MACROECONOMICS FINAL STUDY GUIDE
EXAM 1
Chapter 1:
 Scarcity: limited; implies choice and tradeoffs
o Tradeoffs: the giving up of one thing to get another
 Opportunity Cost: the value of the best thing we give up to get something; tradeoffs
o True cost; not necessarily monetary
 Ceteris Paribus: other things the same
 Rational Self Interest: actions that elicit the most personal benefit
 Positive Economics: “the way the world is”
 Normative Economics: “the way the world ought to be”
Chapter 2:
 Simple Trade:
 Production Possibilities Frontiers:
o Tradeoffs exist
o Resources can be used wisely (efficiently) or wastefully (inefficiently)
Chapter 3:
 Demand: a relationship between the price of a good or service and the quantity demand
 Supply: a relationship between the price a producer receives and the quantity produced
 Diminishing Marginal Utility: as we consume more of something, additional units don’t
bring us as much satisfaction
o Most people display DMU, not everyone
 The Law of Demand: as price falls, quantity demanded rises
 The Law of Supply: as price rises, quantity supplied rises
o NOT necessarily a LAW, just a strong TENDENCY
 Change in demand vs. change in quantity demanded: graph
 Change in supply vs. change in quantity supplied: graph
o Price changes quantity supplied, price doesn’t change supply
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Things that can shift demand:
o Changes in product quality or information about it
o Changes in price of substitutes and compliments
o Seasonal changes/natural disasters
o Changes in income
 Normal goods: income UP, demand UP
 Inferior goods: income UP, demand DOWN
o Changes in expectations
o Changes in number of consumers
Things that can shift supply:
o Price of inputs
o Taxes and subsidies
o Technology
o Changes in the number of producers
o Changes in expectations
o Natural disasters, weather regulations
Consumer Surplus: the difference between what a consumer is willing to pay, and what
the consumer actually pays
Producer Surplus: difference between how much a producer is paid to produce a unit of
output (the price) and the marginal cost of producing that unit of output
Total Surplus: consumer surplus + producer surplus
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Equilibrium: resting place; place where 2 forces are equal
o EQUILIBRIUM IS EFFICIENT
 TS is maximized OR
 Marginal benefit = marginal cost OR
 Every unit that is produced has a benefit to consumers that is greater
than (or equal to) the cost of its production
o Sometimes called Marshallian Efficiency or Kaldor – Hicks Efficiency
o There is no reallocation of goods and resources that has benefits greater than
costs
o There is no way to make TS bigger, you’ve got efficiency
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How changes in supply and demand change equilibrium price and quantity:
o What happens if price is above the equilibrium price? SURPLUS
o What happens is price is below the equilibrium price? SHORTAGE
o What if both curves shift simultaneously?
 Either price or quantity (not both) will be indeterminate (not defined)
Chapter 4:
 Efficiency:
 Elasticity: responsiveness to quantity
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MACROECONOMICS FINAL STUDY GUIDE
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o i.e.: Market for insulin:
 demand for insulin is INELASTIC (unresponsive)
o i.e.: Market for movie tickets:
 supply is INELASTIC, demand is ELASTIC
o In general, goods with many substitutes will have an elastic demand. Goods with
few substitutes will have inelastic demand.
o Graphically: inelastic = steep, elastic = flat
Price Controls: laws that restrict prices
o Price ceiling: maximum legal price
 i.e.: anti-price gouging laws, rent control, charging of interest/usury laws,
maximum wages
o Price floor: minimum legal price
 i.e.: minimum wages, agricultural price supports
o Some price controls are nonbinding
 Nonbinding price ceilings (above equilibrium) = does nothing
 Nonbinding price floors (below equilibrium) = illegal
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 Binding price ceiling = shortages = not efficient
 Binding price floors = surpluses = not efficient
o Price controls are inefficient
Deadweight Loss: lost consumer and producer surplus
i.e.: a reduction in total surplus
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Taxes
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The burden of tax is the deadweight loss
The burden of tax is not determinate by the legal assignment
The burden of tax is determined by the relative elasticities of supply and demand
A tax moves supply and demand, depending on whether it is placed on
consumers or producers
o A tax harms both consumers and producers and is inefficient (but that does not
mean we shouldn’t have taxes)
 i.e.: tax on bananas, paid by seller/producer
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i.e.: tax on bananas, paid by consumer
Chapter 5:
 Market Failure: the self-interested actions of individuals result in outcomes that are
collectively irrational
o Lack of competition: individual firms raise prices above the level that would exist
if there were lots of competition
o Monopoly:
o Public Goods: non-rivalrous (i.e. my consumption doesn’t reduce yours), nonexcludable (i.e. I can’t keep you from consuming if you don’t pay)
 The Free Rider Problem: because people consume without paying, no one
can produce profitably
o Externalities: when some of the costs or benefits of a transaction fall on a third
party
 Negative Externalities: the buyer and the seller ignore the effect on the
third parties, they DO TOO MUCH
 i.e.: pollution (solution: Pigouvian tax, cap and trade)
 Positive Externalities: the buyer and seller ignore the beneficial effects in
the third parties, so they DO TOO LITTLE
 i.e.: education
o Tragedy of the Commons: when a resource is unowned or owned in common, it
is often overused or abused
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i.e.: fisheries (solution: convert to private property, tradeable permits or
quotas)
o Tragedy of the Anti-commons: when there are too many property rights
 i.e.: patent trolls and patent thickets, Russian shopping malls (too many
people with the right to say ‘no’)
o Information Problems: when buyers or sellers lack important information, some
value increasing exchanges do not occur
 i.e.: used car sales, education signaling
Chapter 6:
 The Public Interest View of Government: the government takes the people’s preference
and translates them into beneficial policies
 The Public Choices View of Government: the government is made up of rationally selfinterested individuals. The policies they create are a result of their preferences and the
system of incentives created by laws.
 Voters: want to vote for politicians who provide policies they like
o Does your vote matter? NO
o Rational Ignorance: people rationally choose not to learn some things
o Rational Abstention: people rationally abstain from voting
 Rational bias: holding incorrect views because it is convenient
 Politicians:
o What do they want? To get elected and reelected
o What must they maximize to get it? Votes
 Bureaucrats: carry out policy created by politicians
o What do they want? A bigger budget (for fun, to do more)
o How do they get it? Persuade politicians to give it to them
 Mixon’s Law: bureaucrats always want more funds. They argue this
because they are doing a 1) good job, 2) bad job
 The Special Interest Effect: when a narrow concentrated group fights a widespread
dispersed group, the concentrated group wins
o i.e.: tax preparers vs. people who want simpler taxes
o i.e.: NRA vs. gun control advocates
o i.e.: farmers vs. tax payers
o
Widespread Benefits
Concentrated Benefits
Widespread
Efficiency Possible
Special Interest Effects
Costs
i.e. Social Security
Concentrated Special Interest Effects
Costs
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MACROECONOMICS FINAL STUDY GUIDE
EXAM 2
Chapter 7:
 Stocks (amount) vs. Flows (change):
o i.e.: “bathtub example”
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GDP (flow): is the market value of all final goods and services produced within a country
(or other geographic area) within a year (or other time period)
o Per Capita GDP: GDP/Population
o What is GDP good for? Making comparisons across time
o Circular Flow Diagram
o Calculating GDP:
 The Expenditure Approach: add up everyone’s spending
 Y = C + I + G + NX
 Y: GDP, C: Consumption, I: Investment, G: Government Spending,
NX: Net Exports = Exports (X) – Imports (M)
 The Income Approach: add up everyone’s income
o Problems with GDP as a measure of material well-being:
 Nonmarket Production: GDP doesn’t include house hold or other
nonmarket production
 Black Market (illegal) and Grey Market (legal but under the table)
Production: not included in GDP
 Leisure and Job Quality: not fully captured in GDP
 Product Quality and New Goods: not included in GDP
 Economic “bads”: not counted in GDP, but could make GDP go up
 Income Inequality, Poverty, or other Distributional Concerns: GDP per
capita only shows average income
Final Good vs. Intermediate Good (hasn’t reached final consumer yet)
Price Level (the overall level of prices in the economy measured with a price index) vs.
Inflation (an increase in the price level)
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MACROECONOMICS FINAL STUDY GUIDE
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Deflation: a decrease in the price level
Disinflation: a decrease in the inflation rate
Nominal GDP: GDP measured in a particular year’s prices (the year that quantities come
from)
Real GDP: measured in a base year’s prices
Measuring price level:
o GDP Deflator: Nominal GDP/Real GDP x 100
 i.e.:
 Nominal GDP 2000: $10 trillion (in year 2000 dollars)
 Real GDP 2000: $12 trillion (in year 2009 dollars)
 Nominal GDP 2016: $18 trillion (in year 2016 dollars)
 Real GDP 2016: $16.5 trillion (in year 2009 dollars)
 GDP Deflator 2000: $10 trillion/$12 trillion x 100 = 83.3
 GDP Deflator 2016: $18 trillion/$16.5 trillion x 100 = 109.09
The Consumer Price Index (CPI): A typical consumer doesn’t buy everything in GDP. CPI
tracks the cost of an ordinary consumer’s typical purchases over time.
o CPI overstates inflation because of: improvements in product quality; it doesn’t
account for changes in consumption due to prices
Market Basket: the set of goods purchased by a typical household back when the CPI
survey was first done.
o CPI asks “how much does it cost to buy that market basket today, compared to
buying that same set of goods at some point in the past”?
Calculating the inflation rate: % X = XNEW – XOLD/XOLD x 100%
o i.e.: Suppose that GDP Deflator (or CPI) was 200 last year, and is 206 this year.
What’s the annual inflation rate?
 206-200/200 x 100% = 3%
Using CPI or GDP Deflator to adjust nominal dollar figures for inflation: we can move
dollar figures through time
Chapter 8:
 The Business Cycle: the ups and downs (booms and busts) of the economy
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Categories important for thinking about labor and employment:
o The entire population, the adult (16+) civilization noninstitutionalized
population, the unemployed, the employed, the labor force (employed +
unemployed)
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The Labor Force Participation rate: Labor Force/Adult Noninstitutionalized Civilian
Population x 100%
The Unemployment Rate: Unemployed/Labor Force x 100%
o Problems with the Unemployment rate:
 Discouraged Workers: workers who have given up looking for jobs, but
would take them if offered
 Underemployment: Some people have only part-time work, but want fulltime
Types of unemployment:
o Frictional: ordinary job searches; lack of information
o Structural: worker skills become mismatched with employer needs
o Seasonal: employment that varies with time of year
o Cyclical: caused by the business cycle
Natural Rate of Unemployment: the unemployment rate when the economy is growing
at a “normal” speed
o = Frictional + Structural
Full Employment: the rate of employment when unemployment is at its natural rate
Potential GDP: how much we can produce when at full employment
Unanticipated Inflation (inflation that consumers and business didn’t expect) vs.
Anticipated Inflation (inflation we expected)
o Unanticipated: causes people to use resources to shield themselves from
inflation; the costs of unexpected inflation are worse under very high inflation,
because higher inflation tends to be more variable for reasons we do not
understand
o Anticipated: menu costs (the costs of updating prices); shoe leather costs (the
costs of quickly carrying out transactions with frequent trips to with frequent
trips to the bank); current U.S. capital gains taxes fall on nominal gains, deterring
investment
Chapter 9:
 Circular Flow Model
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MACROECONOMICS FINAL STUDY GUIDE
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The Loanable Funds Market:
o Fisher’s Equation: i = r + pi
o i: nominal interest rate, r: real interest rate, pi: inflation premium
The Foreign Exchange Market:
o Two ways that dollars leave the country:
 Imports
 Capital Outflow
o Two ways that dollars enter the country:
 Exports
 Capital Inflow
o Appreciation: the dollar appreciates if it buys more foreign currency (stronger)
o Depreciation: the dollar depreciates if buys less foreign currency (weaker)
Exports – Imports = Capital Outflow – Capital Inflow
o NET EXPORTS (NX = X – M)
o NET CAPITAL OUTFLOW
Trade Deficit: when M>X or NX<0
Trade Surplus: when M<X
Chapter 13:
 The three uses of money:
o Medium of Exchange (avoid ‘double coincidence of wants’ problem)
o Unit of Account
o Store of Value
 Liquidity: close to being cash (easy to spend)
 Illiquid: far from being cash (hard to spend)
 Fiat Money (money that has value by government order) vs. Commodity Money (based
on the value of some physical thing – a commodity)
 How money is measured:
More
o M0: currency in circulation
Liquid
o M1: M0 + demand deposits + traveler’s checks
To
Less
Liquid
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o M2: M1 + savings accounts + time deposits less than $100,000 and money
market mutual funds
o Monetary Base: currency in circulation + currency in bank vaults + reserves held
on deposit at the Federal Reserve
The Federal Reserve Bank of the U.S. (the Fed): a central bank created by the
government
o Regulates banks
o Current chair: Janet Yellen
Fractional Reserve Banking: only a fraction of deposits are held on reserve at banks
Potential Deposit Expansion Multiplier = 1/Reserve Requirement
Tools to control the money supply:
o Reserve Requirement: if the Fed requires greater reserves, money supply falls
o Open Market Operation: the Fed can buy and sell financial assets, especially
Treasury Bills. Buying Treasury Bills increases money supply.
o Discount Rate: the interest rate the Fed charges on loans. If the Fed lowers
discount rate, money supply rises.
o Interest on Reserves: if the Fed pays greater interest on reserves, money supply
lowers.
The Equation of Exchange:
o Stock: M x V = P x Y
 M: money supply, V: velocity, P: price level, Y: real GDP
o Flows: %changeM + %changeV = %changeP + %changeY
Change 16:
 Economic Growth: is an increase in an economy’s ability to produce goods and services
o Dramatically raised living standards
o Technically an increase in GDP
 Real Per Capita GDP
o Rule of 70: if X is growing at Y% per year, X will double in 70/Y years
 Why do economies grow?
o OK ANSWERS:
 Natural Resources: neither necessary nor sufficient (resource curse:
countries with a single resource tend to stay poor)
 Capital Accumulation: accumulating physical and human capital has big
effects on productivity at first, but this is subject to diminishing returns
 Technological Progress: important for wealthy countries, less so for poor
countries
o BEST ANSWERS:
 The Institutional Environment: rules, laws, norms, that provide incentives
to produce
 Secure and well-defined private property rights
 Rule of Law: the law is clear and enforced the same way for everyone
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Competitive Markets: competition disciplines firms. Monopolies waste
resources and charge high prices.
Stable Money/Low Inflation: if the value of money is more predictable,
people are more willing to invest for the long term.
Avoidance of high marginal tax rates: really high rates discourage people
from undertaking some productive activity.
Avoidance of harmful regulation: (i.e.: labor market regulation)
Low trade barriers: countries with lower tariffs and quotas grow faster.
Open Capital Markets: allow investment across borders.
Chapter 17:
 Healthy Economic Institutions are ones that:
o Allow individuals to be productive in the manner of their choice
o Allow them to be rewarded for success
o And are predictable and stable enough to allow people to rely on them being
similar in the future (which encourages them to make plans and take action
today)
 Dynamic Aggregate Demand comes directly from the Equation of Exchange (flow
version)
o D.A.D. curve shifts right if M or V grow faster, and shifts left if M or V grow
slower
o Inflation is on the vertical axis; Real GDP growth is on the horizontal axis
o D.A.D. is about spending
 The Solow Growth Curve: depicts how fast an economy can grow in the long run
 Long Run: the period during which all prices are fully flexible
 Short Run: the period during which some prices are ‘sticky’
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Comparative advantage is an economic law referring to the ability of any given
economic actor to produce goods and services at a lower opportunity cost than other
economic actors.
Terms of trade (TOT) refers to the relative price of imports in terms of exports and is
defined as the ratio of export prices to import prices.
Chapter 18:
 Short Run Aggregate Supply: a long run equilibrium because we are at the intersection
of AD and SGC
o Why is it upward sloping? As people spend money faster, this encourages firms
to grow faster.
o Why is it curved?
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o Four Cases:
Growth rises temporarily, returns to run rate; inflation rises (postwar Germany)
Growth falls, then returns to run rate; inflation falls
Growth and inflation both rise then fall
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Growth and inflation both fall then rise
Fiscal Policy: raising and lowering government spending and taxes to speed up or slow
down the economy
o Fiscal stimulus is usually paid for borrowing, but borrowing can cause crowding
out
o Fiscal stimulus can fail because of Ricardian Equivalence
 If people anticipate that current stimulus means future taxes, they don’t
spend
Stagflation: a portmanteau of stagnation and inflation, is a situation in which the
inflation rate is high, the economic growth rate slows, and unemployment remains
steadily high.
The Multiplier Effect: an additional dollar of government spending or of income from tax
cuts leads to more than one dollar of GDP
The Marginal Propensity to Consume (MPC): the fraction of an additional dollar of
income that is spent
o The Keyensian Multiplier: 1/1-MPC
Monetary Policy: the use of money supply changes to reduce business cycle fluctuations
o How does it work?
 Interest rates: effects spending behavior; if the Fed injects money faster,
interest rates decline, and stimulates the economy
 Changes in the quantity of money: injecting money faster stimulates the
economy; spending growth = %changeM + %changeV
Problems with both monetary and fiscal policy:
o Crowding out
o Ricardian equivalence
o Lags
 On the other hand, automatic stabilizers help.
Automatic Stabilizers: policies that act quickly without constant input from policymakers
Additional benefits to trade:
o More gains from large scale production
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o Gains from more competitive markets, including quality, variety, and price
o Technology transfer
o Possibly more pressure to adopt institutions that lead to economic growth
Why do countries develop comparative advantage in one thing rather than another?
o Different endowments of natural resources
o Different endowments of other resources
o Historical accident
o Size
Trade with the Supply and Demand model
o Opening to trade increases total surplus, whether the world price is higher or
lower than the domestic price
o There are always people who gain and people who lose from trade, though the
gains are greater than the losses.
o Tariffs (tax on imports) and quotas (quantity restriction on imports) reduce total
surplus – not efficient
Trade is always efficient
o Arguments against:
 National Defense: if we go into war, we will need domestic production
 Infant Industry Argument: should protect small industries so that they
become large and face foreign competition
 Environmental standards are too low in other countries
 Labor standards are too low in other countries
 Dumping is bad: foreign firms will sell at a loss, drive out domestic firms,
then raise prices
 Predatory Pricing doesn’t work
 Trade restrictions save American jobs: save some, but destroy others
 Americans can’t compete with low wage foreign workers: bang/buck =
marginal product/wage
 Trade deficits are bad: no
Trade deficit: Capital Inflow > Capital Outflow
Trade Agreements: agreements between countries that limit trade barriers
o NAFTA, CAFTA, MERCOSUR, GATT
The Petition of the Candle makers: if you like trade barriers, you’ll love blocking the sun!
The Iowa Car Crop: importing cars from Japan in exchange for wheat is like a magic
machine that transforms wheat into cars, or like growing cars in Iowa
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