and Pepsi − Complements example: Sugar and Coffee − Consumer Income • Normal and Inferior Goods • Most goods are normal goods: Income increases, Demand increases • Inferior goods: Income increases, Demand decreases − Example: Ramen Noodles − Consumer Preferences − Number of Buyers − Buyers’ Expectations • Movement vs. Shift in a Curve (Applies to both demand and supply curve) − When the Price of the Good Changes, there is a Movement along the Demand (or Supply) curve. Called Change in Quantity Demanded/Supplied − When Factors Other Than the Price of the good change, there is a shift in the Demand (or Supply) curve. Called Change in Demand/Supply Movement Shift $ $ 5 5 D1 D D2 D1 0 Q 0 Q Q $ Q $ S2 $ S $ S1 S D DS1 5 5 SD 0 Q 0 Q Q $ Q $ • Supply − Supply: Quantity Supplied of a good or service is the amount of the good or service offered for sale at a given price, Holding other Factors Constant − The Supply Curve (or supply schedule): Of a particular good or service shows the various Quantities Supplied at different prices, Holding other Factors Constant − The Supply Curve is generally positively sloped • Factors Shifting the Supply Curve − Prices of Other Goods: Other goods the seller is either producing or can produce − Prices of Relevant Resources − Technology − Number of Sellers − Seller’s Expectations • *** Market Equilibrium − Market Equilibrium: Is at the the intersection of Demand and Supply Curves − Gives Equilibrium price and quantity − Equilibrium price is that price at which the Quantity Demanded of a good equals it Quantity Supply $ {Surplus 5 P1 EP P2 Shortage 5 EQ 5 − Characteristics • Quantity Demanded = Quantity Supplied • No shortage or surplus: The market clears • Equilibrium price is stable: No tendency to rise or fall − Effect on Market EQ of an increase in income: P ⇑ , Q ⇓ − Effect of increase in technology: P ⇓, Q ⇑ • *** Market Equilibrium (cont.) − Effect on Market EQ of an increase in the number sellers and a simultaneous decrease in the number of buyers: P ⇓, Q depends on amount • Elasticity: A measure of a variable's sensitivity to a change in another variable • Price Elasticity of Demand (E D) − Responsiveness of Quantity Demanded of a good to changes in its price − E D = %ΔQ D÷ %ΔP • Ratio of percentages; Does not have a unit • E D, while always negative, is sometimes taken in absolute value for interpretation − E D = 1 (Unit elastic demand) − E D > 1 (Elastic demand) − E D < 1 (Inelastic demand) − Price Elasticity of Demand Determinants • Availability of Substitutes − More substitutes, more elastic demand • Relative importance of the good in consumer’s budget • Time to adjust to price changes • Necessities (E D < 1) vs. Luxuries (E D > 1) • Total Revenue Test − Total Revenue (SALES) = P x Q − If P ⇑ and TR ⇓ then E D > 1 (elastic) − If P ⇑ and TR ⇑ then E D < 1 (inelastic) − If P changes but TR doesn’t change then E D = 1 (unit elastic) − Useful for businesses considering raising prices • Elasticity and Slope − The more horizontal the curve (demand or supply), the more elastic and vice versa Perfectly Elastic Perfectly Inelastic $ $ E D = 0 E D = -∞ D D 0 Q 0 Q $ $ $ $ E = ∞ E S = 0 S S 0 Q 0 Q $ $ • Income Elasticity of Demand (E I) − Responsiveness of Quantity Demanded of a good to changes in income − E I= %ΔQ D ÷ %ΔI (No absolute value) • Example: E I = 0.8 Normal and Necessity • Example: E I = 1.3 Normal and Luxury − E I > 0 = Normal Good (Positive) − E I < 0 = Inferior Good (Negative) − E I < 1 = Necessity − E I < 0 = Luxury • Cross-Price Elasticity of Demand (E XY) − Responsiveness of Quantity Demanded of a good to changes in price of another good − EXY= %ΔQ D(of X) ÷ %ΔP(of Y) (No absolute value) − EXY > 0 X and Y are substitutes − EXY < 0 X and Y are complements − EXY = 0 X and Y are unrelated − Example: • X, Y, and Z are all goods. − E YZ= 0.8 − E YX= 0.5 • E YZ and E YX are both substitutes − E XZ= -1.1 • E XZ are complements • Price Elasticity of Supply (ES) − Responsiveness of Quantity Supplied of a good to changes in its price − ES= %ΔQ S÷ %ΔP (No absolute value) − ES Depends on (i) time the seller has time to respond; and (ii) availability of inputs • E S = 0 (inelastic) immediate run: no time to alter inputs • ** ES > 0 (somewhat elastic) Short Run: time to alter some, but not all inputs • ** ES >> 0 (most elastic) Long Run: time to alter all inputs • Applications of Elasticity (Tax Burden and Sales) − Tax Burden: The party (buyer or seller) with greater unresponsiveness bears greater tax burden − Price Changes: With inelastic Demands, firms can afford to raise prices without worrying about revenue losses EXAM 2 STUDY GUIDE • Consumer Behavior − Preferences: Consumers’ likes and dislikes about goods and services, independent of price and income considerations − Utility: The satisfaction a consumer gets from consuming goods and services − Satisfaction can be negative − Measure satisfaction in utils − Marginal Utility (MU): Extra satisfaction from consuming one more unit of a good or service (change in utility / change in consumption) − Law of Diminishing Marginal Utility: As you consume more of a good, holding the consumption of everything else the same, the additions to satisfaction (i.e. MU) − Demand and Utility • Focusses on the Households and Goods Market exchange • Two questions of Demand and Utility − Where does the Demand curve come from? − What constitutes a best buy? − *** Consumer Equilibrium • In consumer equilibrium, the consumer is consuming the set of goods and services that maximizes satisfaction • Consumer’s income and prices of the goods are assumed to be given • Unless prices and/or income change, a consumer in equilibrium has no incentive to change the satisfaction maximizing bundle of goods and services • Conditions for Consumer Equilibrium (optimizing consumption rule) − All income is spent AND − MU a / Pa = MU b / b = … • Points along the demand curve are consistent with consumer equilibrium. The demand curve results from consumer’s efforts to maximize satisfaction • Example: A consumer spends all his income of $1,000 on two goods: food and clothing. The respective prices are Pf= $10 and Pc= $20. The marginal utilities are: MUf= 50 and MUc=200. Is the consumer maximizing satisfaction? If not, what should the consumer do to maximize satisfaction? MU c / Pc = 200/20 = 10 MU f / Pf = 50/10 = 5 Satisfaction is not maximized; to maximize it the consumer should increase Clothes and decrease Food − Consumer Surplus • Consumer surplus: is a measure of consumer’s well being • Consumer surplus is the difference between a consumer’s willingness to pay for a good and what the consumer actually pays • Graphically it is the area of the triangle below the demand curve and above price • Costs and Productivity − Economic Costs vs. Accounting Costs • Explicit Costs: Costs incurred when money changes hands • Implicit Costs: Money does not change hands, but some alternative is sacrificed • Economic Costs = Explicit + Implicit • Accounting Costs = Explicit Costs − Profits: Economics vs. Accounting • Economic Profits = TR (sales) – (Explicit + Implicit) • Accounting Profits = TR – Explicit Costs • Normal Profits = TR = Explicit + Implicit • This is the Break-even case of zero economic profit − Productivity • Marginal Physical Product: Extra output from one more input (Change in Q / Change in Input) − Law of Diminishing Returns: As you increase one input in equal increments, holding all other inputs the same, its MPP will go down − * There is a negative relationship between MPP and MC − Example: Labor (L) Output (Q) (Δ in Q / Δ in Input (L)) 1 15 10 / 1 = 10 MPP L 2 25 − *** Least-cost Production: MPP k/ Pk = MPP L / L = … K = Capital − K.L.E.M.: Capital, Labor, Energy, Material − For cost minimization Example: The price of capital P k is $100 per machine hour and its marginal product (MMP k) is 1,000 units. The price of labor (i.e.L or wage rate) is $25 per hour and the marginal product of labor (MMP L) is 250 units. Is the firm minimizing its production costs? If not, what should it do so that coasts are minimized? (MMP L/ P ) = 250/25 = 10 (MMP k / Pk) = 1000/100 = 10 Cost is minimized because MPP k/ Pk = MPP / PL Profits cannot be maximized unless costs are minimized − Costs • Fixed Costs (FC): Implies Short-Run • Variable Costs (VC): Change with production • Total Costs (TC): FC + VC • Long Run: All costs are variable • Average Fixed Costs (AFC) = FC/Q • Average Variable Costs (AVC) = VC/Q • Average Total Costs (ATC) = (TC/Q) = AFC + AVC • Marginal Costs (MC) = (Change in TC / Change in Q) = (Change in VC / Change in Q) − Features of Long Run Costs • Every long run is a sequence of short runs • The firm has all the options in the long run that it did in the short run plus more • The long run ATC will envelope (touch from below) the SRATCs − LRAC • Economies of Scale: ATC falls with output increase • Diseconomies of Scale: ATC rises with output increase • Constant Return to Scale: ATC stays constant with output change • Minimum Efficient Scale (MES): Where LRATC is minimized; a large MES acts as a (built in) Barrier to Entry of new firms • Perfect Competition − Characteristics • Large number of buyers and sellers • Perfect information about Price and Quantity • Homogeneous product • No barrier to entry and exit of firms • No buyer or seller is large enough to influence the price − Price Takers and Price Searchers • Perfectly competitive Firms are PRICE TAKERS: Firms take price as given -> Horizontal demand curve -> P = MR • All Non-Competitive Firms are PRICE SEARCHERS -> Negative Sloping Demand Curve -> P > MR − Price and Marginal Revenue (MR) • Total Revenue (TR): Sales = P x Q • Marginal Revenue (MR): Extra revenue from selling one or more unit of a good or service: (Change in TR / Change in Q) − Profit Maximization • *** Profit Maximization Rule: MC = MR − Applies to all firms • Shut Down Rule: − P > AVC (or TR > VC): Do not shut down − P < AVC (or TR < VC): Shut down • Applies in Short Run (SR) only − SR and LR Profit max. under P.C. • In the Short Run, a perfectly competitive firm might shut down, make profits or make losses • In the Long Run, a perfectly competitive firm makes normal Profits (i.e. Break Even) • Long Run Profit Maximization (Equilibrium) under Perfect Competition • Long Run Perfect Competition − Characteristics of Long Run Equilibrium (Profit Maximization) under Perfect Competition • *Firms make normal Profit − *Due to freedom of entry and exit of firms • Firms produce at lowest points on ATC: economic efficiency, no wastage − Producer Surplus • Measure of seller’s well-being • Difference between what a seller receives for a good and the minimum the seller is willing to receive • Graphically, the area above the supply curve and below the price • Together, consumer surplus and producer surplus provide a measure of social welfare • Monopoly − Monopoly Characteristics • One seller, many buyers • No close substitutes for the product • Price Searcher (Maker) P > MR • Barriers to entry of rivals • For a monopoly, the firm and industry are one and the same − Barriers to Entry • Economies of Scale • Patents • Exclusive Ownership of raw materials • Public Franchises • Licensing − Facts About Monopoly • Monopolist need not produce where ATC are minimized • In Monopoly: P > MC (Since P > MR for Price Searchers and MC = MR) • Monopolists produce where demand is elastic • Monopolists DO NOT charge the highest possible price • There is no supply curve of a monopolist • Unlike a P.C. Firm, a monopolist can continue to earn profits in the LR (Due to Entry Barriers) • Comparing P.C. and Monopoly − The Efficiency of Competition • Economic Efficiency: When society’s resources cannot be reallocated to make Everyone better off − Equity – Efficiency Tradeoff • Economic Equity: When resources are allocated according to a widely accepted fair criteria • In general, there is the classic tradeoff between Equity and Efficiency: You have one or the other − Pros and Cons of Monopoly • Pros − Might encourage technical change • Cons − **Contrived (Artificial) Scarcity: Monopolist deliberately reduces output to raise the price (Pm > Pc ; Qm < Qc) − Monopoly leads to Deadweight Loss (i.e. loss in consumer surplus and producer surplus, it measures lost gains from trade) − Pros and Cons of Competition • Pros − Economic Efficiency − Customer receives the lowest price • Cons − MIGHT lead to inequalities − MIGHT NOT be efficient in the presence of externalities − MIGHT NOT be Conducive (Receptive) to high rates of technical change Exam 3 Study Guide INTRODUCTION • Economic Growth: LR increase in the total goods and services produced by the economy • Long term effects on the economy − Economic Growth can also be represented by an outward shift on the PPF − Business Cycle: SR upward and downward movements in the output of an economy • Business cycle has short lived effects on the economy • Four Phases of Business Cycle − Downturn/Recession/Depression (More Severe) − Trough − Expansion (Recovery) − Peak − Recession occurs when the real output in the economy declines for 6 months or more − Depression is a severe downturn in the economic activity for a long period • Unemployment − Labor Force: Number of people employed + Number unemployed − Unemployment Rate: Number of persons unemployed / number of people in the labor force − Natural Rate of Unemployment: That unemployment rate at which there is an approximate balance between the number of unfiled jobs and the number of qualified job seekers − *Natural rate of unemployment is also referred to as full employment • Inflation − Inflation: General increase in prices − Deflation: General decrease in prices − Hyperinflation: Very rapid and accelerated rate of inflation − Rate of Inflation: The rate at which the price level (measured by a price index) is changing • Measuring Inflation − Price Index: Shows the cost of buying the same market basket of goods in different years as a percentage of its cost in some base year − CPI (Consumer Price Index): Measures the level of consumer prices paid by households over time. Narrow measure − GDP (Gross Domestic Product) Deflator: Measures the level of Prices of all final goods and services (consumer goods, investment goods, and Government) produced by the economy. Broad measure • Effects of Inflation − Inflation redistributes income (affecting the standard of living) • Redistributes income away from people who have underestimated it − Inflation creates inefficiencies • Businesses focus more on anticipating inflation than on more productive efforts − Inflation spurts speculation • Inflation creates uncertainty so that Adam Smith’s invisible hand works less efficiently MEASURING AGGREGATE OUTPUT • Measuring GDP − **1. GDP = C + I + G + (X – M) • C = Personal consumption expenditures • I = Investment spending • G = Government purchases (including: federal, state, and local govt’s.) • Net Exports − X = Exports − M = Imports • Foreign Savings = M – X − 2. GDP = Compensation of Employees + Proprietor’s Income + Rental Income + Corporate Profits + Interest + Depreciation + Indirect Bus. Tax − GDI (Gross Domestic Income): Approximate sum of all income earned by factors of production − 3. GDP = Total Sales – Purchases (i.e. the sum of the value added of all industries) − Net Output or Value Added: Value of industry output minus the value of purchases from other industries • Omissions from GDP − Nonmarketed goods and services (i.e. Household production) − Illegal Activities (i.e. Illegal gambling) − Value of Leisure − Transfer Payments: Payments to recipients who have not earned them through the sale of their production factors and who have not supplied current goods and services in exchange for these payments (i.e. subsidies, grants) • Real and Normal GDP − Real GDP: Removes the effect of rising prices on nominal GDP − Real GDP per Capita = (Real GDP / Population) • The best measure of living standards • GNP (Gross National Product) − GNP: The final output produced by U.S. residents whether in the U.S. or abroad − In contrast, GDP includes goods and services produced by labor and capital in the U.S., whether or not suppliers are residents of the U.S. − NNP (Net National Product): GNP – Depreciation − National Income: NNP – Indirect Bus Taxes (= Payments made to all factors) • PPP (Purchasing Power Parity): A rate for converting one economy’s output into the prices of another country. It is the exchange rate between two currencies that equates the real buying power of both currencies ECONOMIC GROWTH • Economic Growth − Growth Rate or Real GDP: Shows the extent to which the total output of the economy is increasing − Growth Rate or Real GDP per Capita: Shows the extent to which the economic well-being of the average person is increasing − Paul Romer • Productivity − Labor Productivity: output per unit of labor (average product of labor) − Capital Productivity: output per unit of capital (average product of capital) − Total Factor Productivity (TFP): output per unit of combined labor and capital input − The growth rate of TFP is approximately the growth rate of real output minus the growth rate of combine factor inputs • Per Capita Production Function: Shows the relationship between Real GDP per Capita and the capital stock per capita Q/L (Real GDP) K/C • Neoclassical Growth Model (Solow, 1950s): explains economic growth by virtue of capital accumulation, population growth, and unexplained technical progress − Endogenous Growth Theory/Neo-Schumpeterian (Romer): Base explanation of technological progress on the desire for profit − Innovations may be product innovations or process innovations − Current innovations make future innovations easier • Factors Generating Economic Growth − Human Knowledge − Saving and Investing − Political Stability − Government Consumption − International Trade AGGREGATE DEMAND AND AGGREGATE SUPPLY • SR Production Function: Shows the output produced with a given amount of employment when capital and technology are fixed − Real wages are money wages divided by the Price level, W/P • Natural Level of Output (Real GDP): That level corresponding to equality in the Demand and Supply of Labor • Natural Rate of Unemployment: The rate at which the labor force is in balance; number of jobs available = number of job seekers • Aggregate Supply (AS) − AS curve shows the amount of Real GDP Firms in the economy are prepared to supply at different Price levels • Aggregate Demand (AD) − AD Curve shows the Real GDP that households, businesses, government, and foreigners are prepared to buy at different prices − Three major factors cause AD to be negatively sloped: The real balance effect, that interest rate, and the foreign trade effect • Real Balance Effect :Occurs when desired consumption falls as increases in the price level reduce the purchasing power of money • Interest Rate Effect: Occurs when increases in the price level push up interest rates in credit markets, which lowers real investment • Foreign Trade Effect : Occurs when a rise in the Domestic Price level lowers the Aggregate Quantity Demanded by pushing down net exports (X – M) • Classical Model: an increase in prices should have no effect on the real output supplied in an economy if Prices, wages, and other costs are all rising at the same rate when wages and prices are flexible, AS is vertical at the natural level of output Price AS level RGDP • Keynesian Model: When wages are sticky (inflexible), falling prices raise real wages and firms reduce their employment and output. AS, therefore, has a positive slope Price level AS Wages Inflexible Prices Flexible RGDP EXAM 4 STUDY GUIDE MONEY − Money: Functions of Money • Medium of exchange • Unit of value • Standard of deferred payment • Store of value − Types of money • Commodity money: whose value as a commodity is as great as its value as money • Fiat money: government created money whose value or cost as a commodity is much less than its value as money − M1: Currency, demand deposits at commercial banks held by nonbanking public, travelers’ checks and other checkable deposits − M2: M1 plus savings and small time deposits, money-market mutual fund shares and other highly liquid assets − Bond Prices and Interest Rate: Because bonds promise a fixed payment in the future, the lower the current price of bonds, the higher is the interest rate yielded − Liquidity: The ease and speed with which an asset can be converted into a medium of exchange without risk of loss − Liquidity Preference (LP): shows the demand for money as the nominal interest rate changes, ceteris paribus − The nominal interest rate is the opportunity cost of holding money − Nominal Interest Rate = Real Interest Rate + Inflation Rate − Money demand is inversely related with nominal interest rate − Value of money (“valuable” means low prices): 1/P − ** Equation of Exchange: MV = PQ • M = Money Supply (M1, M2) • V = Velocity of circulation (how many times, dollar bill changes hands) • P = P level (CPI, GDP Deflator) • Q = RGDP − Money and Prices: The Classical Theory • The classical theory assumes that V is fixed • If (A) M increases while Q stays the same, M and P grow at the same rate • If (B) M and Q both increase, the rate of inflation equals the growth rate of M minus the growth rate of Q • BANKING − Commercial Banks: Backs that have been chartered either by a state agency or by the U.S. Treasury’s Comptroller of currency to make loans and receive deposits − Balance Sheet: Summarizes the current financial position of a firm by comparing the firm’s assets and liabilities − Assets: Anything of value that is owned − Liabilities: Anything owed to other economic agents − Net Worth: Assets – Liabilities − Reserves: Are the funds that the bank uses to satisfy cash demands of its customers − Federal Reserve System • Functions of the FED (Federal Reserve) • 1 Controls the nation’s money supply • 2 Responsible for the orderly working of the nation’s banking system. Supervises private banks, serves as bankers’ bank, clears checks, fills currency needs of private banks and acts as a lender of last resort to banks needing to borrow reserves • Reserve Requirements: Rules that state the amount of reserves that a bank must keep on hand to back bank deposits − Banks can create money when • Demand deposits are used as money • Banks make loans out of excess reserves − Multiple Expansion Deposits of money supply occurs when an increase in reserves causes an expansion of the money supply that is greater than the serve increase • One bank can lend out only its excess reserves. However, the banking system as a whole can lend out a multiple of excess reserves • Real world expansion of money supply is limited due to cash leakages and excess reserves − Banking Regulation • Restrictions on interest payments on deposits • Deposit Insurance: FDIC • Restrictions on permissible activities • Capital requirements • Inspection and control of riskiness • Entry restrictions − **Monetary Base: Sum of reserves on deposits at the FED, all vault cash and the currency in circulation • Smaller than the Money supply • INFLATION − Basic Facts • No inflationary trend before 1930s • Persistent inflationary trend since 1930s • Inflation since the Great Depression has been variable • Money and prices are positively associated (MV = PQ) • Inflation and interest rates are positively associated − Demand side inflation: occurs when AD increases and pills prices up. At a macro level demand-side inflation is associated with rising output and falling unemployment − Supply side inflation: occurs when AS decreases and pushes prices up. Supply side inflation is associated with falling output and rising unemployment − To individual firms, moderate demand-side inflation look like supply side inflation. To determine whether inflation is demand side or supply side, we must know the source of rising prices − MV = PQ • Money = Money Supply • V = Velocity of circulation • P = Price level • Q = Output or RGDP − The rapid growth of MS, well in excess of the growth of Real output, has cause most economists to conclude that sustained inflation is a monetary phenomenon − Inflation and Interest Rates • Normal Interest Rates = Real Interest Rate + Inflation Rate • Changes in nominal interest rates are primarily determined by changes in inflationary expectations − Because future inflation is more important than current inflation in the lending-borrowing context • Short-term interest rates are less affected by inflationary expectations because the lending period is short • Long term interest rates are significantly affected by inflationary expectations − Inflation Expectations • Adaptive Expectations are expectations that we form from past experience and modify only gradually as experience unfolds • Rational Expectations are expectations that we form by using all available information, relying on past experience But Also on the effects of present and future policy actions • 1974 Robert Lucas − Monetary Growth and Interest Rates • Effect on interest rates of a one-shot increase in the MS • SR vs. LR effects • An increase in the MS can initially lower interest rates, but the resulting increase in prices and output pushes interest rates back up in the LR • Effect on interest rates of a continuous increase in the MS • In the LR an increase in the monetary growth raises the nominal interest rate but not the real interest rate − Ratification of Supply side inflation results when the government increase the MS to prevent adverse supply side shocks from rising unemployment • AD is shifted to counter the effects of AS shifts to leave output and unemployment unchanged, but at higher prices − The Wage/Price Spiral occurs when higher prices push wages higher and then higher wages push prices higher, or vice versa. This spiral is sustained by the monetary authorities ratifying the resulting supply-side inflation by increasing the MS − Inflation causes us to engage in economically unproductive activities – investment in precious metals − Inflation reduces gains on long term investment capital − Reduces economic growth − Inflation causes price system distortions • UNEMPLOYMENT − Unemployment Under Classical Model • Labor Market EQ is determined at the intersection of Labor Demand and Labor Supply curves • At the EQ real wage, there will be Frictional Unemployment • Frictional Unemployment: The unemployment associated with the changing of jobs − Unemployment Under Keynesian Model • Implicit Contract: an agreement between employer and employees concerning conditions of pay, employment and unemployment that is unwritten but understood by both parties − Implicit contracts explain how wages can remain steady during periods of high unemployment • Structural Unemployment: Results from the LR decrease of certain industries in response to rising costs, changes in consumer preferences or technical change • Cyclical Unemployment: unemployment associated with general downturns in economy − Note that there will still be frictional unemployment in the Keynesian model − Phillips Curve • Keynesian Model • Phillips Curve: When wages and prices are not flexible, we would expect a negative relation between unemployment and inflation − New Phillips Curve • SR Philips Curve: has a negative relation between inflation and unemployment. When inflationary expectations are constant • New Phillips Curve: There is a different SR Phillips Curve for different expected inflation rates • An increase inflationary expectations causes the SR Phillips curve to shift up • Recall that inflationary expectations can either be from adaptive expectations or rational expectations − Stagflation • Stagflation: the combination of high unemployment and high inflation • Origins of Stagflation: − Full employment policies: pursuit of full employment goals during a period of adverse supply shocks sets off a W/P Spiral [Ratification of supply side inflation] • Unemployment compensation • MONETARY POLICY − Federal Reserve Policy • Open Market Sales and Purchases − Open market purchases increase the monetary base; open market sales lower the monetary base • Open market operations are flexible because they can be transacted quickly and in almost any desired amount • Open market operations are powerful because they have a magnified impact on the MS as banks create new money from new reserves • Monetary base: Vault Cash + Currency in Circulation + Deposits at the FED • Increase in reserve requirements reduce the MS; reductions in reserve requirements increase the MS. This is seldom used for monetary policy • Setting the Discount Rate: Interest rate charged to banks by the FED • Federal Funds Rate: Interest rate on overnight loans among financial institutions • Other instruments of control − Moral suasions: persuade banks to voluntari ly follow policy − Selective credit controls: consume credit card restrictions • Margin credit: Restrictions on borrowing against stock − Monetary Policy: The deliberate control of the MS and, in some cases, credit conditions for the purposes of achieving macroeconomic goal such as a certain level of unemployment or inflation − FED controls money and credit by: • Controlling the monetary base thru open market operations • Adjusting reserve requirements • Setting the discount rate • Targeting the federal funds rate • Applying moral persuasion • Imposing selective credit controls − Effectiveness of Monetary Policy • Problems of monetary control − The FED does not have direct control over MS, it can only control the monetary base − The MS itself will depend upon the reserve/deposit ratio that banks hold, which depends partly on the reserve requirements imposed by the FED as well as on the excess reserves desired by banks, and the public’s desired currency/deposit ratio − *Monetarism: Prescribes that MS must expand at a constant rate roughly equal to the LR growth of RGDP. In other words, monetarists recommend a constant money growth rule


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