REVIEW GUIDE FOR PRINCIPLES OF MACRO ECONOMICS
ECON 2301
Instructor: J.H. Ewing
1. One core challenge of macroeconomics is to understand how fiscal
policies and monetary policies are used to correct inflationary conditions
and deflationary conditions (recessions and/or depressions). Doing so
allows us to correct undesirable phases of the business cycle and aspire to
achieve macroeconomic goals: such as enjoying real growth with low or
no inflation along with low or no unemployment. Thus in studying
macroeconomics we need to address the following:
 What is Inflation? Deflation?
 What is an Inflationary gap? Deflationary gap?
 What are phases in the business cycle? What forces affect the cycle?
 What are the tools of fiscal policy?
 What are the tools of monetary policy?
 How are these applied? When are they applied? Who applies them?
2. Understand what is meant by GDP
 Both Nominal and Real. (Understand the concept of nominal and real
as it applies to wages, interest rates, and prices.)
 Deflators such as the Consumer Price Index
o EXPENDITURE approach to measuring GDP: aggregate spending
(C+I+G+Net X). Aggregate Demand
 INCOME approach to measuring GDP:
 National Income: --factor payments: rent, wages, interest, individual
profit, corporate profit
 Understand each component, such as C…(Consumption), I
(Investment), G (Government Purchases), NX (net exports: exports –
imports)
 Note this distinction: Government Expenditure includes not only
goods and services the government buys, but it includes transfer
payments. Since transfer payments do not buy goods and services,
they are not included in calculating GDP.
 Be sure you know what Transfer Payments are and how they might
affect the income multiplier
 Recognize the importance of S = I; Savings = Investment
(relates to whether we have a leakage or an injection)
 What are MPC, MPS
 How do these determine the money multiplier which works on any
Marginal injection into or marginal leakage from the economy
 Importance of multipliers and understand why the income multiplier
is 1/MPS or if you prefer 1/ 1 – MPC. These are the same thing since
MPS + MPC = 1
Understand how to apply these multipliers to any money added to or
taken from the economy such as tax cuts, net exports, government
deficit spending, etc. – as described in the diagram of the economy
we have become familiar with as the “Circular Flow Diagram.”
Review the “Circular Flow Diagram” well.
3. Money and money supply
o Definitions of money (M1, M2, M3)
 Characteristics and functions of money
 Understand the concept of liquidity
 Equation of exchange MV =PQ
 Role of Banking system, esp. the money creation process:
1/reserve requirement (the arithmetic is similar to the money
multiplier).
 Federal Reserve System, the importance of an independent FED
4. Monetary Policy and how it affects the money supply and interest rates.
Understand the FED’s main powers:
 Discount Rate
 Reserve requirement
 Open Market Operations
How does each of these work to increase/decrease the money supply
and in turn affect interest rates and in turn affect economic activity?
When and how are these monetary policies applied?
 Understand these limitations to monetary policy
Liquidity traps
Investment may move with Expectations of profit or loss Not
Necessarily the absolute interest rate
financial capital movements out of an economy: $ to Euros, etc
(The carry trade)
5. Fiscal Policy
 Tax (types of taxes—progressive, regressive, proportional – “flat”)
 Taxes (income, sales, property…)
 Government Spending
 Transfer Payments (Social Security, welfare, etc.)
 Automatic stabilizers such as unemployment benefits and the
progressive income tax
 Budget deficits and budget surpluses
 Understand that the cumulative sum of these fiscal deficits is the
national debt
(and understand the pros and cons of the national debt issue)
 How do fiscal policies affect aggregate demand or aggregate supply
and in turn affect economic activity?
 Understand these limitations to Fiscal Policy
Time Lags: formulation, Congressional deliberation, administrative,
implementation. (1 – 2 years delayed action….)
Crowding Out. (As government borrows money it may raise interest
rates which in turn “crowds out” Private sector investment and hence
reduces the effect of the fiscal policy.)
6. Basic Economic concepts
 Supply; Demand. Quantity Supplied; Quantity Demanded
 Excess supply; excess demand and the effect on price
 Surpluses and shortages
 What factors change demand (shift the demand curve); what factors
change supply (shift the supply curve)
 Equilibrium Price
 Elasticities and Inelasticities basics
 Externalities both positive and negative and how we might correct for
these
 Price ceilings and price floors
 Factors of production
 Production possibility curves
 Opportunity costs
 Macroeconomics; Microeconomics
 Positive (descriptive) economics; normative (prescriptive)
economics
 Nominal and Real GDP, prices, wages
 Nominal and real interest rates (real is always the nominal adjusted
for inflation or deflation.)
 The concept of Nominal and Real is so important with anything we
measure in dollars – since the dollar’s purchasing power fluctuates.
We must “fix” the dollar by indexing it to a base year if we are to
“scrub” the inflation out and establish a meaningful comparison.
 Concept of Marginal – e.g. marginal income; marginal propensity to
save (MPS), marginal propensity to consume (MPC). Marginal is so
important when we addresses “leakages” and “injections” since it is
the amount that will be multiplier via the multiplier process.
 Demand Pull and Cost Push inflation
 Discretionary and non-discretionary fiscal polices
 How Exchange Rates are determined: supply and demand in a free
market; or managed in a controlled market
7. Employment and Unemployment
 Frictional; seasonal, cyclical; structural
 Relationship of employment to inflation—full employment
 The Natural Rate of Unemployment (We have used 5% as a
benchmark. Understand that the natural rate is the sum of frictional
(including seasonal) and structural. Unemployment associated with
the business cycle and linked to changes in levels of business activity
is cyclical unemployment.)
 Generally, when we are in periods of recession, the rate of
unemployment exceeds 5%. Conversely, when we are in periods of
inflation, the unemployment rate is less than 5%. Cost push inflation
and stagflation may alter this general observation.
8. Linkage of these elements to accomplish the goals implicit in # 1 above
a. The Keynesian transmission mechanism
MS … i.r. … Aggregate Expenditure …GDP... Unemployment
C+I+G+NX
How is this mechanism interrupted by a Liquidity Trap? Or by
Investment that may be insensitive to interest rates? Or by money
flows among nations as savers pursue higher interest rates abroad.
9. Understand how the above fit into an Open Global Economy, especially
how they are related to:
Imports and Exports and Net Exports
Trade deficits and trade surpluses
Changes in Net Foreign Investment (and that net foreign investment will
equal Net Exports -- NX)
If we have a surplus in our trade balance, we will, ceteris paribus,
Increase our foreign investment. Thus both + +
If we have a negative in our trade balance, foreigners invest here, and
When netted, the U.S. foreign investment decreases. Thus -- -Exchange rate determination (We no longer use the gold standard to back
currency or to set exchange rates. Both now are based on fundamental
supply and demand – free market forces.)
What affects the Appreciation and Depreciation of a currency?
What is meant by Capital Flight? (Large financial capital outflows often
caused by political crises.)
How would financing a budget deficit affect exchange rates, trade, and
net foreign investment. (Basically: to fund the deficit, we must
borrow. We borrow by selling bonds. The Bond price declines and
the interest rate increases. To buy the bonds, foreigners must buy the
dollar since bonds are so denominated. So the dollar strengthens. The
stronger dollar makes our exports more expensive and our imports
less expensive. This affects the trade balance and in turn affects our
net foreign investment: Net exports decline and U.S. Net Foreign
Investment also declines.
10. Understand how Net Exports are related to Net Foreign Investment.
(For example in recent years, the U.S. trade deficit has been negative.
I.E. our X < M. So foreigners build up dollars which they invest in the
U.S. – in part buying our bonds and increasing their portion of our
national debt. So, THEIR foreign investment increases. Netted against
OUR foreign investment, the U.S. net foreign investment declines. In
short, the Trade deficit and the U.S. Net Foreign Investment move
together—a decline in the U.S. trade deficit leads to a decline in U.S. net
foreign investment. Conversely, A surplus in our trade balance, gives us
currencies to increase our net foreign investment.
11. The above is clearly summarized in the Balance of Payments.
O Current Account
The trade balance: Goods (tangibles) and Services (intangibles)
Individual Transfers (e.g. foreign Guestworkers send money
home.)
Interest and earnings from investments
Tourism
O Capital Account: Buying and selling assets such as
Real estate
Direct investment
Portfolio investment
U.S. Bonds
O Official Government transfers
O Balancing (Errors and Omissions)
__________________________________
The Balance of Payments will balance (sum to zero)
Thus, if our current account balance is negative, these money outflows
will return to us as a positive in our capital account.
12. Understand traditional arguments for Free trade: Diversity, choice, and
allocation of resources, etc. and arguments against Free Trade: National
Security, Jobs, Infant Industry. Understand the issue of “a level playing
field” that might be affected by environmental, OSHA, or EEO standards
that might affect production costs.
13. Consider some similarities and differences between NAFTA and the
European Union. What is the Eurozone?
14. Understand the concepts of Absolute and Comparative Advantage
15. Contemplate the causes of economic growth and the impediments to
economic growth. (technology, capital, natural resources, human
resources, economic scale, economic systems, climate, culture,
organization, etc.)
16. Review the economists we have met along the way, including:
Adam Smith—invisible hand; specialization and division of labor
A.W. Phillips – the Phillips curve (Inverse short-term relationship
between Inflation and Unemployment.)
Thomas Malthus—Malthusian Doctrine (population growth rate is
higher than food growth rate. Forecast
Doomsday.)
David Ricardo—Comparative Advantage
Jean Baptiste Say – Say’s Law (“supply creates its own demand.”)
Ben Bernanke – current FED chairman who replaced Alan Greenspan in
early 2006
Max Otto Lorenz – Studied income distribution, and provided us an
analytical tool (the Lorenz Curve) to measure inequalities in income
distribution. The same analytical tool can be used to depict wealth
distribution.
John Maynard Keynes – Keynesian economics; MPS & MPC;
Revolutionized classical economics with General Theory
In 1936; stresses aggregate demand; fiscal policy
Arthur Laffer – Laffer Curve (tax rates and total tax revenue)
Arthur Okun—Okun’s Law: each additional 1 % of unemployment
(above the natural rate) can be associated with a 2% loss in real GDP
output
John Taylor – the Taylor Rule establishing monetary rule by which the
FED would adjust interest rates in response to particular triggers in the
economy – example of non-discretionary monetary policy or “rule by
formula.”
Mohammed Yunus – Nobel Peace Prize winner and advocate of
Microfinance: small loans to village entrepreneurs who collectively
might “put poverty into a museum.”
17. Develop a mental framework
A. Understand fundamental economic goals: low or no inflation; low or
no unemployment; sustainable economic growth., equitable income
distribution, protection of the environment, etc.
B. Diagnose the economic Problem – deviation from above goals; for
example: recession or inflation, lack of economic growth, etc.
C. Know the fiscal and monetary tools available to correct problems
D. Understand how the FED applies monetary tools to correct the
problem. For example: Apply expansionary policies to correct
recessions; Apply contractionary policies to correct inflation.
E. Understand the fiscal policy tools of Congress: spending and taxing
powers as well as the associated polices of managing transfer
payments and managing the National Debt.
18. Have a working understanding of some of the tools we have used
throughout the course:
Supply and Demand curves
The circular flow diagram
The effect of Leakages and Injections
The Production-possibilities curve
MV = PQ………… or MV =PY
C+I+G+ (X-M)
The 45 degree line to compare two variables (income and expenditure)
As in Lorenz curve which depicts income distribution .
The Phillips Curve: short-term trade off depicting an inverse relationship
between inflation and unemployment.
A Laffer curve to depict relationship between tax rate and total tax
revenue
19. What is meant by “Supply Side Economics?”
How do tax policies, technology, human capital, infrastructure,
deregulation of industry, and research affect the supply side?
How do taxes affect incentives which in turn affect output and
productivity. (e.g. investment tax credits, accelerated depreciation,
reducing marginal income tax rates.)