Principles of Macroeconomics
Principles of Macroeconomics ECON 1202
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Economics review Monday December 13 2010 222 PM Economics the social science that studies the choices that individuals businesses governments and societies make as they cope with scarcity and the incentives that influence and reconcile those choices Microeconomics the study of choices that individuals and businesses make the way that these choices interact in markets and the influence of governments Macroeconomics is the study of the performance of the national economy and the global economy Factors of production Land rent Labor wages Capital interest Entrepreneurship profit Self interest choices made in best interest of individual Social interest choices made in best interest of society Big Tradeoff the tradeoff between equality and efficiency that occurs as a result of government programs redistributing income Positive statement can be true or false Normative statement opinions Marginal Bene t benefit that arises from an increase in an activity Marginal Cost cost of an increase in activity What people choose how to spend their incomes How businesses choose among alternative production technologies For Whom arise when choices change the distribution of buying power across individuals Production Possibilities Frontier PPF boundary between those combinations of goods and services that can be produced and those that cannot inside ppf attainable outside are not attainable Any point on the PPF curve production ef ciency Opportunity cost the highest valued alternative foregone decrease in production of one good divided by the increase of the increase in production in the other Allocative ef ciency reached when goods and services are produced at the lowest possible cost and in the quantities that provide the greatest benefit MB MC Marginal Cost opportunity cost of producing one more unit of it Economic Growth occurs when production expands Influenced by technological change and capital accumulation Shifts PPF outward Comparative Advantage ability to produce at a lower opportunity cost Absolute Advantage can produce more goods in a given amount of time Gains in trade Firm economic unit that hires factors of production and organizes those factors to produce and sell goods and services Market any arrangement that allows buyers and sellers to do business with each other Markets pool information into a price which signals buyers and sellers about the actions they should take Property rights are social arrangements that govern the ownership use and disposal of anything people value Law of Demand the higher the price the lower the quantity demanded Change in quantity demanded movement along the demand curve Change in demand shift in the demand curve Factors that influence demand Substitute Coke higher price and pepsi demand increases Complement hotdogsrise in price and buns demand decreases Expected future prices expected to rise demand increases Income if income rises Normal good demand increases filet mignon Inferior good demand decreases ramen Expected future income and credit if these increase demand increases Population increase increase in demand Preferences if people like a good more it39s demand increases Law of supply the higher the price of a good the greater is the quantity supplied Change in quantity supplied movement along supply curve Change in supply shift in the supply curve Factors that influence supply Prices of factors of production rise in this decrease in supply Prices of related goods Substitute Coke higher price Pepsi supply decreases Complement hotdogs rise in price buns supply increases Expected future prices if expected price goes up supply decreases Number of suppliers More suppliers higher supply Technology increase in technology higher supply State of nature Natural disasters can cause supply to decrease Equilibrium price price where quantity demanded quantity supplied Neither shortage nor surplus Equilibrium quantity quantity bought and sold at equilibrium price If quantity supplied gt quantity demanded there is a surplus Surplus forces prices down If quantity supplied lt quantity demanded there is a shortage Shortage forces price up Demand increases EP rises EQ increases Demand decreases EP falls EQ decreases Supply increases EP falls EQ increases Supply decreases EP rises EQ decreases SD increases EP EQincreases SD decreases EP EQ decreases Decrease in demand Increase in supply EP EQ decreases Increase in demand Decrease in supply EP EQincreases Gross Domestic Product GDP market value of all final goods and services produced in a country in a given time period Final good item bough by its final user Intermediate good item produced by one firm bought by another firm and used as a component of a final good or service these are excluded in GDP to avoid double counting Factor markets households sell firms pay for income wages interest receive profit Goods market firms sell households buy consumer goods and services Consumption expenditure total payment for consumer goods and services Investment purchase of new equipment buildings addition to inventories Government Expenditure government buys goods and services from firms Expenditure is financed by taxes These are not part of the circular flow Exports goods and services sold to the rest of the world Imports goods and services bought from the rest of the world Net exports X M value of exports minus imports If this is negative flow is from rest of world to US firms If this is positive flow is from US firms to rest of world Depreciation decrease in the value of a firms capital that results from wear and tear on obsolescence Gross investment total amount spent on purchases of new capital and on replacing depreciated capital Net investment is the increase in the value of the firms capital Net investment Gross investment Depreciation Expenditure approach GDP C G XM or sum of consumption expenditure investment government quot on gs and net exports Income approach GDP W R Profit Real GDP value of final goods and services produced in a given year when valued at the prices of a reference base yea r ex year 2000 To find Real GDP multiply quantity of new year 2009 times price of base year 2000 Nominal GDP the value of goods and services produced during a given year valued at the prices that prevailed in that same year Real GDP per person real GDP Population Potential GDP value of real GDP when all the economy39s labor land capital and entrepreneurial ability are fully employed Lucas Wedge dollar value of the accumulated gap between what real GDP per person would have been if the 196039s growth rate had persisted Business cycle periodic but irregular up and down movement of total production and other measures of economic activity Expansions real GDP increases Recessions real GDP degreases growth is negative for at least 2 quarters Labor force sum of employed and unemployed workers Population 1 Working age population number of people 16 who are not in jail hospital etc a People in the labor force b People not in the labor force 2 People too young to work lt16 or in institutional care Unemployed 1 No job but has made an effort to find a job this month 2 Waiting to be called back from a job that he or she has been laid off from 3 Waiting to start a job within 30 days Unemployment rate percentage labor force unemployed Number of people unemployed Labor force x 100 Labor force participation rate percentage of workingage population who are members of labor force Labor force Working age population x 100 Frictional arises from normal labor market turnover Structural created by changes in technology and foreign competition Cyclical fluctuating unemployment over the business cycle Natural unemployment rate no cyclical unemployment full employment all unemployment is frictional and structural Price level average level of prices and the value of money Inflation rate annual percentage change in price level Hyperinflation workers are paid twice a day because money loses value so quickly Consumer Price Index CPI Measures the average of the prices paid by urban consumers for a fixed basket of consumer goods and services 100 is the reference base If CPI is currently 220 CPI is 120 higher Calculating CPI Find the cost of the CPI basket at baseperiod prices 2 Find the cost of the CPI basket at currentperiod prices 3 Calculate the CPI for the current period CPI cost of basket at current prices cost of basket at base prices x 100 Ex Base prices 50 Current Prices 70 CP 70S50 x 100 14000 or 40 higher Inflation rate CPI this year CPI last year CPI Last year x 100 CPI may overstate true inflation due to biases Core in ation rate CPI inflation rate excluding volatile elements food and fuel Economic growth rate annual percentage change of real GDP Rule of 70 number of years it takes for the level of a vriable to double is 70annual percentage growth rate of the variable Ex 1 7 doubles in 10 years 2 2 doubles in 35 years 3 1 doubles in 70 years Growth trends 1 US and rich countries are similar 2 US and poor countries gap widens Aggregate production function tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same Increase in labor increase in GDP Real wage rate money wage rate price level Potential GDP Growth Growth in Supply of Labor aggregate hours increasing Growth in Labor productivity quantity of real GDP produced by an hour of labor Y depends on L K T Quantity of real GDP produced quantity of labor quantity of capital and the state of technology Growth accounting calculates the contribution of capital growth and technological change to labor productivity growth 13 rule on average with no change in technology a 1 percent increase in capital per hour of labor brings a 13 increase in labor productivity Ex if capital per hour of labor increases by 3 percent and labor productivity grows by 25 capital growth 13 3 1 This means that 15 comes from technological change Growth theories Classical growth theory view that growth of GDP per person is temporary and when it rises above the 39 39 level a 39 39 explosion quot brings the real GDP per person back to subsistence level Subsistence real wage rate minimum real wage rate needed to maintain life Neoclassical growth theory real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow New Growth theory real GDP per person grows because of choices that people make in the pursuit of profit and that growth can persist indefinitely Finance looks at how households and firms obtain and use financial resources and how they cope with the risks that arise in this activity Money looks at how households and firms use it how much they hold how banks create and manage it and how its quantity influences the economy Wealth value of all things that people own Saving amount of income that is not paid in taxes or spent on consumption Savings increases weath Savings funds can be supplied and demanded by Loan markets Bond Market and Stock Markets Physical Capital tools instruments machines buildings and other items that have been produced in the past and that are used today to produce goods and services Financial Capital funds that firms use to buy physical capital Investment Gross total amount spent on purchases of new capital and on replacing depreciated capital Net change in quantity of capital Gross investment Depreciation Depreciation the decrease in the quantity of capital that results from wear and tear on obsolescence Financial institution A firm that operates on both sides of the market borrower and lender Ex banks insurance companies mortgage lenders Net worth total market value of what it has lent minus the market value of what it has borrowed Solvent positive net worth Insolvent negative net worth Market for loanable funds aggregate of all the individual financial markets Funds 1 Household saving S 2 Government budget surplus TG 3 Borrowing from the rest of the world MX Nominal interest rate number of dollars that a borrower pays and a lender receives in interest a year expressed as a percentage of the number of dollars borrowed and lent Ex Interest paid on 500 loan 25 Nominal interest rate 25S500 5year Real interest rate nominal interest rate adjusted to remove the effects of inflation on the buying power of money It is the opportunity cost of borrowing nominal interest rate inflation rate Ex Nominal interest rate 5year Inflation rate 2year Real interest rate 52 3year Market for loanable funds market in which households firms governments financial institutions borrow and lend demand Demand for loanable funds relationship between quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same Real interest rate Expected profit Supply Supply of loanable funds the relationship between the quantity of loanable funds supplied and the real interest rate Saving makes up supply of loanable funds 2 3 4 5 Real interest rate Disposable income Expected future income Wealth Default risk Equilibrium Funds supplied funds demanded Government in the market for loanable funds Surplus increases supply increases investment decreases saving lowers interest rate Deficit increases demand quotcrowds outquotdecreases investment increase saving raises real interest rate Borrowers net exports are negative Lenders net exports are positive Money any commodity or token that is generally acceptable as a means of payment Means of payment method of settling debt Medium of exchange object that is generally accepted in exchange for goodsservices Unit of account agreed measure for stating the prices of goods and services Store of value money can be held for a time and later exchanged for goods and services Currency notes and coins held by households and firms M1 currency and traveler39s checks and checking deposits owned by individuals and businesses M2 M1 plus time savings deposits money market mutual funds and other deposits Liquidity property of being able to instantly convert to means of payment with little loss of value Depository institution a firm that takes deposits from households and firms and makes loans to other households and firms Advantages Create liquidity pool risk lower cost of borrowing and lower the cost of monitoring borrowers Commercial bank private firm licensed by Comptroller of Currency or state agency to receive deposits and make loans Thrift institutions Savings and loan associations savings banks credit unions Money market mutual funds fund operated by a financial institution that sells shares in the fund and holds asses such as US treasury bills Federal Reserve System central bank of the US they aim to keep inflation in check maintain full employment moderate the business cycle contribute toward achieving longterm growth Central bank public authority that regulates a nations depository institutions and control the quantity of money Federal funds rate interest rate that banks charge each other on overnight loans of reserves Federal Open Market Committee FOMC the main policymaking group in the Federal reserve system board of governers president of fed bank of NY 11 presidents of other fed banks Required reserve ratios minimum percentages of deposits that Dl39s must hold as reserves Lender of last resort the fed stands ready to lend reserves to depository institutions that are short Open market operation purchase or sale of government securities us treasury bills and bonds by the feds in the open market Currency drain ratio ratio of currency to deposits How Banks create money 1 Banks have excess reserves Banks lend excess reserves The quantity of money increases New money is used to make payments Some of the new money remains on deposit Some of the new money is a currency drain Desired reserves increase because deposits have increased Excess reserves decrease but remain positive Money multiplier ratio of change in the quantity of money to the change in the monetary base Ex 100000 gt 350000 multiplier is 25 Quantity theory of money in the long run an increase in the quantity of money brings an equal percentage increase in price level Velocity of circulation average number of times in a year a dollar is used to purchase goods and services in GDP MV PY V velocity of circulation P price level Y Real GDP M quantity of money Money growth rate rate of velocity change Inflation rate Real GDP growth Foreign currency foreign bank notes coins and bank deposits Foreign exchange market market in which the currency of one country is exchanged for the currency of another Appreciation fall in the value relative to the other Depreciation rise in the value relative to the other Nominal exchange rate value of the US dollar expressed in units of foreign currency per US dollar Real exchange rate relative price of foreign produced goods and services Measures quantity of real GDP Tradeweighted index average exchange rate of the US dollar against other currencies weighted by their importance in US international trade Quantity Demanded Dependencies 1 Exchange rate 2 World demand for US exports 3 Interest rates in the US and other countries 4 Expected future exchange rate As exchange rate rises quantity of US dollars demanded falls As exchange rate falls quantity of US dollars demanded rises Quantity Supplied Dependencies 1 Exchange rate 2 World demand for US imports 3 Interest rates in the US and other countries 4 Expected future exchange rate As exchange rate rises quantity of US dollars demanded rises As exchange rate falls quantity of US dollars demanded falls Interest rate parity equal interest rates Purchasing power parity equal value of money Long run RER E x PP Real exchange rate nominal exchange rate x US Price levelJapanese price level Short run RER E x PIP Real exchange rate nominal exchange rate x JAP Price level US price level Balance of payments accounts records its countries international trading borrowing and lending Current account exports imports net interest net transfers Capital account records foreign investment in the US minus US investment abroad Official settlements account records change in US reserves US reserves gov holdings of foreign currency increase OSA is negative Debtor borrows more than it lends Creditor invested more than others have invested in it CAB NX Net interest income Net Transfers current account balance net exports net interest income net transfers NXTGS net exports net taxes government expenditure saving investment Flexible permits exchange rate to be determined by DS with no intervention Fixed pegs exchange rate at a value decided by the gov and blocks forces of demand and supply by direct intervention in the FEM Crawling peg policy that selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path Long run Aggregate supply LAS relationship between quantity of real GDP supplied and price level when real GDP potential GDP vertical at potential GDP Short run aggregate supply SAS relation ship between quantity of real GDP supplied and price level when all things remain constant Upward sloping Aggregate demand AD relationship between the quantity of real GDP demanded and price level Y C H G XM goods and services in US 39 I quot 39 government expenditure net exports Equilibrium Short Run when quantity of real GDP demanded quantity of real GDP supplied where AD intersects SAS Long Run when real GDP potential GDPwhere LAS intersects AD Inflationary gap real GDP gt potential GDP Recessionary gap real GDP lt potential GDP Schools of thought Classical economy is selfregulating always at full employment New classical business cycle fluctuations are responses of technological change Keynesian if left alone the economy would not operate at full employment fiscalmonetary policy is required New Keynesian money wage rate prices of goods are sticky Monetarist economy is self regulating if policy is not erratic Disposable income YD Y T disposable income real GDP net taxes YD C S spend on consumption savings Multiplier amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP Multiplier 1 1 slope of AE curve Demandpull inflation that starts because aggregate demand increases Costpush inflation that starts with an increase in costs Stagflation combination of rising price level and decreasing real GDP Phillips curve shows the relationship between inflation rate and unemployment rate Short runSRPC downward sloping curve expected inflation rate and natural unemployment rate constant Long runLRPC vertical at natural unemployment rate actual inflation rate expected inflation rate Federal budget annual statement of federal governments outlays and tax revenues Supply side effect the effects fiscal policy has on employment potential GDP and aggregate supply Fiscal imbalance present value of the governments commitments to pay benefits minus the present value of its revenues Generational imbalance the division of fiscal imbalance between the current and future generations assuming that the current generation will enjoy the existing levels of taxes and benefits I only did this for a free TShirt