Koofers

Final Exam Flash Cards - Flashcards

Flashcard Deck Information

Class:ECO 2013 - PRIN OF MACROECON
Subject:ECONOMICS
University:Florida State University
Term:Spring 2010
- of -
INCORRECT CORRECT
- INCORRECT     - CORRECT     - SKIPPED
Shuffle Remaining Cards Show Definitions First Take Quiz (NEW)
Hide Keyboard shortcuts
Next card
Previous card
Mark correct
Mark incorrect
Flip card
Start Over
Shuffle
      Mode:   CARDS LIST       ? pages   PRINT EXIT
How are poverty and scarcity different? Scarcity is wanting more than is available. Poverty is not meeting a “basic level”. Scarcity cannot be eliminated. Poverty Can.
Rationing mechanism in a market economy: How are goods rationed in “modern” market economies? Why is this a superior method? Price is used to ration goods. This is superior because (as opposed to first come, first served) goods are allocated to those willing to give up “other things” to get them. People have incentive to pay required price.
Eight Guideposts to Economic Thinking: Have a clear understanding of what is meant by these 8 ideas. 1) Something must be given up to make/obtain something else. 2) People will “economize” (choose purposefully with least possible cost). 3) Incentives matter (as benefits change so do values of a good). 4) Focus on marginal changes. 5) Uncertainty is a fact of life (info is scarce). 6) Economic events often generate secondary effects. 7) Value of a good is subjective. 8) Test of an economic theory is ability to predict and explain events in real world.
Positive versus Normative Economic Thinking Positive thinking can be proven either true or false. Normative is what ought to be.
Generated by Koofers.com
Pitfalls to Avoid in Economic Thinking: Ceteris Paribus, Good Intentions versus Good Outcomes, Fallacy of Composition (what is true for an individual is also true for the group), and Association is Not Causation (Statistics alone cannot establish causation)
6. Opportunity Costs: Define. Accounting versus economic costs; how are they different? Opportunity Cost is the highest valued alternative that must be given up to get something else. Accounting costs focus just on #s while Economic costs measure opportunity cost.
How Trade Creates Value: Be able to give an example; ex: Ticket Scalping What is not worth much to someone may be worth a lot more to someone else.
Transactions Costs: What are they, and how do they affect the potential gains from trade? Time, effort and other resources to (search, negotiate and make exchange). They reduce ability to produce gains from trade.
Generated by Koofers.com
Middlemen, Stockbrokers, Realtors, and Mutual Fund Managers: Do these professionals increase or decrease the gains from trade? How/Why? They reduce transaction costs which thereby increases gains from trade. (Think about having to search forever to find someone selling the shoes you want)
Opportunity Cost – Application: How opportunity cost should be considered when evaluating travel options. If I take a plane it will sot more money, but I could spend more time with my family then if I was in the car the whole time.
Comparative Advantage – Specialization – Division of Labor Application “What should we produce? Who should produce it? For whom should it be produced?” Be able to (a) identify which party has comparative advantage in a similar example, and (b) whether or not output could be expanded with division of labor and specialization. If so, what should be the price for the goods traded? Be able to calculate from a table. A party should produce a good that incurs the least opportunity cost and trade for goods which incur high opportunity costs to produce. Specialization makes workers do only what they are best at, and they can get better faster. To calculate: Given Up/Being produced=cost per unit of good being produced 4 bananas/2 apples = 2 bananas per each apple produced Opportunity cost of an apple is 2 bananas
Property Rights : What are they? How do property rights create incentives? The right to use, control, and obtain benefits from a resource, good or service. You have incentive to take care of things you own. Incentive to conserve for the future. Owners can use their property to gain when others need it.
Generated by Koofers.com
Production Possibilities Model What combinations of x, y are “efficient”? Inefficient? Impossible? How does an economy expand its future possible output? What role does saving play in b, above? On the line are efficient. Inside line inefficient. Outside the line impossible unless economy is expanded. Can be done by increasing the resource base, advances in technology, improvement in (laws, policies…), by working harder. If you give up consuming something now, investment can create greater output in the future.
Market Organatiization: What are the two types of “modern” market organizations? How are they different from the standpoint of market organizon? Capitalism - a method that allows for unregulated prices and decentralized decisions of private property owners to resolve basic economic problems (capitalism). Socialism – economic system based on government ownership of property and control of economic decisions. Communism – economic system based on societal ownership. Society controls for whom and what to produce for best interest of society as a whole.
Explain the Law of Demand. Explain the difference between Quantity Demanded and Demand. Inverse relationship between price and quantity consumers are willing to pay. QD is Price and movement along curve. Demand is everything else and shift of curve.
What is meant by “consumer surplus”/producer surplus? Where are these areas on the model? Consumer surplus is what they would have paid versus what they paid.
Generated by Koofers.com
What factors shift the Demand Curve? Changes in consumer income-number of consumers-price of RELATED good-expectations-Demographic changes-changes in consumer preference.
Explain the Law of Supply. Explain the difference between Quantity Supplied and Supply. Positive relationship between price and amount of good supplied. QS is price and moves along curve, Supply is everything else and complete shift in curve.
What does the term “elastic demand” mean? “Inelastic demand”? What factors determine elasticity of demand? How does an inelastic curve appear on the model? An elastic curve? Elasticity of demand is change in QD when price is changed. If it changes a lot it is elastic and visa-versa. The steeper the curve the less elastic.
What does the term “elastic supply” mean? “inelastic supply”? What factors determine elasticity of supply? How does an inelastic curve appear on the model? An elastic curve? Elasticity of supply is sentitivity of QS when price changes. If price leads to large change in QS then it is elastic and visa-versa. The steeper the curve, the less elastic.
Generated by Koofers.com
What factors shift the Supply Curve? Changes in resource prices- Technology – Taxes- and Elements of nature and political disruption
What constitutes market equilibrium? Is the market “efficient” at equilibrium? Why or why not Market equilibrium is where QD and QS meet. Market is efficient at equilibrium because there is no excess supply or demand.
How market prices are determined? Price is determined where QS = QD and its relation to #of goods at a particular price.
If a market is in an initial equilibrium, what will be the effect of an Increase in Demand/Supply on equilibrium price and quantity? What will be the effect of a Decrease in Demand/Supply on equilibrium price and quantity? Increase in supply will make quantity increase and price decrease. Increase in demand will make quantity increae and price increase. Decrease in supply will make quantity decrease and price increase. Decrease in demand will make quantity decrease and price decrease.
Generated by Koofers.com
a. How is market price affected by an Excess Demand? b. How is market price affected by an Excess Supply? Upward Pressure on Price Downward Pressure on Price
What is the definition of Gross Domestic Product? What is included in/excluded from GDP? Market value of final goods and services produced in a country during a time period. Only transactions involving production (in geographic borders, during current period) are included. Financial Transactions and Income transfers are EXCLUDED
Two Ways of Measuring GDP: Know the components and be able to calculate if given a set of data Expenditure Approach – totaling expenditures on final-user goods/services during period Components => Personal consumption Purchases + gross private investment (including inventories) + government purchases (consumption and investment) + net exports (exports minus imports) Resource Cost-Income Approach – summing income payments to the resource suppliers and indirect cost of producing goods/services. Components => Aggregate income (employee compensation + Income of self-emplyed + rents + profits + interest) + Non-income cost items (indirect business taxes + depreciation) + Net income of foreigners purchases (consumption and investment) + net exports (exports minus imports)
a. What does the term Nominal represent from an economic perspective? Real? Real means adjusted for inflation.
Generated by Koofers.com
b. What is a “price index”? What is the purpose of a price index? What are the two price indexes that economists use? Which one is used to measure how all prices in the economy have changed (the broadest measure)? Which one is used to compare changes in the cost of the “typical” consumer basket of goods and services? Price index are used to adjust income and output data for inflation. Measures cost of purchasing a bundle of goods a a point in time relative to cost of purchasing the same basket in an earlier year. Consumer Price Index (CPI) measures impact of price changes on cost of typical bundle purchased by households. GDP Deflator measures change in avg. price of bundle included in GDP (is broader than CPI).
c. Know how to convert nominal GDP to real GDP. GDP Deflator Method: Real GDP2 = Nominal GDP2 X (GDP Deflator1/GDP Deflator2)
d. What does the term “inflation” mean? What is the formula for calculating inflation? How would you “inflate” an earlier value to a current value? Inflation is increase in general level of prices. Inflation rate = ((Current price index-previous price index)/Previous price index) all X 100 To inflate to current $ = Early $ Figure X (Current price index/Early price index)
What are some of the shortcomings of GDP as a measure of current output and income? Does not count non-market production – Doesn’t count underground economy – makes no adjustment for leisure – Probably understates output increases b/c of the problem of estimating improvements in quality of products – Doesn’t adjust for harmful side effects.
Generated by Koofers.com
Economic Freedom: What are the elements of economic freedom? Why are they important to growth? Voluntary exchange, market allocation, freedom to compete, protection of people and their property from aggressors. They create gains from trade, entrepreneurial discovery and investment.
2. Economic Freedom of the World Index: Understand in general terms what this is, and its significance in explaining differences in standards of living worldwide. Measures consistency of nations institutions and policies with economic freedom. A country must provide protection of privately owned property, provide evenhanded enforcement of conrtacts, provide stable monetary environment, keep taxes low, refrain from barriers to trade, rely on markets to allocate goods not government.
What explains the early adoption of institutions and systems that fostered long-term economic growth among countries like the U. S., Canada, Australia, New Zealand? Contrast this with the early history of countries like the Belgian Congo. Countries with the most freedom grew the most. US Canada Australia nad New Zealond were established by colonial settlers who planned on staying developed institutions and policies that protected individual property rights and limited power of government. Countries that were established by colonizers with short-term interest did the opposite.
4. Legal Systems: Why are sound legal systems crucial to economic growth? A legal system has to be firm in protecting property rights an enforcing contracts fairly because this results in gains from exchange, entrepreneurial discovery, and investment.
Generated by Koofers.com
Do democracy and economic freedom necessarily go hand in hand? Why/why not? No, China has been the world’s fastest growing economy since 1980.
Business Cycles: What exactly are business cycles? How do they differ from long-run growth? Business cycles are expansions, peaks, contrations and recessionary troughs.
Phases of the Business Cycle: There are four phases. What are they and what are the conditions in the economy with respect to output and employment during these phases? Business cycles are expansions, peaks, contrations and recessionary troughs.
a. Civilian Labor Force Civilians (16 or older) who are either employed or unemployed
Generated by Koofers.com
b. Employed Person who is working for pay at least 1 hour per week, self employed, working 15 hours or more without pay in a family-operated enterprise
c. Unemployed – Unemployment Rate Actively seeking a job, waiting to bein a job, on layoff waiting to return to previous job. Rate of Unemployment = # unemployed/# in labor force
d. Labor Force Participation Rate # in labor force/Civilian Polulation (16+)
5. Types of Unemployment: What is the difference between structural, frictional, and cyclical unemployment? Frictional: employers are not aware of workers (and qualifications) and workers are not aware of jobs offered. Structural: Imperfect match of employee skills to skill requirements of available jobs. Reflects structural and demographic characteristics of the labor market. Cyclical: Business cycle conditions (when there is a downturn in business activity, cyclicacal unemployment rises
Generated by Koofers.com
6. Unemployment and the Economy: What is the difference between Actual and Potential GDP? When the economy is performing at its potential, what type of unemployment will be experienced? What is meant by “full employment”? Potential GDP is maximum sustainable output level compared to economy’s resource base. Actual and Potential GDP will be equal when economy is at full employment. At potential, unemployment will be “natural rate of unemployment” Full employment is level of employment that results when rate of unemployment is normal.
If the economy is coming out of a recession/boom will the unemployment rate be above or below the “natural” rate? During a recession unemployment rises above natural rate. During a boom unemployment falls below natural rate.
7. Which of the two will have more of an adverse effect on the economy; Anticipated or Unanticipated Inflation? Why? What’s the difference? Unanticipated inflation alters outcomes of long-term projects. People will respond to variable rates of inflation by spending less time producing and more time trying to protect their wealth.
8. Causes of Inflation: What are the two primary causes of inflation? Rapid growth of money supply making each dollar’s purchasing power decrease.
Generated by Koofers.com
Unemployment Duration: Which type of unemployment is generally longer in duration; Frictional or Structural? Structural
Fiscal and Monetary Policy: What are Fiscal Policy and Monetary policy, and by whom are they administered? Monetary Policy is the process a government, central bank, or other authority uses to control supply of money, availability of money, interest rate needed to attain a set of objectives oriented towards growth and stability of the economy. The Federal Reserve System administers this. Fiscal Policy is the use of government expenditure and taxation to influence the economy. These changes can impact Aggregate demand, pattern of resource allocation and distribution of income. This is administered by the government.
What are the four key macroeconomic markets? How is “price” expressed in each one? Resource market coordinates actions of business demanding resources and household supplying them in exchange for income. Goods/Services Market coordinates demand for and supply of GDP. (Businesses supply goods and services in exchange for revenue. Households, investors, governments and (net exports) demand goods. Foreign Exchange bring the purchases from foreigners into balance with sales. (imports with (exports + net inflow of capital)). Loanable Funds brings net household saving and net inflow of foreign capital into balance with borrowing of businesses and governments.
What are the three sources of “leakage” in the flow of income through the economy (which explain why income and expenditure do not truly equalize)? Savings, Taxes, and Imports. People make money and instead of spending it, it leaks and doesn’t go back into the economy.
Generated by Koofers.com
a. Aggregate Demand Curve: What does the Aggregate Demand Curve represent? Why is it downward-sloping? Represents sum of all demand curves in one. Downward sloping to indicate inverse relationship between goods/services demanded and price level.
b. Short Run Aggregate Supply Curve: What does the Short-Run Aggregate Supply Curve represent? Why is it upward sloping? Represents all supply curves in one. Slopes upward to the right to show an increase in price level corresponds to expansion in output by firms.
What does the Long-Run (LRAS) Aggregate Supply Curve Represent? What is the fundamental difference between SRAS and LRAS? Why is the LRAS curve perfectly vertical? Can it ever change position? What would cause this to happen? Represents relationship between price level and quantity of output after sufficient time to adjust prior commitments. A higher price level does not loosen the constraints imposed by economy’s resource base, level of technology, and efficiency of its institutional arrangements => So an increase in price level will not lead to a sustainable expansion in output thus a vertical LRAS curve.
SRAS/AD and LRAS Equilibrium: Be able to describe the economy at this state, in terms of output, unemployment, and the price level. If all three are in equilibrium, does the actual level of inflation agree with the level that has been anticipated? How could we tell from this model if current price levels were unanticipated? Short Run: SRAS and AD intersect. Aggregate QD = Aggregate QS Long Run: Potential GDP = Maximum sustainable output in relation to its resource base, current technology, and institutional structure. Full employment (Actual rate of unemployment = natural rate of unemployment) when AD, SRAS and LRAS intersect. Unexpected Increase will improve profit margins of firms which would make them expand output and employment in short-run.
Generated by Koofers.com
Effects of Lower Price Levels on Quantity Demanded: What are the three major effects of lower price levels that cause the quantity demanded for all goods and services to rise? Be able to explain why these effects occur. A lower price level will increase wealth of people holding $, lead to lower interest rates (demand for money will be reduced) (stimulating more purchases), and make domestically produced goods cheaper relative to foreign goods. (If price level drops, you can buy more for the same price)
The Interest Rate: What does it represent? What is the difference between the nominal interest rate and the real interest rate? What does the inflation premium tell us about people’s expectations? What happens to inflow/outflow of foreign capital with changes in the real interest rate? Interest rate coordinates actions of borrowers and lenders. Borrower’s interes is cost paif for earlier availability. Lender’s interest is premium received for waiting, for delaying possible expenditures into the future. Real Interest Rate is Money interest rate-Inflationary Premium (reflects expected decline in purchasing power of a dollar) When people expect prices to rise, money interest rate will rise but real interest rate will remain the same. When demand for loanable funds is strong, real interest rates will be high and consequently an inflow of capital.
Foreign Exchange: Understand the factors that will appreciate/depreciate a nation’s currency, and the impact upon exports/imports. Outflow of capital will generate demand for foreign currency in foreign exchange market. When Americans sell products and assets to foreigners, supply of foreign currency will increase. Exchange rate will bring quantity of foreign exchange demanded into equality with quantity supplied.
What factors will shift Aggregate Demand (the entire curve)? Change in real wealth, Change in real interest rate, Increase in optimism/pessimism of businesses and consumers about future economic decisions, change in expected rate of inflation, change in real incomes, change in exchange rate value of nation’s currency.
Generated by Koofers.com
What factors will shift Short-Run Aggregate Supply (the entire curve)? It will help you to work with examples of supply “shocks”; positive and negative. What factors will shift the Long-Run Aggregate Supply curve? Short Run: change in resource prices (hence production costs), change in expected inflation, (un)favorable supply shocks like (bad)good weather or (increase)reduction in world price of a key imported resource. Long Run: Change in supply of resources, change in technology and productivity, institutional changes that change efficiency of resource use.
How the economy adjusts to unanticipated changes in AD or SRAS: When increases/decreases occur in the short-run, how are output, employment, and the price level affected? How does the economy adjust over time? In short-run, output will deviate from full employment as prices deviate from expected price level. Unanticipated increase in AD: 1) strong demand and higher price level will improve profit margins. 2) Output will increase, rate of unemployment will drop below natural rate and output will temporarily exceed economy’s long run potential. 3) With time, contracts will be modified, resource prices will rise and return to their competitive position relative to prices. 4) Output will recede to the long-run potential. Unanticipated increase in SRAS: “Supply Shocks”. SRAS shifts to right; output temporarily exceeds long-run potential. Long-term production capacity will not be altered. If individuals recognize the current high level of income will not remain, they increase saving, lower interest rates, and additional capital may result.
What are the two causes of recessions? What are the two causes of booms? What are the results in terms of changes in output, unemployment, and the price level? Recessions occur because prices in market are low relative to costs of production and resource prices. Caused by unanticipated reductions in AD and unfavorable supply shocks. Real resource prices will fall because demand will be weak and rate of unemployment will be high. Real intreset rates will decline because of weak demand for investment. Price level will remain constant because falling interest rates will increase AD while lower resource prices will increase SRAS keeping everything even. Booms occur when prices are high relative to resource prices. Caused by unanticipated increase in AD and favorable supply shocks.
What are the two forces that direct the economy back to equilibrium following a recession or a boom? Be able to explain how these work. Recession: interest rates will fall increasing AD, resource prices will fall increasing SRAS Boom: interest rates will rise decreasing AD, resource prices will rise decreasing SRAS
Generated by Koofers.com
One of the drawbacks of the AS/AD model is that it cannot predict how quickly the economy will be directed back to equilibrium. Did Keynes believe that the self-correcting mechanism works? Why or why not? What was the fundamental error in his logic? Keynesian economists did not believe falling real interest rates and lower real resource prices would direct economy back to full employment. They believe equilibrium is when spending = current output => if demand is deficient, depressed conditions and high levels of unemployment will persist.
The “multiplier principle”: Relate this to the MPC (Marginal Propensity to Consume) and how the MPC determines the Multiplier. The multiplier principal is the proportion of additional income that households spend on consumption (marginal propensity to consume). 100$ more income leads to 75$ MPC = ¾. Multiplier = 1/(1-MPC)
The multiplier convinced Keynes that the economy is “fragile”. What do contemporary economists believe about the economy’s stability? Relate this to Friedman’s “permanent income hypothesis”. Modern economists believe economy is less fragile then originally perceived. Resource price and interest rate adjustments will keep a modern economy on track.
What is meant by the terms: a. Balanced Budget b. Budget Deficit c. Budget Surplus Balanced budget is when total government spending equals total revenue from all sources. Budget Deficit is when government spending exceeds total revenue from all sources (then borrowing must be done by the US Treasury issuing bonds). Budget Surplus is when total government spending is less than total revenue.
Generated by Koofers.com
What is “discretionary fiscal policy”. Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.
The Great Depression led Keynes to believe that the budget is a “tool” that can be used to achieve economic goals. Explain (and be able to model) Expansionary, Restrictive, Countercyclical Fiscal Policies. Expansionary fiscal policy should be used when economy is operating below its potential output. This includes increasing the government/s purchases of goods and services and/or cutting taxes. Restrictive fiscal policy should be used when inflation is a potential problem. This includes reducing government spending and/or raising taxes. Countercyclical fiscal policies are the idea to plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.
How does the “crowding out effect” reduce the intended impact of the government running budget deficits to stimulate aggregate demand? This is the idea that increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy.
The New Classical View argues that budget deficits in reality, do not stimulate aggregate demand. Explain this in terms of Ricardian Equivalence. This view argues that when debt is substituted for taxes: people save the increased income so they will be able to pay for higher future taxes, therefore budget deficit does not stimulate aggregate demand.
Generated by Koofers.com
Even if fiscal policy could be 100% effective in theory, in reality there are conditions which make this virtually impossible, and in fact likely that the opposite results will be achieved. What are these three conditions, and how could they interfere with achieving the desired economic outcome? This is because there are problems with proper timing. It takes time to institute a legislative change. There is a time lag between it being instituted and when it exerts significant impact. If timed correctly, it can reduce instability however if times incorrectly, it can do the complete opposite.
What are “automatic stabilizers” and how do they work to stabilize the economy? These increase deficit (reduce surplus) during a recession and increase surplus (reduce deficit) during a boom. They institute a coutercylical fiscal policy without delays. Examples are unemployment compensation, corporate profit tax and a progressive income tax.
From a political standpoint, which are more likely to prevail; budget deficits or surpluses? Why? Tax cuts or tax increases? Why? Politicians are reluctant to raise taxes to benefit votes. Therefore there is a bias towards spending and budget deficits
Explain the Modern Synthesis point of view. This is the idea that proper timing of discretionary fiscal policy is crucial, automatic stabilizer reduce fluctuation of AD and all 3 demand-side models are necessary for a comprehensive view of fiscal policy.
Generated by Koofers.com
Definition of money: How is money defined? What is(are) the acceptable form(s) of money? What type of money is used in the U.S. ? Are credit cards money? Definition of money: How is money defined? What is(are) the acceptable form(s) of money? What type of money is used in the U.S. ? Are credit cards money?
Functions of money: What are the three important functions of money? It is a medium of exchange, a store of value, and a unit of measurement.
Monetary Aggregates: Define M1 and M2. Which is the most volatile? Which is the broadest measure of the money supply? How is the supply of money related to the price level? M1 is actual practical money (most volatile): currency, checking deposits, and traveler’s checks. M2 is a broader measure and includes all of M1, savings, time deposits and money market mutual funds.
Fractional Reserve System: What is it? What are required reserves versus excess reserves? Which may a bank lend against? Be able to determine if a bank has sufficient reserves and how much it can lend. The US banking system is this; banks are required to maintain only a fraction of their assets a reserves against the deposits of their customers (required reserves*). Excess reserves (actual reserves in excess of legal requirement) and can be used to extend new loans and make new investments.
Generated by Koofers.com
The lower the percentage of reserve requirement, the greater potential expansion in money supply. The actual deposit multiplier will be less than the potential because some people will not put money in the bank, and some banks may not use all their excess reserves to extend loans. The Fed is the bank for banks and regulates the commercial banking sector; it is responsible for conduct of monetary policy (in control of money supply).
Deposit Multiplier: Be able to explain how the monetary base is different from the money supply, and how the deposit multiplier works between the two; i.e. how banks “create” money The lower the percentage of reserve requirement, the greater potential expansion in money supply. The actual deposit multiplier will be less than the potential because some people will not put money in the bank, and some banks may not use all their excess reserves to extend loans.
Federal Open Market Committee A 12 member board that establishes Fed policy regarding buying and selling of government securities.
District Banks 12 US districts – each district bank monitors commercial banks in their region and assists them with clearing of checks.
Generated by Koofers.com
Board of Governors In D.C. have a 14 year term and they set all rates and regulations for the depository institutions.
The Fed : How does the Fed maintain political independence, and financial independence? Why is this so important to economic stability? Its independence strengthens its ability to pursure long-term monetary policies. They have lengthy terms and the Feds revenues are derived from the interest on the bond that it holds rather than allocations from congress (they need to “perform” well to get paid).
Tools of the Fed: What are the three tools that the Fed can use to control the monetary base? Which is most effective and how does it work? How does this relate to the control of interest rates? Reserve requirements, open market operations (buying and selling of US government securities in open market, Discount rate (setting interest rate which it loans funds to banks and other institutions) (federal funds rate is interest rate that is not set by discount rate so they can manipulate the discount rate to reduce or expand supply of money). Open market operations are primary tool. This is when Fed can reduce fed fund rate by buying bonds or vice versa.
U. S. Treasury: What is its primary role? How does this differ from the role of the Fed? The Treasury is concerned with finance of federal government; they issue bonds to general public to finance budget deficits of federal government and do not determine money supply. The Fed is concerned with monetary climate for the economy, does not issue bonds (just buys and sells them) and they determine money supply.
Generated by Koofers.com
Demand for Money: Why is the Demand curve for money downward sloping? What two factors will shift the entire Demand curve? Why? The QD of money is inversely related to interest rates. Higher interest rates make it more costly to hold money instead of interest earning assets (like bonds).
Supply of Money: How is the Supply of money determined? Explain the shape of the Supply. It is established by the fed and determined independently of the interest rate thus making it vertical. (money interest rate is x (vertical) axis and quantity of money is y (horizontal) axis).
Disruptive Monetary Policy: If the Fed implements expansionary or contractionary monetary policy, the effects depend upon whether the economy is in a recession/boom at the time, or at equilibrium. Explain. This must be timed correctly because it can lead to instability and either cause a recession or inflation.
Short-Run vs. Long-Run Effects of Monetary Policy: Be able to explain how the economy responds in the short-run to expansionary/contractionary policy, and how this differs from the long-run effects. If the economy is already at full employment, then the short-run increase in output will lead to excess demand, and higher product prices. In the long run, a strong demand pushes up resource prices shifting SRAS to the left back to full employment. However, this new equilibrium will make price level rise. If Fed institutes a restrictive monetary policy, if it sells bonds it depresses bond prices, drains reserves from banks, which places upward pressure on real interest rates; therefore reducing AD and decreasing output and employment.
Generated by Koofers.com
Monetary Policy Transmission: If the Fed implements expansionary monetary policy, what actions does it take, and how does this action affect the market for money, loanable funds, and goods and services? Explain the effect on the dollar and exports. Why would expansionary monetary policy cause asset prices to rise? If the fed implements expansionary monetary policy: it usually buys more bonds and expands the money supply. This shifts supply right in money market and provides banks with more reserves. When banks have new reserves, this increases supply of loanable funds (shifting supply right in loanable funds market) which puts downward pressure on real interest rate (real interest rate on x axis and qty of loanable funds on y axis). Lower interest rates increase demand in goods and services market which increases price level. This leads to a short-run increase in output and thus an increase in inflation.
The Quantity Theory of Money: What is the Quantity Theory, and what do the variables in the equation represent? What is the “velocity” of money”? Be able to use the Equation of Exchange to show the price-level effects of a change in the money supply. Money x Velocity = Price x Income
Inflation and Interest Rates: In this chapter, we discovered a contradiction between the idea that an expanding money supply will cause interest rates to fall, and the actual market effect in the longer-run. Why does persistent inflation actually lead to higher, not lower interest rates? When expansionary policy leads to rising prices, decision makers anticipate higher inflation rates. Then, money interest rates, wages and incomes will reflect the expected inflations, making real interest rates, wages, and real output to return to long-run normal levels. Therefore, money supply growth will lead to higher prices (inflation).
Expected Inflation and the Loanable Funds Market: Explain the effect of persistent inflation (from #8, above) on the Demand and Supply of Loanable Funds. If rapid monetary expansion leads to a long-term higher inflation rate (shifting demand to right) (shifting supply to left), borrowers and leers will incorporate the higher rates into their decision making thus, the nominal interest rate will rise.
Generated by Koofers.com
Anticipated Inflation: If inflation is anticipated, can expansionary monetary policy have an effect on output and employment? Why or why not. Much like the long-term, nominal prices and interest rates rise, but real output remains unchanged. If expected (aggregate supply declines), so nominal wages, prices and interest rates rise but their values remain constant, inflation results because price level increases).
Theories or Reality? Do our theories about the effect of the money supply on price levels and interest rates match “real world” data? Is there evidence to support them? Yes
Economic instability; the last 100 years: What explains economic instability prior to 1950; after 1950? Economic instability; the last 100 years: What explains economic instability prior to 1950; after 1950?
Activist versus Non-Activist Views: Explain the difference in their views, and the basis of these differences. Activists believe policy makers can respond to changing economic conditions and insititute policy that will promote stability. Non-activists argue that discretionary use of monetary and fiscal policy in response to changing economic conditions is more likely to do harm than good.
Generated by Koofers.com
Index of Leading Indicators: In general, what is this, and what is the significance to forecasting business cycles? This is a composite statistic based on 10 key variables that generally turn down before a recession and turn up before an expansion.
Rational Expectations versus Adaptive Expectations: What is the difference in these two methods of formulating expectations? What do they both say about sustained expansionary policies? Adaptive expectations is when individuals from their expectations about the future based on data from recent past. Rational expectations is assuming people use all information, including data on current policy to weigh expectations about the future. Adaptive: when expansionary policy leads to inflation, there will be a significant time lag before people come to expect the inflation and incorporate it into their decision making. Rational: when inflation is rising, decision makers will not tend to underestimate future rate of inflation, unlike adaptive.
Stimulus Policies – Outcomes: How are they different under Rational Expectations versus Adaptive Expectations? Adaptive: an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment. Rational: decision makers do not make systematic errors and therefore the impact is unpredictable.
The Phillips Curve: What relationships does it explain? This indicates the relationship between rates of inflation and unemployment. It is not the rate of inflation but the actual rate of inflation relative to the expected rate that will influence both output and employment. When inflation is greater than anticipated, profit margins will improve, output will expand and unemployment will fall below its natural rate. Alternatively, when actual rate of inflation is less than the expected rate, profits will be abnormally low, output will recede, and unemployment will rise above its natural rate. When inflation rate is steady, people will come to anticipate the steady rate accurately. Therefore, profit margins will be normal, output will move toward the economy’s long-run potential, and the actual rate of unemployment will equal its natural rate.
Generated by Koofers.com
The Modern Consensus: What are its four elements regarding stabilization policies? Demand stimulus policies cannot reduce the rate of unemployment below the natural rate. Wide swings in both monetary and fiscal policy should be avoided. Using discretionary fiscal policy as an effective stabilization tool is impractical, particularly in countries like US where substantial checks and balances are present. Monetary policy should focus on price stability.
Recent Performance: How has the U.S. economy performed in recent years with respect to inflation? What explains this? Low and steady inflation rates have lead to low rates of unemployment
Generated by Koofers.com

List View: Terms & Definitions

  Hide All 106 Print
 
Front
Back
 How are poverty and scarcity different? Scarcity is wanting more than is available. Poverty is not meeting a “basic level”.
Scarcity cannot be eliminated. Poverty Can.
 Rationing mechanism in a market economy: How are goods rationed in “modern” market economies? Why is this a superior method? Price is used to ration goods. This is superior because (as opposed to first come, first served) goods are allocated to those willing to give up “other things” to get them. People have incentive to pay required price.
 Eight Guideposts to Economic Thinking: Have a clear understanding of what is meant by these 8 ideas.1) Something must be given up to make/obtain something else. 2) People will “economize” (choose purposefully with least possible cost). 3) Incentives matter (as benefits change so do values of a good). 4) Focus on marginal changes. 5) Uncertainty is a fact of life (info is scarce). 6) Economic events often generate secondary effects. 7) Value of a good is subjective. 8) Test of an economic theory is ability to predict and explain events in real world.
 Positive versus Normative Economic ThinkingPositive thinking can be proven either true or false. Normative is what ought to be.
 Pitfalls to Avoid in Economic Thinking: Ceteris Paribus, Good Intentions versus Good Outcomes, Fallacy of Composition (what is true for an individual is also true for the group), and Association is Not Causation (Statistics alone cannot establish causation)
 6. Opportunity Costs: Define. Accounting versus economic costs; how are they different? Opportunity Cost is the highest valued alternative that must be given up to get something else. Accounting costs focus just on #s while Economic costs measure opportunity cost.
 How Trade Creates Value: Be able to give an example; ex: Ticket ScalpingWhat is not worth much to someone may be worth a lot more to someone else.
 Transactions Costs: What are they, and how do they affect the potential gains from trade?Time, effort and other resources to (search, negotiate and make exchange). They reduce ability to produce gains from trade.
 Middlemen, Stockbrokers, Realtors, and Mutual Fund Managers: Do these professionals increase or decrease the gains from trade? How/Why? They reduce transaction costs which thereby increases gains from trade. (Think about having to search forever to find someone selling the shoes you want)
 Opportunity Cost – Application: How opportunity cost should be considered when evaluating travel options.If I take a plane it will sot more money, but I could spend more time with my family then if I was in the car the whole time.
 Comparative Advantage – Specialization – Division of Labor Application “What should we produce? Who should produce it? For whom should it be produced?” Be able to (a) identify which party has comparative advantage in a similar example, and (b) whether or not output could be expanded with division of labor and specialization. If so, what should be the price for the goods traded? Be able to calculate from a table. A party should produce a good that incurs the least opportunity cost and trade for goods which incur high opportunity costs to produce.
Specialization makes workers do only what they are best at, and they can get better faster.
To calculate: Given Up/Being produced=cost per unit of good being produced
4 bananas/2 apples = 2 bananas per each apple produced
Opportunity cost of an apple is 2 bananas
 Property Rights : What are they? How do property rights create incentives?The right to use, control, and obtain benefits from a resource, good or service. You have incentive to take care of things you own. Incentive to conserve for the future. Owners can use their property to gain when others need it.
 Production Possibilities Model What combinations of x, y are “efficient”? Inefficient? Impossible? How does an economy expand its future possible output? What role does saving play in b, above?On the line are efficient. Inside line inefficient. Outside the line impossible unless economy is expanded.

Can be done by increasing the resource base, advances in technology, improvement in (laws, policies…), by working harder.

If you give up consuming something now, investment can create greater output in the future.
 Market Organatiization: What are the two types of “modern” market organizations? How are they different from the standpoint of market organizon?Capitalism - a method that allows for unregulated prices and decentralized decisions of private property owners to resolve basic economic problems (capitalism).
Socialism – economic system based on government ownership of property and control of economic decisions.
Communism – economic system based on societal ownership. Society controls for whom and what to produce for best interest of society as a whole.
 Explain the Law of Demand. Explain the difference between Quantity Demanded and Demand.Inverse relationship between price and quantity consumers are willing to pay. QD is Price and movement along curve. Demand is everything else and shift of curve.
  What is meant by “consumer surplus”/producer surplus? Where are these areas on the model? Consumer surplus is what they would have paid versus what they paid.
 What factors shift the Demand Curve? Changes in consumer income-number of consumers-price of RELATED good-expectations-Demographic changes-changes in consumer preference.
 Explain the Law of Supply. Explain the difference between Quantity Supplied and Supply.Positive relationship between price and amount of good supplied. QS is price and moves along curve, Supply is everything else and complete shift in curve.
 What does the term “elastic demand” mean? “Inelastic demand”? What factors determine elasticity of demand? How does an inelastic curve appear on the model? An elastic curve?Elasticity of demand is change in QD when price is changed. If it changes a lot it is elastic and visa-versa. The steeper the curve the less elastic.
 What does the term “elastic supply” mean? “inelastic supply”? What factors determine elasticity of supply? How does an inelastic curve appear on the model? An elastic curve?Elasticity of supply is sentitivity of QS when price changes. If price leads to large change in QS then it is elastic and visa-versa. The steeper the curve, the less elastic.
 What factors shift the Supply Curve?Changes in resource prices- Technology – Taxes- and Elements of nature and political disruption
 What constitutes market equilibrium? Is the market “efficient” at equilibrium? Why or why notMarket equilibrium is where QD and QS meet. Market is efficient at equilibrium because there is no excess supply or demand.
 How market prices are determined?Price is determined where QS = QD and its relation to #of goods at a particular price.
 If a market is in an initial equilibrium, what will be the effect of an Increase in Demand/Supply on equilibrium price and quantity? What will be the effect of a Decrease in Demand/Supply on equilibrium price and quantity? Increase in supply will make quantity increase and price decrease.
Increase in demand will make quantity increae and price increase.
Decrease in supply will make quantity decrease and price increase.
Decrease in demand will make quantity decrease and price decrease.
 a. How is market price affected by an Excess Demand? b. How is market price affected by an Excess Supply? Upward Pressure on Price

Downward Pressure on Price
 What is the definition of Gross Domestic Product? What is included in/excluded from GDP?Market value of final goods and services produced in a country during a time period.
Only transactions involving production (in geographic borders, during current period) are included.
Financial Transactions and Income transfers are EXCLUDED
 Two Ways of Measuring GDP: Know the components and be able to calculate if given a set of dataExpenditure Approach – totaling expenditures on final-user goods/services during period
Components => Personal consumption Purchases + gross private investment (including inventories) + government purchases (consumption and investment) + net exports (exports minus imports)
Resource Cost-Income Approach – summing income payments to the resource suppliers and indirect cost of producing goods/services.
Components => Aggregate income (employee compensation + Income of self-emplyed + rents + profits + interest) + Non-income cost items (indirect business taxes + depreciation) + Net income of foreigners
purchases (consumption and investment) + net exports (exports minus imports)

 a. What does the term Nominal represent from an economic perspective? Real?Real means adjusted for inflation.
 b. What is a “price index”? What is the purpose of a price index? What are the two price indexes that economists use? Which one is used to measure how all prices in the economy have changed (the broadest measure)? Which one is used to compare changes in the cost of the “typical” consumer basket of goods and services? Price index are used to adjust income and output data for inflation. Measures cost of purchasing a bundle of goods a a point in time relative to cost of purchasing the same basket in an earlier year.
Consumer Price Index (CPI) measures impact of price changes on cost of typical bundle purchased by households.
GDP Deflator measures change in avg. price of bundle included in GDP (is broader than CPI).
 c. Know how to convert nominal GDP to real GDP. GDP Deflator Method:
Real GDP2 = Nominal GDP2 X (GDP Deflator1/GDP Deflator2)
 d. What does the term “inflation” mean? What is the formula for calculating inflation? How would you “inflate” an earlier value to a current value? Inflation is increase in general level of prices. Inflation rate = ((Current price index-previous price index)/Previous price index) all X 100
To inflate to current $ = Early $ Figure X (Current price index/Early price index)
 What are some of the shortcomings of GDP as a measure of current output and income?Does not count non-market production – Doesn’t count underground economy – makes no adjustment for leisure – Probably understates output increases b/c of the problem of estimating improvements in quality of products – Doesn’t adjust for harmful side effects.
 Economic Freedom: What are the elements of economic freedom? Why are they important to growth?Voluntary exchange, market allocation, freedom to compete, protection of people and their property from aggressors. They create gains from trade, entrepreneurial discovery and investment.
 2. Economic Freedom of the World Index: Understand in general terms what this is, and its significance in explaining differences in standards of living worldwide.Measures consistency of nations institutions and policies with economic freedom. A country must provide protection of privately owned property, provide evenhanded enforcement of conrtacts, provide stable monetary environment, keep taxes low, refrain from barriers to trade, rely on markets to allocate goods not government.
 What explains the early adoption of institutions and systems that fostered long-term economic growth among countries like the U. S., Canada, Australia, New Zealand? Contrast this with the early history of countries like the Belgian Congo. Countries with the most freedom grew the most. US Canada Australia nad New Zealond were established by colonial settlers who planned on staying developed institutions and policies that protected individual property rights and limited power of government.
Countries that were established by colonizers with short-term interest did the opposite.
  4. Legal Systems: Why are sound legal systems crucial to economic growth? A legal system has to be firm in protecting property rights an enforcing contracts fairly because this results in gains from exchange, entrepreneurial discovery, and investment.
 Do democracy and economic freedom necessarily go hand in hand? Why/why not? No, China has been the world’s fastest growing economy since 1980.
 Business Cycles: What exactly are business cycles? How do they differ from long-run growth?Business cycles are expansions, peaks, contrations and recessionary troughs.
 Phases of the Business Cycle: There are four phases. What are they and what are the conditions in the economy with respect to output and employment during these phases?Business cycles are expansions, peaks, contrations and recessionary troughs.
 a. Civilian Labor ForceCivilians (16 or older) who are either employed or unemployed
 b. EmployedPerson who is working for pay at least 1 hour per week, self employed, working 15 hours or more without pay in a family-operated enterprise
 c. Unemployed – Unemployment RateActively seeking a job, waiting to bein a job, on layoff waiting to return to previous job.
Rate of Unemployment = # unemployed/# in labor force
 d. Labor Force Participation Rate # in labor force/Civilian Polulation (16+)
 5. Types of Unemployment: What is the difference between structural, frictional, and cyclical unemployment? Frictional: employers are not aware of workers (and qualifications) and workers are not aware of jobs offered.
Structural: Imperfect match of employee skills to skill requirements of available jobs. Reflects structural and demographic characteristics of the labor market.
Cyclical: Business cycle conditions (when there is a downturn in business activity, cyclicacal unemployment rises
 6. Unemployment and the Economy: What is the difference between Actual and Potential GDP? When the economy is performing at its potential, what type of unemployment will be experienced? What is meant by “full employment”?Potential GDP is maximum sustainable output level compared to economy’s resource base.
Actual and Potential GDP will be equal when economy is at full employment.
At potential, unemployment will be “natural rate of unemployment”
Full employment is level of employment that results when rate of unemployment is normal.
 If the economy is coming out of a recession/boom will the unemployment rate be above or below the “natural” rate? During a recession unemployment rises above natural rate.
During a boom unemployment falls below natural rate.
 7. Which of the two will have more of an adverse effect on the economy; Anticipated or Unanticipated Inflation? Why? What’s the difference?Unanticipated inflation alters outcomes of long-term projects. People will respond to variable rates of inflation by spending less time producing and more time trying to protect their wealth.
 8. Causes of Inflation: What are the two primary causes of inflation?Rapid growth of money supply making each dollar’s purchasing power decrease.
 Unemployment Duration: Which type of unemployment is generally longer in duration; Frictional or Structural? Structural
 Fiscal and Monetary Policy: What are Fiscal Policy and Monetary policy, and by whom are they administered?Monetary Policy is the process a government, central bank, or other authority uses to control supply of money, availability of money, interest rate needed to attain a set of objectives oriented towards growth and stability of the economy. The Federal Reserve System administers this.
Fiscal Policy is the use of government expenditure and taxation to influence the economy. These changes can impact Aggregate demand, pattern of resource allocation and distribution of income. This is administered by the government.
 What are the four key macroeconomic markets? How is “price” expressed in each one?Resource market coordinates actions of business demanding resources and household supplying them in exchange for income.
Goods/Services Market coordinates demand for and supply of GDP. (Businesses supply goods and services in exchange for revenue. Households, investors, governments and (net exports) demand goods.
Foreign Exchange bring the purchases from foreigners into balance with sales. (imports with (exports + net inflow of capital)).
Loanable Funds brings net household saving and net inflow of foreign capital into balance with borrowing of businesses and governments.
 What are the three sources of “leakage” in the flow of income through the economy (which explain why income and expenditure do not truly equalize)?Savings, Taxes, and Imports. People make money and instead of spending it, it leaks and doesn’t go back into the economy.
 a. Aggregate Demand Curve: What does the Aggregate Demand Curve represent? Why is it downward-sloping?Represents sum of all demand curves in one. Downward sloping to indicate inverse relationship between goods/services demanded and price level.
 b. Short Run Aggregate Supply Curve: What does the Short-Run Aggregate Supply Curve represent? Why is it upward sloping? Represents all supply curves in one. Slopes upward to the right to show an increase in price level corresponds to expansion in output by firms.
 What does the Long-Run (LRAS) Aggregate Supply Curve Represent? What is the fundamental difference between SRAS and LRAS? Why is the LRAS curve perfectly vertical? Can it ever change position? What would cause this to happen?Represents relationship between price level and quantity of output after sufficient time to adjust prior commitments. A higher price level does not loosen the constraints imposed by economy’s resource base, level of technology, and efficiency of its institutional arrangements => So an increase in price level will not lead to a sustainable expansion in output thus a vertical LRAS curve.
 SRAS/AD and LRAS Equilibrium: Be able to describe the economy at this state, in terms of output, unemployment, and the price level. If all three are in equilibrium, does the actual level of inflation agree with the level that has been anticipated? How could we tell from this model if current price levels were unanticipated? Short Run: SRAS and AD intersect. Aggregate QD = Aggregate QS
Long Run: Potential GDP = Maximum sustainable output in relation to its resource base, current technology, and institutional structure. Full employment (Actual rate of unemployment = natural rate of unemployment) when AD, SRAS and LRAS intersect.
Unexpected Increase will improve profit margins of firms which would make them expand output and employment in short-run.
 Effects of Lower Price Levels on Quantity Demanded: What are the three major effects of lower price levels that cause the quantity demanded for all goods and services to rise? Be able to explain why these effects occur.A lower price level will increase wealth of people holding $, lead to lower interest rates (demand for money will be reduced) (stimulating more purchases), and make domestically produced goods cheaper relative to foreign goods. (If price level drops, you can buy more for the same price)
 The Interest Rate: What does it represent? What is the difference between the nominal interest rate and the real interest rate? What does the inflation premium tell us about people’s expectations? What happens to inflow/outflow of foreign capital with changes in the real interest rate? Interest rate coordinates actions of borrowers and lenders. Borrower’s interes is cost paif for earlier availability. Lender’s interest is premium received for waiting, for delaying possible expenditures into the future.
Real Interest Rate is Money interest rate-Inflationary Premium (reflects expected decline in purchasing power of a dollar)
When people expect prices to rise, money interest rate will rise but real interest rate will remain the same.
When demand for loanable funds is strong, real interest rates will be high and consequently an inflow of capital.
 Foreign Exchange: Understand the factors that will appreciate/depreciate a nation’s currency, and the impact upon exports/imports.Outflow of capital will generate demand for foreign currency in foreign exchange market.
When Americans sell products and assets to foreigners, supply of foreign currency will increase.
Exchange rate will bring quantity of foreign exchange demanded into equality with quantity supplied.
 What factors will shift Aggregate Demand (the entire curve)? Change in real wealth, Change in real interest rate, Increase in optimism/pessimism of businesses and consumers about future economic decisions, change in expected rate of inflation, change in real incomes, change in exchange rate value of nation’s currency.
 What factors will shift Short-Run Aggregate Supply (the entire curve)? It will help you to work with examples of supply “shocks”; positive and negative. What factors will shift the Long-Run Aggregate Supply curve?Short Run: change in resource prices (hence production costs), change in expected inflation, (un)favorable supply shocks like (bad)good weather or (increase)reduction in world price of a key imported resource.
Long Run: Change in supply of resources, change in technology and productivity, institutional changes that change efficiency of resource use.
 How the economy adjusts to unanticipated changes in AD or SRAS: When increases/decreases occur in the short-run, how are output, employment, and the price level affected? How does the economy adjust over time?In short-run, output will deviate from full employment as prices deviate from expected price level.
Unanticipated increase in AD: 1) strong demand and higher price level will improve profit margins. 2) Output will increase, rate of unemployment will drop below natural rate and output will temporarily exceed economy’s long run potential. 3) With time, contracts will be modified, resource prices will rise and return to their competitive position relative to prices. 4) Output will recede to the long-run potential.
Unanticipated increase in SRAS: “Supply Shocks”. SRAS shifts to right; output temporarily exceeds long-run potential. Long-term production capacity will not be altered. If individuals recognize the current high level of income will not remain, they increase saving, lower interest rates, and additional capital may result.
 What are the two causes of recessions? What are the two causes of booms? What are the results in terms of changes in output, unemployment, and the price level?Recessions occur because prices in market are low relative to costs of production and resource prices. Caused by unanticipated reductions in AD and unfavorable supply shocks. Real resource prices will fall because demand will be weak and rate of unemployment will be high. Real intreset rates will decline because of weak demand for investment. Price level will remain constant because falling interest rates will increase AD while lower resource prices will increase SRAS keeping everything even.
Booms occur when prices are high relative to resource prices. Caused by unanticipated increase in AD and favorable supply shocks.
 What are the two forces that direct the economy back to equilibrium following a recession or a boom? Be able to explain how these work.Recession: interest rates will fall increasing AD, resource prices will fall increasing SRAS
Boom: interest rates will rise decreasing AD, resource prices will rise decreasing SRAS
 One of the drawbacks of the AS/AD model is that it cannot predict how quickly the economy will be directed back to equilibrium. Did Keynes believe that the self-correcting mechanism works? Why or why not? What was the fundamental error in his logic? Keynesian economists did not believe falling real interest rates and lower real resource prices would direct economy back to full employment. They believe equilibrium is when spending = current output => if demand is deficient, depressed conditions and high levels of unemployment will persist.
 The “multiplier principle”: Relate this to the MPC (Marginal Propensity to Consume) and how the MPC determines the Multiplier.The multiplier principal is the proportion of additional income that households spend on consumption (marginal propensity to consume). 100$ more income leads to 75$ MPC = ¾.
Multiplier = 1/(1-MPC)
 The multiplier convinced Keynes that the economy is “fragile”. What do contemporary economists believe about the economy’s stability? Relate this to Friedman’s “permanent income hypothesis”. Modern economists believe economy is less fragile then originally perceived. Resource price and interest rate adjustments will keep a modern economy on track.
 What is meant by the terms: a. Balanced Budget b. Budget Deficit c. Budget SurplusBalanced budget is when total government spending equals total revenue from all sources.
Budget Deficit is when government spending exceeds total revenue from all sources (then borrowing must be done by the US Treasury issuing bonds).
Budget Surplus is when total government spending is less than total revenue.
 What is “discretionary fiscal policy”. Deliberate changes in government spending and/or taxes designed to affect the size of the budget deficit or surplus.
 The Great Depression led Keynes to believe that the budget is a “tool” that can be used to achieve economic goals. Explain (and be able to model) Expansionary, Restrictive, Countercyclical Fiscal Policies.Expansionary fiscal policy should be used when economy is operating below its potential output. This includes increasing the government/s purchases of goods and services and/or cutting taxes.
Restrictive fiscal policy should be used when inflation is a potential problem. This includes reducing government spending and/or raising taxes.
Countercyclical fiscal policies are the idea to plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.
 How does the “crowding out effect” reduce the intended impact of the government running budget deficits to stimulate aggregate demand? This is the idea that increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy.
 The New Classical View argues that budget deficits in reality, do not stimulate aggregate demand. Explain this in terms of Ricardian Equivalence.This view argues that when debt is substituted for taxes: people save the increased income so they will be able to pay for higher future taxes, therefore budget deficit does not stimulate aggregate demand.
 Even if fiscal policy could be 100% effective in theory, in reality there are conditions which make this virtually impossible, and in fact likely that the opposite results will be achieved. What are these three conditions, and how could they interfere with achieving the desired economic outcome?This is because there are problems with proper timing. It takes time to institute a legislative change. There is a time lag between it being instituted and when it exerts significant impact. If timed correctly, it can reduce instability however if times incorrectly, it can do the complete opposite.
 What are “automatic stabilizers” and how do they work to stabilize the economy?These increase deficit (reduce surplus) during a recession and increase surplus (reduce deficit) during a boom. They institute a coutercylical fiscal policy without delays. Examples are unemployment compensation, corporate profit tax and a progressive income tax.
 From a political standpoint, which are more likely to prevail; budget deficits or surpluses? Why? Tax cuts or tax increases? Why? Politicians are reluctant to raise taxes to benefit votes. Therefore there is a bias towards spending and budget deficits
 Explain the Modern Synthesis point of view. This is the idea that proper timing of discretionary fiscal policy is crucial, automatic stabilizer reduce fluctuation of AD and all 3 demand-side models are necessary for a comprehensive view of fiscal policy.
 Definition of money: How is money defined? What is(are) the acceptable form(s) of money? What type of money is used in the U.S. ? Are credit cards money? Definition of money: How is money defined? What is(are) the acceptable form(s) of money? What type of money is used in the U.S. ? Are credit cards money?
 Functions of money: What are the three important functions of money? It is a medium of exchange, a store of value, and a unit of measurement.
 Monetary Aggregates: Define M1 and M2. Which is the most volatile? Which is the broadest measure of the money supply? How is the supply of money related to the price level?M1 is actual practical money (most volatile): currency, checking deposits, and traveler’s checks.
M2 is a broader measure and includes all of M1, savings, time deposits and money market mutual funds.
 Fractional Reserve System: What is it? What are required reserves versus excess reserves? Which may a bank lend against? Be able to determine if a bank has sufficient reserves and how much it can lend. The US banking system is this; banks are required to maintain only a fraction of their assets a reserves against the deposits of their customers (required reserves*). Excess reserves (actual reserves in excess of legal requirement) and can be used to extend new loans and make new investments.
 The lower the percentage of reserve requirement, the greater potential expansion in money supply. The actual deposit multiplier will be less than the potential because some people will not put money in the bank, and some banks may not use all their excess reserves to extend loans.The Fed is the bank for banks and regulates the commercial banking sector; it is responsible for conduct of monetary policy (in control of money supply).
 Deposit Multiplier: Be able to explain how the monetary base is different from the money supply, and how the deposit multiplier works between the two; i.e. how banks “create” moneyThe lower the percentage of reserve requirement, the greater potential expansion in money supply. The actual deposit multiplier will be less than the potential because some people will not put money in the bank, and some banks may not use all their excess reserves to extend loans.
 Federal Open Market CommitteeA 12 member board that establishes Fed policy regarding buying and selling of government securities.
 District Banks12 US districts – each district bank monitors commercial banks in their region and assists them with clearing of checks.
 Board of GovernorsIn D.C. have a 14 year term and they set all rates and regulations for the depository institutions.
 The Fed : How does the Fed maintain political independence, and financial independence? Why is this so important to economic stability?Its independence strengthens its ability to pursure long-term monetary policies. They have lengthy terms and the Feds revenues are derived from the interest on the bond that it holds rather than allocations from congress (they need to “perform” well to get paid).
 Tools of the Fed: What are the three tools that the Fed can use to control the monetary base? Which is most effective and how does it work? How does this relate to the control of interest rates? Reserve requirements, open market operations (buying and selling of US government securities in open market, Discount rate (setting interest rate which it loans funds to banks and other institutions) (federal funds rate is interest rate that is not set by discount rate so they can manipulate the discount rate to reduce or expand supply of money).
Open market operations are primary tool. This is when Fed can reduce fed fund rate by buying bonds or vice versa.
 U. S. Treasury: What is its primary role? How does this differ from the role of the Fed?The Treasury is concerned with finance of federal government; they issue bonds to general public to finance budget deficits of federal government and do not determine money supply.
The Fed is concerned with monetary climate for the economy, does not issue bonds (just buys and sells them) and they determine money supply.
 Demand for Money: Why is the Demand curve for money downward sloping? What two factors will shift the entire Demand curve? Why?The QD of money is inversely related to interest rates. Higher interest rates make it more costly to hold money instead of interest earning assets (like bonds).
 Supply of Money: How is the Supply of money determined? Explain the shape of the Supply. It is established by the fed and determined independently of the interest rate thus making it vertical. (money interest rate is x (vertical) axis and quantity of money is y (horizontal) axis).
 Disruptive Monetary Policy: If the Fed implements expansionary or contractionary monetary policy, the effects depend upon whether the economy is in a recession/boom at the time, or at equilibrium. Explain. This must be timed correctly because it can lead to instability and either cause a recession or inflation.
 Short-Run vs. Long-Run Effects of Monetary Policy: Be able to explain how the economy responds in the short-run to expansionary/contractionary policy, and how this differs from the long-run effects.If the economy is already at full employment, then the short-run increase in output will lead to excess demand, and higher product prices. In the long run, a strong demand pushes up resource prices shifting SRAS to the left back to full employment. However, this new equilibrium will make price level rise.
If Fed institutes a restrictive monetary policy, if it sells bonds it depresses bond prices, drains reserves from banks, which places upward pressure on real interest rates; therefore reducing AD and decreasing output and employment.
 Monetary Policy Transmission: If the Fed implements expansionary monetary policy, what actions does it take, and how does this action affect the market for money, loanable funds, and goods and services? Explain the effect on the dollar and exports. Why would expansionary monetary policy cause asset prices to rise?If the fed implements expansionary monetary policy: it usually buys more bonds and expands the money supply. This shifts supply right in money market and provides banks with more reserves. When banks have new reserves, this increases supply of loanable funds (shifting supply right in loanable funds market) which puts downward pressure on real interest rate (real interest rate on x axis and qty of loanable funds on y axis). Lower interest rates increase demand in goods and services market which increases price level. This leads to a short-run increase in output and thus an increase in inflation.
 The Quantity Theory of Money: What is the Quantity Theory, and what do the variables in the equation represent? What is the “velocity” of money”? Be able to use the Equation of Exchange to show the price-level effects of a change in the money supply.Money x Velocity = Price x Income
 Inflation and Interest Rates: In this chapter, we discovered a contradiction between the idea that an expanding money supply will cause interest rates to fall, and the actual market effect in the longer-run. Why does persistent inflation actually lead to higher, not lower interest rates? When expansionary policy leads to rising prices, decision makers anticipate higher inflation rates. Then, money interest rates, wages and incomes will reflect the expected inflations, making real interest rates, wages, and real output to return to long-run normal levels. Therefore, money supply growth will lead to higher prices (inflation).
 Expected Inflation and the Loanable Funds Market: Explain the effect of persistent inflation (from #8, above) on the Demand and Supply of Loanable Funds. If rapid monetary expansion leads to a long-term higher inflation rate (shifting demand to right) (shifting supply to left), borrowers and leers will incorporate the higher rates into their decision making thus, the nominal interest rate will rise.
 Anticipated Inflation: If inflation is anticipated, can expansionary monetary policy have an effect on output and employment? Why or why not.Much like the long-term, nominal prices and interest rates rise, but real output remains unchanged. If expected (aggregate supply declines), so nominal wages, prices and interest rates rise but their values remain constant, inflation results because price level increases).
 Theories or Reality? Do our theories about the effect of the money supply on price levels and interest rates match “real world” data? Is there evidence to support them?Yes
 Economic instability; the last 100 years: What explains economic instability prior to 1950; after 1950? Economic instability; the last 100 years: What explains economic instability prior to 1950; after 1950?
 Activist versus Non-Activist Views: Explain the difference in their views, and the basis of these differences. Activists believe policy makers can respond to changing economic conditions and insititute policy that will promote stability.
Non-activists argue that discretionary use of monetary and fiscal policy in response to changing economic conditions is more likely to do harm than good.
 Index of Leading Indicators: In general, what is this, and what is the significance to forecasting business cycles? This is a composite statistic based on 10 key variables that generally turn down before a recession and turn up before an expansion.
 Rational Expectations versus Adaptive Expectations: What is the difference in these two methods of formulating expectations? What do they both say about sustained expansionary policies? Adaptive expectations is when individuals from their expectations about the future based on data from recent past.
Rational expectations is assuming people use all information, including data on current policy to weigh expectations about the future.
Adaptive: when expansionary policy leads to inflation, there will be a significant time lag before people come to expect the inflation and incorporate it into their decision making.
Rational: when inflation is rising, decision makers will not tend to underestimate future rate of inflation, unlike adaptive.
 Stimulus Policies – Outcomes: How are they different under Rational Expectations versus Adaptive Expectations?Adaptive: an unanticipated shift to a more expansionary policy will temporarily stimulate output and employment.
Rational: decision makers do not make systematic errors and therefore the impact is unpredictable.
 The Phillips Curve: What relationships does it explain? This indicates the relationship between rates of inflation and unemployment.
It is not the rate of inflation but the actual rate of inflation relative to the expected rate that will influence both output and employment.
When inflation is greater than anticipated, profit margins will improve, output will expand and unemployment will fall below its natural rate.
Alternatively, when actual rate of inflation is less than the expected rate, profits will be abnormally low, output will recede, and unemployment will rise above its natural rate.
When inflation rate is steady, people will come to anticipate the steady rate accurately. Therefore, profit margins will be normal, output will move toward the economy’s long-run potential, and the actual rate of unemployment will equal its natural rate.
 The Modern Consensus: What are its four elements regarding stabilization policies?Demand stimulus policies cannot reduce the rate of unemployment below the natural rate.
Wide swings in both monetary and fiscal policy should be avoided.
Using discretionary fiscal policy as an effective stabilization tool is impractical, particularly in countries like US where substantial checks and balances are present.
Monetary policy should focus on price stability.
 Recent Performance: How has the U.S. economy performed in recent years with respect to inflation? What explains this? Low and steady inflation rates have lead to low rates of unemployment
36, "/var/app/current/tmp/"