Final Exam Study Guide
Final Exam Study Guide Eco2013
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This 18 page Study Guide was uploaded by Karina Oms on Tuesday December 8, 2015. The Study Guide belongs to Eco2013 at Florida State University taught by Calhoun in Summer 2015. Since its upload, it has received 55 views. For similar materials see Macroeconomics in Business at Florida State University.
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Date Created: 12/08/15
ECO2013 Macroeconomics Final Exam Study Guide 1. The Economic Way of Thinking There are Always Trade Offs o What you give up is your opportunity cost (The value of the nest best alternative) o Opportunity cost is NOT the sum of everything you give up, just the next best thing Individuals choose purposefully o This is referred to as economizing behavior or national behavior (try to get the most benefits for the least cost of effort) Incentives matter o As the incentive goes up, you will be more likely to do something o Incentive does not have to be money Think on the margin, not in total or on average o Marginal means additional o Marginal cost is additional cost, marginal revenue is additional revenue o Continue to engage in an activity as long as the expected marginal benefit is greater than the expected marginal cost o Benefit>cost More information leads to better decision-making, but more information is costly to get o There are always trade offs o Individuals choose purposefully o Incentives matter o Think on the margin Many choices create a secondary effect o The primary effect is often immediate and visible o The secondary effect usually comes later and is not as visible Value is subjective o Beauty is in the eyes of the beholder o Value is determined by the purchaser Economic thinking is scientific thinking o Economists use data and information generated by people to explain and predict actions o It is a science 2. Pitfalls to avoid in Economic Thinking Violation of ceteris paribus o Ceteris paribus-other things constant o Want to isolate variables so we typically allow for only one change at a time Good intentions do not necessarily result in good outcomes Association is not causation o Ex: Doing superstitious sports activity will have no effect on the actual game Fallacy of composition o Assuming what’s good for the individual is good for the group o Making the assumption when it’s false is the fallacy 3. What Shall We Give up Opportunity cost-value of the next best alternative Ex: you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can't spend the money on something else 4. Trade Creates value Two opposing views of trade: o When people trade, one person gains and one person loses (referred to as a zero-sum game) o When people trade, both parties gain Wealth is created by trade Voluntary trade creates wealth and promotes economic progress o Voluntary trade is expected to benefit both parties involved, otherwise it wouldn’t occur Potential trades: o Barter- exchange without money, goods for goods o Money-exchange goods for money 5. The Importance of Property Rights Two kinds of property rights o Common rights: everybody owns it o Private rights: only one person owns it U.S. Constitution Amendment IV o The right that protects people against unreasonable search and seizures which states that there needs to be probable cause to issue a warrant that describes in detail the thing being searched Incentives created by property rights o Give proper care, take are of what you own o Conserve for the future o Use resources in ways other people value o Mitigate possible harm to others If you own something you receive 100% of the benefit and cost of owning it If you don’t own something you receive less benefit and cost from it 6. Trade, Output and Living Standards Law of comparative advantage o Make something you’re good at and trade for something you’re not good at The law of comparative advantage creates: o Low opportunity cost o Comparative advantage o Specialization o Division of labor o Voluntary trade o Increased wealth Adam Smith wrote about this in the Wealth of Nations Self-sufficiency is the quickest and most absolute path to poverty 7. Changes In Demand Versus Change In Quantity Demanded When price changes, quantity demanded changes o This is a movement along a demand curve When something else changes, demand changes o This is a movement of the entire curve o Typical ‘something else’ changes: Income Number of consumers Prices of related goods (substitutes and compliments) Expectations Demographics Tastes and preferences Why is the consumer buying more or less of something? o If price is the reason= quantity demanded changes (movement along the demand curve) o If anything besides price is the reason=demand changes (shift the demand curve) 8. Changes In Supply Versus Change in Quantity Supplied When price changes, quantity supplied changes o This is a movement along a supply curve When something else changes, supply changes o This is a movement of the entire curve o Typical ‘something else’ changes Resource prices (labor costs, paychecks, etc.) Technology (better technology, more supply) Nature Political Taxes Why is the firm producing more or less of something? o If price is the reason=quantity supplied changes (movement along the supply curve) o If anything besides price changes=supply changes (shift the supply curve) 9. How Market Prices are Determined: Demand and Supply Interact Excess supply (surplus) and excess demand (shortage) are not unique points Equilibrium is a unique point because there’s only one point of equilibrium 10. How Market Prices respond to Changes in Demand and Supply This is called supply and demand analysis Three-step procedure: o Identity the change o Determine if supply or demand is affected and how o Reason through the change Invisible Hand Principle o Adam Smith- An Inquiry into the Nature and Cause of the Wealth of Nations o Personal self interest directed by market prices is a powerful force promoting economic progress o When you focus on yourself but it consequentially helps others in the process 11. Similarities and Differences between Political and Market Allocation Public choice o Using the tools of economics to understand the political process is called public choice analysis o Public choice decides where to allocate resources Economics of voting o Rational ignorance effect: a rational individual has little or no incentive to acquire information needed to cast an informed vote A person doesn’t care to become informed o Marginal benefit of voting: the chance that your vote was the deciding vote multiplied by how much you care that a certain candidate wins Chance your vote was the deciding vote (x) how much you care the candidate wins Knowing your vote makes little difference The cost of informing yourself, registering to vote, and actually voting o Median voter theory: a vote-maximizing politician in a two party system will be close to the middle do that there is little difference between the candidates Gravitate towards median so third party systems do not exist Congregate around the median because that’s where you get the most votes As a result of this, there are not usually wide swings in policy Far right and far left rarely get elected into office 12. When the Political Process Works Poorly Political Process works poorly when: o Voters receive benefits in disproportion to the costs they incur o Disproportion of who benefits and who pays o As a result, unproductive projects will be passed and productive projects may not Causes of inefficiency (government failure): o Special interest effect Small group get substantial benefits by generating minimal costs to a larger group Small group benefits from larger group How its done: Logrolling: trading votes by a politician to get the necessary support to pass legislation o If you vote for me, ill vote for you Pork-barrel legislation: spending projects benefitting local areas financed through the federal government o Things added by committee members after law was already passed o Shortsightedness Effect Politicians will favor programs that generate current visible benefits, even if long-term costs of the project outweigh the benefits o Rent-Seeking Actions taken by individuals and groups in order to use the political process to take the wealth of others People spend time trying to gain political favors instead of producing Use political process to take money from others o Lack of profit Motive Unlike private firms, the public sector lacks the incentive to produce efficiently 13. Political Favoritism, Crony Capitalism and Government Failure Market entrepreneurs get ahead by providing consumers with products that are more highly valued that the resources required for their production o Product more valued than resources used to make it Crony capitalists get ahead by providing political players with campaign contributions and other political resources in exchange for government contracts, subsidies, tax benefits, and other forms of political favoritism o Give political players money in exchange for political favoritism 14. GDP- A Measure of Output GDP: the market value of final goods and services produced within a country during a specific time period One of the primary indicators used to gauge the health of a country's economy The total dollar value of all goods and services produced over a specific time period The size of the economy The sum of purchases GDP= C+I+G+X o C = consumption (what you buy) o I = investment (businesses buying final goods and services to use in their production of another good AND consumers buying houses) o G = government purchases o X = net exports (exports-imports) 15. Adjusting for Price Changes and Deriving Real GDP Nominal (money) GDP=current years data only Real GDP= adjusted for inflation o Ex: Avatar is the current highest grossing movie of all time but when you adjust Titanic’s earnings for inflation, they are higher than Avatar’s Two indexes used to adjust nominal data to real data: o CPI: consumer price index Sample of goods bought by households ‘market basket’ Small sample of goods o GDP deflator: accounts for almost all goods bought Broader measure of GDP More time consuming to calculate but more accurate o Inflation: the percentage change in an index End value-beginning value/beginning value 16. Swings in the Economic Pendulum Average annual rate is 3% There are four phases in the business cycle: o Expansion o Peak o Contraction o Recessionary The business cycle varies and is unpredictable 17. Three Types of Unemployment Two categories: o Under the age of 16 and institutionalized (in prison) o Over the age of 16 Not in the labor force (students, retirees, disabled) In the labor force Employed Unemployed, but want to be employed Unemployed: person not currently employed but is actively seeking a job or is waiting to begin or return to a job Three reasons why people are unemployed: Frictional: imperfect information o Employer and employees don’t know Structural: workers don’t possess desired skills Cyclical: result of business cycle 18. Employment Fluctuations- The Historical Record Some unemployment is unavoidable and desirable Natural rate of unemployment: “normal” frictional and structural unemployment There is naturally always unemployment The natural rate occurs when the economy is operating at a sustainable rate (3%) Full employment is when the natural rate of unemployment exists (3% growth) Natural rate is about 5% Full employment is about 95% 19. The Effects of Inflation Inflation is a persistent increase in the general level of prices Why is inflation bad? o It reduces investment Long term projects become more risky o It distorts information delivered by prices Relative prices are skewed because some prices adjust more quickly than others o It results in less productive use of resources People will spend more time trying to combat the effects of inflation rather than engaging in productive activity Key Points: o The business cycle varies and is unpredictable o Potential GDP= average annual growth rate = 3% o Natural rate of unemployment= 5% o Natural rate of unemployment means cyclical unemployment=0, frictional and structural unemployment remain o When actual GDP> potential GDP, unemployment fails, upward pressure on prices o When actual GDP<potential GDP, unemployment rises, downward pressure on prices o Jobs are important, but the production from those jobs is more important More production first, higher incomes result 20. Equilibrium in the Goods and Services Market When the economy is in long run equilibrium: o Actual GDP=potential GDP o Actual unemployment rate=natural rate of unemployment o SRAS, LRAS and AD are equal When the economy is in an expansionary phase: o Actual GDP> potential GDP o Actual unemployment rate < natural rate of unemployment o Short run equilibrium is greater than average and greater than long run equilibrium When the economy is un recessionary phase: o Actual GDP< potential GDP o Actual unemployment rate >natural rate of unemployment o Short-run equilibrium is less than average, and less than long-run equilibrium 21. Loanable Funds Market The loanable funds market is the coordination between borrowers and lenders o Borrowers demand funds o Lenders supply funds o The interest rate is the price: Borrowers pay a price to receive money now Lenders receive a price to wait Interest rates: o Money interest rate = nominal interest rate o Real interest rate = money rate- inflation o The money (or nominal) interest rate is the only rate you can put in writing o The real interest rate will change, depending on inflation 22. Foreign Exchange Market Dollar price of foreign currency = how many dollars you must give up to get foreign currency Dollar price= money/foreign currency Foreign exchange terms: o The dollar appreciates when you need fewer dollars to receive the same amount of foreign currency or (equivalently) when you can buy more foreign goods with the same $1 Americans import more, export less Dollar is strong or strengthening o The dollar depreciates when you need more dollars to receive the same amount of foreign currency or (equivalently) when you can buy less foreign goods with the same $1 Americans import less, export more The dollar is weak or weakening A trade deficit (imports > exports) requires an inflow of capital (foreigners purchasing US assets > Americans purchasing foreign assets) A trade surplus (exports> imports) allows for an outflow of capital (Americans purchasing foreign assets > foreigners purchasing US assets) If exports < imports (deficit), then outflow < inflow If exports > imports (surplus), then outlaw > inflow o Import=inflow o Export=outflow 23. Unanticipated Changes and Market Adjustments What if AD increases? o Firms will increase production Move along SRAS Firms produce more to satisfy customers, actual output > potential output Need more labor so, actual unemployment < natural rate (less unemployment) o Resources prices will begin to rise o Interest rates will rise as demand for loanable funds increases Producers/consumers want loans o Foreigners will purchase more US assets, the dollar with appreciate o SRAS will begin to fall (shift left) and consumers will buy less (move along AD curve) People buy less, resource prices increase o The economy will return to long run equilibrium What if AD decreases? o Firms will decrease production Move along SRAS Firms will produce less, actual output < potential output Need less labor so, actual unemployment> natural rate (more unemployment) o Recourses prices will begin to fall o Interest rates will fall as demand for loanable funds decreases Don’t borrow as much because people are buying less o Foreigners will purchase fewer US assets, the dollar will depreciate Because U.S. business are doing poorly o SRAS will begin to rise (shift right) and consumers will buy more (move along AD curve) Because things become cheaper o The economy will return to long run equilibrium If AD increases, SRAS will eventually decrease If AD decreases, SRAS will eventually increase A change in AD is temporary and will quickly move back to its original position so SRAS doesn’t need to change If SRAS surprisingly changes: o If change is temporary: SRAS will shift back, no change in LRAS o If change is permanent: SRAS will shift and stay, LRAS will also shift Key points: o The US economy is large and complex o ‘real’ changes such as exchange rates, resource prices and interest rates are important o Cause and effect relationships are difficult to identify Ceteris paribus is difficult to use 24. Unanticipated Changes, Recessions and Booms Will the economy move from disequilibrium point back to long-run equilibrium on its own? o Yes o The four key markets are tightly connected o A change in one market will cause a reaction in another market Two key components: o Interest rate changes are key incentives Higher interest rates cause less consumption and investment Lower interest rates cause more consumption and investment o Resource price changes redirect production Higher resource prices in one market will lower production there and increase production somewhere else Lower resource prices in one market will raise production there and decrease production somewhere else 25. The Great Depression and the Macroadjustment Process John M. Keynes o Ideology: Resource prices and interest rates are not very flexible so they wont direct an economy to equilibrium Changes in output will direct an economy to equilibrium The solution to a weak economy: o Increase government power o If C (consumption), I (investments) and X (net exports) are stagnant or declining, increase G (government) What is the multiplier and how does it work? o Give $ to students so they go out and spend it in order to stimulate the economy What are some problems associated with the multiplier? o Students can save the $ or pay off debts with the $ given to them instead The multiplier: o Works with an increase in C,I,G or X o Is more potent when: Unemployment is unusually high There is an increase in C,I or X o Is less potent when: Unemployment is closer to natural rate There in an increase in G (government) 26. The Keynesian View of Fiscal Policy What is fiscal policy? o Fiscal policy is the tools (usually government spending and taxes) used by Congress and the President to alter economic activity (pass laws and bills) 27. Fiscal Policy, Borrowing, and the Crowding-Out Effect Basic components of crowding out: o Y= C+I+G+X o If government spends more, G rises o Then, businesses, consumers, and foreigners spend less, C, I and X fall First Secondary Effect o When the government spends more, it either needs to borrow more or raise taxes to fund that spending o If the government borrows more, the demand for loanable funds increases, which increases interest rates o If the government raises taxes consumers and businesses have less income which causes C and I to fall Second Secondary Effect o If the government borrows more, the demand for loanable funds increases which increases interest rates o Higher interest rates will attract foreign investment which will cause the dollar to appreciate because the demand for the dollar will increase o When the dollar appreciates, US exports fall and imports rise (buy more, sell less) 28. Political Incentives and the Effective Use of Discretionary Fiscal Policy Fiscal policy is less effective than when Keynes first prescribed it 29. The Supply-Side Effects of Fiscal Policy Fiscal policy can change AS too 30. U.S. Fiscal Policy: 1990-2013 On January 1, 2009, the national debt was $10.7 trillion Today its over $17 trillion The debt is divided into two categories: o Privately held (about 60%) About one-half is owned by foreigners o Publicly held (about 40%) 31. The Business of Banking Explanation of fractional reserve banking: o A bank receives checking and savings deposits from one group of customers o It uses those funds in two ways: To pay checks and withdrawals from those same customers To loan out to another group of customers o As a safety device, banks are required to keep a portion of their deposits as reserves- either vault cash or deposits at the federal reserve bank This is in case more than the expected number of customers want their money withdrawn Hence the name fractional reserve banking- banks can only lend a portion of their deposits, not all of them Typical assets and liabilities of banks o Assets Vault cash Reserves at the Fed Loans to customers Bonds o Liabilities Checking deposits Savings deposits Borrowings 32. How Banks Create Money by Extending Loans Commercial banks are required to keep a portion of their deposits as reserves at the Federal Reserve Bank or as cash in the vault o These are requires reserves o Equal to 10% of deposits called the required reserve ratio o Required reserve ratio=10% Commercial banks may keep or loan out additional reserves o These are excess reserves o Excess reserves earn interest from the Federal Reserve Bank, so the commercial bank must decide where it’s earning the biggest return (either by loaning them out or by keeping them with the fed) The potential deposit expansion multiplier= 1/required reserve ratio o Example: 1/0.10=10 So $1 could create $10 in new deposits But the actual deposit expansion multiplier could be less o If one or more banks lend less than all of their excess reserves the multiplier is less o If one bank doesn’t lend any, the whole process stops and the multiplier is less 33. The Federal Reserve System Four tools of the Fed to control the money supply: o Reserve requirements 10% o Open market operations Buying and selling bonds o Extend loans Bank goes to Fed and extends loan from the Fed o Interest paid on excess and required reserves Bank gets small interest on excess (can touch) and required (cant touch) reserves New policy Expansionary monetary policy o To give the economy a boost Buy securities (bonds, treasury bonds) Extend more loans Reduce the interest rate paid on reserves Restrictive monetary policy Sell securities Extend fewer loans Increase the interest rate paid on reserves Open market operations is the key tool the Fed uses o Open market operations is the buying and selling of bonds, usually US treasury securities How do open market operations affect the discount rate and federal funds rate? o The Fed is referred to as the “lender of last resort” o If a bank needs money to meet its required reserve ratio, it goes to the federal funds market first Borrow from other banks at the federal funds interest rate o If you cant borrow there, then go to the Fed and pay the discount rate When the Fed buys and sells securities, it shifts supply in the federal funds market o Buy securities- shift supply right o Sell securities- shift supply left Quantitative Easing (QE) o The Fed buying certain kinds of bonds to lower interest rates 34. How Does Monetary Policy Affect the Economy When the Fed increases the money supply: o Interest rates fall o Consumption and investment increase o The dollar will depreciate, causing exports to rise, imports to fall and net exports to rise When the Fed decreases the money supply: o Interest rates rise o Consumption and investment decrease o The dollar will appreciate causing exports to fall, imports to rise and net exports to fall What if AD increases? o Firms will increase production Move along SRAS Firms produce more to satisfy customers, actual output > potential output Need more labor so, actual unemployment < natural rate (less unemployment) o Resources prices will begin to rise o Interest rates will rise as demand for loanable funds increases Producers/consumers want loans o Foreigners will purchase more US assets, the dollar with appreciate o SRAS will begin to fall (shift left) and consumers will buy less (move along AD curve) People buy less, resource prices increase o The economy will return to long run equilibrium What if AD decreases? o Firms will decrease production Move along SRAS Firms will produce less, actual output < potential output Need less labor so, actual unemployment> natural rate (more unemployment) o Recourses prices will begin to fall o Interest rates will fall as demand for loanable funds decreases Don’t borrow as much because people are buying less o Foreigners will purchase fewer US assets, the dollar will depreciate Because U.S. business are doing poorly o SRAS will begin to rise (shift right) and consumers will buy more (move along AD curve) Because things become cheaper o The economy will return to long run equilibrium 35. Monetary Policy in the Long Run If your income doubled and the price level doubled, would anything really change? o The Quantity Theory of Money is used to support the hypothesis that a rapid increase in the money supply causes inflation Equation of exchange: MC=PY o M= money supply o V= velocity, how quickly $1 passes through the economy o P=price level o Y=GDP=output o MV=total spending o PY=total receipts In the short run, Y (output) and V (velocity) are assumed to be constant or change slowly Therefore, an increase in M (money supply) causes an increase in P (price level) The long run effects: o Increase in money supply leads to an increase in aggregate demand leads to an increase in resource prices leads to a decrease in SRAS 36. Sources of Economic Growth and High Incomes Four key sources of growth: o Gains from trade Value is created through voluntary trade Each country should make the good/service for when they have a low opportunity cost (comparative advantage) o Entrepreneurship and technology New way of doing things leads to the destruction of the old way o Investment in physical and human capital Physical capital=machines, equipment, buildings Human capital= knowledge and skills o Institutions Institutions=rules of the game or the policies and regulations that govern behavior Institutions can be both official laws or social norms 37. What Institutions and Policies Will Promote Growth? Secure property rights and political stability Competitive markets Stable money and prices Minimal regulation Relatively low marginal tax rates Trade openness 38. Institutions, Policies and Economic Performance Economic freedom: o Personal choice o Market based voluntary exchange Supply/demand o Competitive entry into markets Entrepreneurs, individuals, businesses o Private property Established private property laws The governments policies and involvement in the economy are important, but too much government intervention can harm growth The more free the economy is, the higher the growth rate will be When an economy is more free the country will achieve: o A higher growth rate o A more equal distribution of income o Better environmental quality o Better health outcomes o Higher standards of living 39. Gains From Specialization and Trade Comparative vs. Absolute advantage o Comparative advantage: doing one thing, giving up something else (opportunity costs) o Absolute advantage: who can produce more (bigger, stronger, faster producer) Rules: o Make and trade away the good for which you have a comparative advantage o Trade for the good for which you don’t have a comparative advantage You have a comparative advantage if you have a lower opportunity cost than someone else 40. Supply, Demand, and International Trade Who is helped/ harmed? o With exports: US consumers pay a higher world price Foreign consumers buy more products US producers receive a higher world price US producers sell more products o With imports: US consumers pay a lower world price Foreign producers sell more products US producers receive a lower world price US producers sell fewer products o With exports and imports: The benefits outweigh the costs, a net gain exists 41. Trade Barriers and Popular Trade fallacies o A country cannot simultaneously reduce imports and increase exports for an extended period of time o Our imports give purchasing power to foreigners o They, in turn, purchase our exports o If we limited imports, we would limit the income of foreigners and they wouldn’t be able to buy as many of our exports o Free trade is harmful to come Americans but is helpful to America o More people are helped by free trade than are hurt by free trade America experiences a net gain
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