Macroeconomics Review
Mc Connell-Brue-Flynn 19th edition
Created by Lissette Pino
Chapter 1
Economic Perspective-The economic way of thinking has several components:
1. Scarcity and Choice: resources are not unlimited, but human wants are, so choices
are necessary. When something is produced, something else isn’t (opportunity cost).
2. Purposeful Behavior: people do things to increase their utility (pleasure gained from
consuming goods and services)
3. Marginal Analysis: when making a choice, one analyzes marginal benefits and
marginal costs
Theories, Principles, and models.
Economists base their models on the scientific method. The procedures are:
1.Observation
2. Hypothesis (an educated guess based on the observation
3. The testing of the hypothesis
4. The acceptance, rejection, or modification of the original hypothesis
5. After continuous testing, the hypothesis becomes a theory. A very well-tested theory
is called an economic principle.
Combinations of these laws and principles are incorporated into models, which are
simplified representations of how things work
Economic principles are:
1. Generalizations relating to economic behavior or to the economy itself
2. Other-Things-Equal assumption (the assumption that factors other than those being
considered do not change)
3. Graphical Expression = many economic models are expressed graphically
Macroeconomics vs. Microeconomics
1. Macroeconomics = focuses either on the economy as a whole, or its basic
subdivisions, such as the government, households, and business sectors.
2. Microeconomics = is concerned with individual units such as a person or firm
3. Positive economics = what the economy is actually like.
4. Normative economics = what the economy should be like
Individual’s Economizing Problem
We need to choose because we have limited income but unlimited wants.
Budget line = curve showing various combinations of 2 products a consumer can
purchase with a specific money income. An increase in money income shifts the budget
line to the right; a decrease in money income shifts it to the left.
Society’s Economizing Problem
Society must also make choices under conditions of scarcity because it has to choose
between, for example, devoting money to healthcare or education.
Society also has limited resources, or factors of production. These are:
1. Land = all natural resources
2. Labor = physical/mental talents of individuals
3. Capital = tools and machines
4. Entrepreneurial Ability = entrepreneurs...
a. Combine resources
b. Make business decisions that set the courses of enterprises
c. Commercialize new products, production techniques, or forms of business
organization
d. Bear the risks
Production Possibilities
Society uses its resources to produce goods and services. We will assume:
• Full employment
• Fixed resources
• Fixed technology
• Production of only 2 goods
1. Production Possibilities table = lists the different combinations of two products that
can be produced with a specific set of resources, assuming full employment.
Remember: having more of something means having less of something else.
2. Production Possibilities curve = a graph of the PP table. Points inside the curve are
meh, those on the curve are the best of the best, and those outside the curve are not
attainable yet. This curve illustrates the law of increasing opportunity costs. As the
production of a particular good increases, the opportunity cost of producing an
additional unit rises because many resources are better at producing one type of
good than at producing others.
Things that change the curve:
• Unemployment = economy produces inside PP curve
• Increases in resource supply
• Advances in Technology
➡Goods for the present are consumer goods (food, clothing, and entertainment)
➡Goods for the future = increase the quantity and quality of property resources,
enlarge the stock of technological information, and improve the quality of human
resources. Ex: capital goods, research and education, and preventive medicine.
Glossary:
• Economics = social science concerned with making choices under conditions of
scarcity
• Economic perspective = economic way of thinking
• Opportunity cost = forgoing one thing to obtain another
• Utility = pleasure from consuming a good or service
• Marginal analysis = evaluating marginal costs and benefits
• Scientific method
• Economic principle = statement about economic behavior or the economy that lets us
predict the outcome of certain actions
• Other-things-equal assumption = assumption that nothing else changes
• Macroeconomics = examines the economy as a whole or its basic subdivisions
• Aggregate = collection of specific economic units treated as one
• Microeconomics = examines individuals
• Positive economics = examines how the economy is
• Normative economics = examines what the economy should be like
• Economizing problem = the need to make choices because wants exceed needs
• Budget line = shows combinations of two products one can purchase with a certain
income
• Economic resources = all resources that go into the production of resources
• Land = all natural resources
• Labor = all individual talents
• Capital = machines
• Investment = purchase of capital goods
• Entrepreneurial ability = ability of entrepreneurs
• Factors of production = resources
• Consumer goods =satisfy our wants directly
• Capital goods = satisfy our wants indirectly by making possible the production of more
capital goods
• Production possibilities curve = displays the different combinations of goods a fullyemployed society can produce
• Law of increasing opportunity costs = as the production of one good increases, the
opportunity cost of producing another unit rises
• Economic growth = a larger total output
Chapter 2
Economic Systems
Every society needs an economic system and a coordinating mechanism to determine
what goods are produced, how they are produced, who gets them, how to
accommodate change, and how to promote technological progress.
Two types:
Command System
Market System
A.K.A.
socialism/communism
capitalism
Resources owned by
the government
individuals
Prices and amount
produced changed by
central planning
AD and AS (the market)
Characteristics of the Market System
1. Private Property
2. Freedom of choice and enterprise
3. Self-interest
4. Competition
5. Markets and prices
6. Technology and capital goods
7. Specialization
7.1. Division of labor
7.2. Geographic
8. Use of money
9. Active but limited government
1.
2.
3.
4.
5.
What goods and services will be produced? Those that are in demand and profitable
How will the goods and services be produced? As cheaply as possible
Who will get the goods and services? Whoever can and will pay for it
How will the system accommodate change? Through changes in prices and profits
How will the system promote progress? By letting the best supplant the worst
The Circular Flow Model = The dynamic market economy creates continuous, repetitive
flows of goods and services, resources, and money. These flows are illustrated in the
Circular flow diagram
Glossary:
• Economic system = set of institutional arrangements and coordinating mechanism to
respong to the economic problem.
• Command system = socialism or communism
• Market system = capitalism
• Private property = private ownership of capital
• Freedom of enterprise = free to obtain and use resources for production
• Freedom of choice = enables owners to do with their property as they see fit
• Self-interest = motivating force of economic units
• Competition = 2 or more buyers and sellers
•
•
•
•
•
•
•
•
•
•
Market = brings buyers and sellers together
Specialization =using resources to produce a few goods and services, not all of them
Division of labor = human specialization
Medium of exchange = makes trade easier (money)
Barter = trading goods
Money = social invention to facilitate trade
Consumer sovereignty = the customer is always right
Dollar votes = consumers buy what they want and can afford
Creative destruction = the creation of new products obliterates old ones
Invisible hand = firms and suppliers, wanting to make money, will give the people what
they want
• Circular flow diagram = illustrates flows of goods, services, resources and money
• Resource market = resources are bought and sold
• Product market = products are bought and sold
Chapter 3
Markets bring together buyers (demanders) and sellers (suppliers).
Demand = quantity of goods purchased at each price level.
Law of demand = the lower the price, the higher the demand (inverse rel.)
Why?
1. Common sense
2. Diminishing marginal utility
3. Income effect
4. Substitution effect
*The demand curve is downward sloping because of its inverse relationship with prices
By adding the quantities demanded by all consumers at each of the various possible
prices, we can get from individual demand to market demand.
The basic determinants of demand are
1.Consumers’ tastes
2.Number of buyers in the market
3.Consumers’ incomes
4.Prices of related goods
5.Consumer expectations.
*Changes in these determinants shift the entire demand curve. Changes in quantity
demanded cause a movement from one point on the curve to another.
Supply = quantity of goods producers will make for sale at each price level.
Law of supply = the higher the price, the higher the supply (direct rel.)
*The supply curve is upsloping, reflecting this law
We can add all the quantities supplied at all price levels to obtain market supply.
The basic determinants of supply are
1.Resource prices
2.Technology
3.Taxes and subsidies
4.Prices of other goods
5.Producer expectations
6.Number of sellers in the market.
*Changes in these determinants shift the entire supply curve. Changes in quantity
supplied cause a movement from one point on the curve to another.
The equilibrium price occurs where demand = supply, or where the two curves cross.
Anything above that causes a surplus, anything below, a shortage.
Competitive markets produce goods with productive and allocative efficiency.
Government-set prices:
• Price ceilings
• Price floors
• Rent controls
Glossary:
• Demand = quantity consumed at a price level
• Demand schedule = shows quantity consumed at different price levels
• Law of demand = inverse relationship between demand and prices
• Diminishing marginal utility = the more you have of one good, the less you need
another one
• Income effect = a lower price increases purchasing power
• Substitution effect = at lower prices, buyers will substitute other goods for that one
• Demand curve = graph of demand, downsloping
• Determinants of demand = demand shifters
• Normal goods = products whose demand varies directly with money income
• Inferior goods = products whose demand varies inversely with money income
• Substitute good = replace another good
• Complementary good = are used with another good
• Change in demand = shift of the demand curve
• Change in quantity demanded = shift along the demand curve
• Supply = quantity produced at a price level
• Supply schedule = shows quantity produced at different price levels
• Law of supply = direct relationship between supply and prices
• Supply curve = graph of supply, upsloping
• Determinants of supply = supply shifters
• Change in supply = shift in supply curve
• Change in quantity supplied = movement along the supply curve
• Equilibrium price = price where the intentions of buyers and sellers match
• Equilibrium quantity = the quantity demanded and supplied
• Surplus = excess supply
•
•
•
•
•
Shortage = excess demand
Productive efficiency = producing as cheaply as possible
Allocative efficiency = producing the best mix of goods
Price ceiling = prices cannot go higher
Price floor = prices cannot go lower (ex: minimum wage)
Chapter 23
Households as Income Receivers
Functional distribution of income = indicates how the nation’s income is earned. The
largest portion of income is earned in wages and salaries.
Personal distribution of income = indicates how the nation’s money is divided among
households, represented as quintiles. The highest quintile receives 50% of all income.
Households as Spenders
Spending = households spend on services, (-3years) nondurable goods and durable
goods (+3years).
Taxes = personal taxes have risen.
Saving = households save about 3% of their income.
The Business Population
Plant
Firm
Physical establishment that Business organization that
actually makes the goods. owns and operates plants.
Industry
Group of firms that produce
the same or similar goods.
Firms can be:
1. Multi-plants
a. Vertically integrated - several plants perform different stages of a process.
b. Horizontally integrated - several plants doing the same thing.
2. Conglomerates - have plants that produce products in several industries.
Legal Forms of Business
Sole
Proprietorship
Owned and
operated by one
person.
Corporation
Legal creation that can perform the
functions of any other enterprise.
Corporate Securities:
*Stocks - share in ownership of a
corp.
*Bonds - IOU
Easy to sell = more investors.
Easy to get bank loans.
Limited liability - risk only what you
own in stock.
Hire specialists.
Immortal
Principal-Agent Problem
Owners don’t want to spend but hire
managers who want to spend.
Partnership
Two or more
individuals own
and operate a
business.
Advtg.
Disdvtg.
Government’s Role
I.
Providing the Legal Structure = enforces contracts, protects the rights of private
ownership, establishes the rules.
II. Maintaining Competition = prohibits monopolies through regulation and antitrust.
(Sherman Act of 1890). Regulated monopolies exist.
III. Redistributing Income
A. Transfer Payments = welfare, food stamps, unemployments.
B. Market Intervention = minimum wages.
C. Taxation = progressive taxation.
IV. Reallocating Resources
A. Externalities = when the effects of a good spill over.
1. Negative (pollution). Corrected by
a) Legislation
b) Specific Taxes
2. Positive (education).
a) Subsidize consumers and suppliers
b) Provide goods via government
B. Public Goods and Services = no rivalry or excludability. Free-rider problem.
C. Quasi-Public Goods = public goods that exist privately. Education, libraries,
medical care, security...
D. The Reallocation Process = taxing allows the government to reduce the demand
for certain services and get the money to produce them themselves.
V. Promoting Stability
A. Unemployment = when private spending does not create enough jobs, the
government increases its spending or reduces taxes so the private sector
increases production.
B. Inflation = when spenders try to buy more than can be produced. The
government reduces spending and increases taxes so spenders buy less.
LOOK AT CIRCULAR FLOW DIAGRAM
Federal Finance
Expenditures:
1. Pensions and Income Security
2. Health
3. National Defense
Tax Revenues:
1. Personal Income tax = levied on taxable income. Progressive.
Marginal tax rate is the rate at which the tax is paid on each additional unit of taxable
income.
Average tax rate is the total tax divided by the total taxable income.
2. Payroll taxes = taxes based on wages and salaries. Fund Social Security and
Medicare.
3. Corporate Income tax = levied on the profits.
4. Excise taxes = sale taxes fall on many products, excise taxes fall on few.
State Finance
Expenditures:
1. Education
2. Public Welfare
3. Health
4. Highways
5. Public Safety
Local Finance
Expenditures:
1. Education
2. Health and Welfare
3. Public Safety
4. Housing, Parks, Sewage
5. Streets and Highways
State Finance
Revenues:
1. Sales and excise taxes
2. Personal Income taxes
3. Corporate Income taxes
4. License fees
Local Finance
Revenues:
1. Property taxes
2. Sales and excise taxes
Chapter 23
International Linkages
Goods and services flows (Trade flows) = exporting and importing.
Capital and labor flows (Resource flows) = foreign firms in U.S, U.S firms abroad.
Information and technology flows
Financial flows = money transfers
The U.S. and World Trade
*Volume: The U.S.’s exports are absolutely larger than other nations’ but a smaller
percentage of GDP than other nations’.
*Dependence: the U.S. is almost entirely dependent on other countries.
*Trade Patterns: a trade deficit occurs when imports exceed exports. U.S. in goods.
A trade surplus occurs when exports exceed imports. U.S. in services.
The U.S.’s main exports are:
1. Chemicals
2. Consumer durables
3. Agricultural products
Its main imports are:
1. Petroleum
2. Automobiles
3. Household appliances
MOST IMPORTANT TRADING PARTNER = CANADA.
Rapid Trade Growth is caused by:
1. Improved transportation and communication technology
2. Decline in tariffs (duties on imported products)
Multinational corporations = firms that have large production and distribution activities in
other countries.
Specialization and Comparative Advantage
Specialization results in greater overall output and income.
International trade is explained by comparative advantage.
Comparative advantage = if nation A produces goods at a lower opportunity cost than
nation B, even if B has the absolute advantage in that it can produce those goods more
quickly, they should trade because A has comparative advantage.
The Foreign Exchange Market
Market in which different currencies are exchanged. The equilibrium prices in these
markets are called exchange rates.
If a foreign currency appreciates, the dollar depreciates so exports increase and imports
decrease.
If the dollar appreciates, exports decrease and imports increase.
The Government and Trade
Protective tariffs = taxes placed on imported goods to shift demand towards domestic
products.
Import quotas = limits on how many of a product can be imported.
Non-tariff barriers = ridiculous licensing requirements, unreasonable quality standards,
etc.
Export subsidies = government payments to domestic producers of export goods so
they can lower their prices and sell more.
Why does the government intervene?
1. Misunderstanding gains from trade
2. Politics = they want the vote of domestic producers.
Trade Agreements
Smoot-Hawley Tariff Act = increased tariffs and caused revenge tariffs in other
countries.
Reciprocal Trade Agreements Act = reduced tariffs by
1. Negotiating authority - let the president negotiate
2. Generalized reductions - introduced the most-favored-nation clause (reduced tariffs to
one nation apply to all the others in the group)
General Agreement on Tariffs and Trade (GATT) = included many nations.
World Trade Organization = GATT’s successor. Critics say that it allows firms to
circumvent national laws that protect workers and the environment.
The European Union (EU) = free-trade zone (trade bloc) between european countries.
Members use the Euro as a common currency.
North American Free Trade Agreement (NAFTA) = between Canada, the U.S. and
Mexico.
Chapter 24
National income accounting:
1. Assesses the health of the economy
2. Tracks the long-run course of the economy
3. Formulates policies to help improve the economy
Gross Domestic Product
GDP = the total market value of all FINAL goods and services produced in a year.
1. Monetary measure
2. Avoids multiple counting
2.1. Intermediate goods = are resold. Not counted
2.2. Final goods = sold to the consumer. Counted.
2.3. Value added = another way to avoid multiple counting. It’s the market value of
a firm’s output minus its inputs.
3. Excludes non-production transactions
3.1. Financial transactions
3.1.1. Public transfer payments = social security, welfare, veteran’s checks.
3.1.2. Private transfer payments = the money parents give kids, etc.
3.1.3. Stock market transactions = exchanging stocks and bonds.
3.2. Secondhand sales
Two ways of finding GDP
Expenditures
Income
C - Personal Consumption Exp.
C - Salaries and wages
Ig - Gross private domestic investment
R - Rents
G - Government purchases
I - Interest
Xn - Net exports (exp - imp)
P - Corporate Profits (C.I. taxes, dividends,
and profits)
T - Taxes on production and imports
Net private domestic investment = gross inv - depreciation
Net domestic product = GDP - depreciation
National income = NDP - stat. discrepancy + net foreign factor income
Personal income = NI - taxes on p&i - S.S. - C.I.taxes - C.Prof + Transfer payments
Disposable income = PI - personal taxes
SEE CIRCULAR FLOW DIAGRAM AGAIN
Nominal GDP
based on the prices of that year
Real GDP
adjusted for depreciation/appreciation
Real GDP = nominalGDP/price index(hundredths)
Price index = price of market basket in one year/price in base year x 100
OR
nominalGDP/RealGDP
Shortcomings of GDP
1. Non-market Activities
2. Leisure
3. Improved Product Quality
4. The Underground Economy
5. GDP and the Environment (it doesn’t count pollution)
6. Composition and Distribution of output (rifle is the same as book)
7. Non-economic sources of well-being (happiness)
Chapter 25-26
Economic Growth
Growth is an important economic goal because it lessens the burden of scarcity.
Main sources of growth are:
• Increasing inputs
• Increasing productivity of existing inputs.
Growth doesn’t measure quality improvements or increased leisure time, but it also
doesn’t take into account adverse effects on the environment or human security.
Business cycle:
1. Peak - temporary maximum
2. Recession - decline
3. Through - temporary minimum
4. Recovery - rise
What causes business cycles?
• Major innovations may trigger new investment and/or consumption spending.
Changes n productivity may be a related cause.
• Most agree that the level of aggregate spending is important, especially changes on
capital goods and consumer durables.
• Major changes in productivity
Spending on durable (capital) goods is very unstable because they are rarely day to day
necessities and easily postponed.
Types of unemployment:
- Structural unemployment
- Frictional unemployment
- Cyclical unemployment
• The full-employment unemployment rate is equal to the total frictional and structural
unemployment.
The population is divided into three groups:
1. Not in labor force - young or hospitalized
2. Labor force - willing and able to work (includes part-time workers)
3. Unemployed
*Discouraged workers (want a job but have given up) are counted in the labor force
Economic cost of unemployment:
GDP gap and Okun’s Law
• Noneconomic costs include loss of self-respect and social and political unrest.
Unequal burdens of unemployment exist:
• Rates are lower for white-collar workers.
• Teenagers have the highest rates
• Blacks have higher rates than whites.
• Rates for males and females are comparable
• Less educated workers have higher unemployment rates
Inflation: all nations have experienced it.
Demand-pull inflation
Cost-push inflation
Inflation:
• Hurts fixed-income groups
• Hurts savers
• Helps borrowers but hurts lenders
*If inflation is anticipated, its effects are less severe.
Unexpected deflation has the opposite effects.
Does inflation affect output?
• Cost push inflation could cause both output, real income and employment to decline.
• Mild inflation has uncertain effects.
• Danger of creeping inflation turning into hyperinflation ,which can cause speculation,
reckless spending, and more inflation
Chapter 27
Income-Consumption and Income-Saving relationships
• Saving=Disposable income-consumption
• The 45 degree line on the consumption schedule is the line in which disposable
income is equal to consumption, meaning no personal saving is taking place
The consumption schedule
• The consumption schedule is a schedule that shows the various amounts that
households would plan to consume at each of the various levels of disposable income.
• The income-consumption schedule is upward-sloping
The saving schedule
• The saving schedule is a schedule that shows the various amounts that households
would plan on saving at each of the various levels of disposable income.
• There is a direct relationship between disposable income and saving.
• Dissaving will occur at relatively low incomes
• The break-even income is the income at which households plan to consume all of their
income.
• This is shown as an intersection of the 45 degree line
Average and Marginal Propensities
• The fraction or percentage of total income that is consumed is the Average propensity
to consume (APC)
• The fraction or percentage of total income that is saved is the Average propensity to
Save (APS)
• The proportion of any change in income consumed is called the Marginal propensity to
consume (MPC)
• The fraction of any change in income saved is called the Marginal propensity to save
(MPS)
• MPS+MPS=1
• The Marginal propensity to save can be seen as the slope of the consumption or
savings schedules
Non-Income determinants of Demand (can cause more or less spending or saving at
various income levels)
1. The Basic Determinant = amount of disposable income
2. Wealth
3. Expectations:
4. Real Interest Rates
5. Household Debt
Changes in the amount consumed: Movement from one point to another on a given
schedule – solely caused by change in real GDP
Changes in one or more of the non income determinants of consumption: An upward or
downward shift of the entire schedule
• Schedule shifts = consumption & saving schedules will always shift in opposite
directions unless the shift is caused by a tax change
• Taxation = lower taxes shift both schedules up; higher taxes shift both down
• Stability = consumption & saving are both stable unless altered by major tax increases
or decreases.
The Interest-Rate-Investment Relationship
***Investment = spending on capital goods. Relies on marginal analysis.
• Marginal Benefit: Expected rate of return
• Marginal Cost: Interest rate that must be paid for borrowed funds
***Expected Rate of Return
• Businesses only invest if they think such purchases will be profitable
• Expected economic profit (Total Revenue –Total Cost) compared to cost of investment
The real interest rate is the nominal rate corrected for expected inflation
• Real interest rate = nominal - inflation
• Represents either the cost of borrowed funds or the opportunity cost of investing your
own funds. If the real interest rate exceeds expected rate of return, the investment
should not be made
The Investment demand curve = illustrates the inverse relationship between the interest
rate and the investment
• The investment demand curve is constructed by arraying all potential investment
projects in descending order of their expected rates of return.
The investment demand curve shifters:
• Acquisition, maintenance, and operating costs- the higher they are, the fewer
investments that will take place at each possible interest rate
• Business Taxes- Lowers the expected rate of return
• Technological advance- stimulates investment with possibly cheaper and more
efficient production
• Stock of Capital goods on hand- when firms are overstocked, investment drops. When
capital is understocked, investment grows
Instability of Investment
• Durability of capital goods = spending can be postponed
• Irregularity of Innovation
• Variability of Profits
• Variability of Expectations
The Ripple Effect: The economy has continuous flows of expenditures and income. Any
change in income will cause both consumption & saving to vary in the same direction as
the initial change in income, and by a fraction of that change.
real GDP)/(
spending).
• Multiplier= (
Marginal Propensity to Consume (MPC)-The fraction of the change in income that is
spent. Size directly related to multiplier
Marginal Propensity to Save (MPS)-The fraction of the change in income that is saved.
Size inversely related to multiplier
Multiplier = 1 / (1-MPC)
Remember: MPC+MPS = 1
MPS = 1-MPC
Multiplier =1 / MPS
Chapter 28
1.
2.
3.
4.
5.
6.
7.
8.
AE falls = total output and employment fall. AE rises = total output and emp. rise
At equilibrium, GDP = C+Ig
More investment = higher GDP
+net exports = GDP up
-net exports = GDP down
Prosperity abroad increases exports
Tariffs abroad reduce exports
Depreciation of the dollar increases exports while decreasing imports, appreciation
decreases exports and increases imports
9. Equilibrium GDP occurs where C+Ig+G+Xn = GDP
Limitations of the Model:
-Doesn’t show price-level changes
-Ignores premature D-P inflation
-Limits real GDP to Qf
-Ignores C-P inflation
-Doesn’t allow for self-correction
Basically, you know all this. Study the glossary.
I
I
V
Glossary:
• Planned investment = amounts business firms collectively intend to invest
• Investment schedule = shows the amount of investment at each level of GDP
• Aggregate expenditures schedule = shows the amount spent at each possible output
or income level (C+Ig)
• Equilibrium GDP = level at which the total quantity of goods produced (GDP) equals
the goods purchased (C+Ig)
• Leakage = saving, withdrawal of spending from the income-expenditures stream
• Injection = investment, adds spending into the income-expenditures stream
• Unplanned changes in inventory = <-------- (see name)
• Net exports = exports - imports
• Lump-sum tax = a tax yielding the same revenue at each level of GDP
• Recessionary expenditure gap = amount by which aggregate expenditures at the fullemployment GDP fall short of those required to achieve full-employment GDP
• Inflationary expenditure gap = amount by which an economy’s aggregate expenditures
at the full-employment GDP exceed those necessary to achieve the full-employment
GDP
Chapter 29
Prices up = real GDP demanded down (and vice-versa)
Why does the AD curve slope downward?
1. Real-balances effect
2. Interest-rate effect
3. Foreign purchases effect
Determinants of AD:
• Consumer spending
• C. wealth
• C. expectations
• C. debt
• Personal taxes
• Investment spending
• Interest rates
• Expected returns
• Expectations
• Technology
• Degree of excess capacity
• Business taxes
Govt.
spending
•
• Net export spending
• National income abroad
• Exchange rates
Aggregate supply
Short-run = upsloping
Long-run = vertical at Qf
Determinants of AS:
• Input prices
• Domestic resource prices
• Prices of imported resources
• Market power = a change in the ability to set prices above competitive levels held
by sellers of major inputs
• Productivity
• Legal-Institutional environment
• Business taxes and subsidies
• Government regulation
Equilibrium and changes:
1.Increases in AD = D-P inflation. Higher demand pulls prices up.
2.Decreases in AD = Recession and cyclical unemployment. Deflation can occur
because prices are inflexible downwards for several reasons:
a.Fear of price wars
b.Menu costs
c.Wage contracts
d.Morale, effort, and productivity
e.Minimum wage
3.Decreases in AS = C-P inflation. Higher costs of resources push prices up.
Glossary:
• AD-AS model = analyzes changes in real GDP and the price level
• Aggregate demand = curve showing the amounts of GDP that buyers decide to
purchase at each price level
• Real-balances effect = a higher price level reduces the purchasing power of the
public’s savings
• Interest-rate effect = higher prices cause a higher demand for money, which drives up
interest rates
• Foreign purchases effect = when the US price level rises, exports decrease and
imports increase, which reduces net exports
• Determinants of aggregate demand = shift the demand curve
• Aggregate supply = curve showing the level of real domestic output that firms will
produce at each price level
• Long-run AS curve = vertical at full-employment level
• Short-run AS curve = upsloping
• Determinants of AS = shift the supply curve
• Productivity = measure of the relationship between a nation’s level of real output and
the amount of resources used to produce it
• Equilibrium price level = intersection of AD and AS
• Equilibrium real output = what will be produced at the equilibrium price level
• Menu costs = cost of changing prices
• Efficiency wages = elicit maximum work effort and thus minimize labor costs per unit
of output
Chapter 30
Fiscal policy = changes made by the government in spending and taxes to expand or
contract the economy.
1. Discretionary - CEA comes up with a plan, which Congress must approve before it
begins.
a. Expansionary - used to counteract a recession or a cyclical downturn. Stimulates
the economy by increasing aggregate demand. Creates a budget deficit (govt.
spending > tax revenues).
b. Contractionary
2. Non-discretionary - occurs automatically. Taxes and government transfer payments
(unemployment and welfare).
Problems with fiscal policy:
1.Timing
a.recognition lag
b.administrative lag
c.operational lag
2.Political considerations
3.Future policy reversals = can’t work if people expect a reversal
4.Offseting state and local finance
5.Crowding-out effect
Fiscal policy is important and useful, but monetary policy works best.
The Public Debt
50% is owned by US government agencies and the Federal Reserve. 25% is owned by
foreigners.
False concerns:
1. Bankruptcy = easily avoided with
a. Refinancing
b. Taxation
2. Burdening future generations = no because most of the debt is owned by the
government itself and by Americans.
Real Issues:
1.Income distribution
2.Incentives (interest on the debt)
3.Foreign-owned public debt
4.Crowding-out effect
Glossary:
1. Fiscal policy = deliberate changes in government spending and tax collection
designed to achieve full employment, control inflation, and encourage growth
2. Council of Economic Advisers (CEA) = group of three economists appointed by the
president to provide expertise
3. Expansionary fiscal policy = tries to stimulate aggregate demand
4. Budget deficit = when government spending exceeds tax revenues
5. Contractionary fiscal policy = tries to reduce aggregate demand
6. Budget surplus = when tax revenues exceed government spending
7. Built-in stabilizer = anything that decreases budget surplus or increases deficit
during a recession and does the opposite during inflation
8. Progressive tax system = the average tax rate rises with GDP
9. Proportional tax system = the average tax rate is constant
10. Regressive tax system = the average tax rate decreases as GDP rises
11. Standardized budget = full-employment budget. Measures what the budget deficit or
surplus would be at full-employment output
12. Cyclical deficit = a by-product of a recession
13. Political business cycle = using fiscal policy to increase popularity
14. Crowding-out effect = an expansionary fiscal policy may increase the interest rate
and reduce private spending, canceling itself out
15. Public debt = total accumulation of deficits and surpluses the Fed has incurred
through time
16. US securities = financial instruments issued by the Fed to borrow money to finance
excess spending not financed by tax revenues
17. External public debt = percentage of the US debt owned by foreigners
18. Public investments = increase the economy’s future production capacity
Chapter 31
The functions of money:
• Medium of exchange - used for buying and selling
• Unit of account - used to measure the value of goods. Easier to compare prices and
calculate taxes, GDP, etc.
• Store of value - enables people to transfer purchasing power from the present to the
future. Most liquid of all assets.
Components of the money supply:
1. M1= currency + checkable dep.
1. Currency
1. Coins = token money. The value of the metal in the coin is worth less than its
face value to prevent their melting down.
2. Paper Money = Federal Reserve Notes issued with the authorization of
Congress.
2. Checkable Deposits (deposits in commercial banks that can be cashed). More
convenient because they’re:
1. Safer
2. Theft doesn’t mean you’re doomed
3. Easier to write a check than count and carry large sums of money
Institutions that offer checkable deposits:
• Commercial banks = accept deposits, keep money safe until it is demanded but
meanwhile use it to make loans.
• Thrift institutions = savings and loan associations, mutual savings banks, and credit
unions. S&Ls and mutual savings banks accept deposits and use them to provide
loans. Credit unions accept deposits from and lend only to members.
Checkable deposits AKA demand deposits, negotiable order of withdrawal accounts,
automatic transfer service accounts and share draft accounts.
*NOTE: currency owned by banks/the govt. is not counted.
2. M2 = M1+near monies
1. Near monies = assets that can become money quickly
1. Savings deposits (including MMDAs) =
1. Savings account - easy to withdraw and transfer funds
2. Money Market Deposit Account - interest-bearing account containing
short-term securities. Have a minimum-balance requirement and a limit on
how often funds can be withdrawn
2. Small (<$100K) time deposits = certificates of deposit (CDs) that can be
cashed after a certain time without a penalty or before with large penalties.
Interest rates are higher than on MMDAs.
3. Money Market Mutual Funds (MMMFs) held by individuals = mutual fund
companies offer MMMFs. They use the combined funds of shareholders to
buy short-term credit instruments (CDs & securities) and offer interest on the
accounts of the shareholders that own them.
3. Money Zero Maturity (MZM) = M2-small time dep. + corporate MMFs
MZM includes monetary balances that are immediately available for transactions
without any cost. Small time deposits are not included because they cannot be freely
withdrawn at any time. Corporate MMFs are included because they’re immediately
available for purchases.
Advantage of MZM: includes the main items (currency, CDs, MMDAs, and MMMFs)
used daily and excludes time deposits, which are mostly used to save.
NOTE: if something increases M1, it will increase M2 & MZM because they include M1
--------> Are credit cards money? NO. They’re short-term loans.
What backs the money supply?
The government’s ability to keep the value of money relatively stable.
1. Money as Debt
The major components of the money supply (paper money & checkable deposits) are
promises to pay. The government manages the money supply by trying to provide the
amount of money needed for business activity. This is smarter than linking money to
something else, like gold, because if the supply of that thing changed rapidly the
economy would experience an inflation/recession.
2. Value of Money: What gives money its value?
1. Acceptability - people accept it as a medium of exchange
2. Legal Tender - money is a legal way to pay for things.
3. Relative Scarcity - there is not an infinite supply
3. Money and Prices
Prices and the dollar have an inverse relationship. The higher prices are, the less a
dollar is worth. V = 1/P
An economy can use money only while its value is stable, otherwise people will refuse
to accept it. When the value of money changes too quickly in one country, people resort
to barter, the nation takes up another official currency or other currencies are unofficially
used.
4. Stabilizing Money’s Purchasing Power
Rapid inflation is usually caused by imprudent economic policies. Price-level stability
needs good monetary and fiscal policies.
The Federal Reserve and the Banking System
The monetary authorities are the members of the Board of Governors of the Federal
Reserve System. The Fed controls the lending ability of banks and thrifts.
Historical Background:
1. Early 20th cent. = unregulated banking resulted in numerous bank notes being used.
The money supply was inadequate (too little/too much)
2. 1907 = terrible banking crisis
3. Congress appointed the National Monetary Commission to outline a course of action
4. 1913 = Federal Reserve Act
Parts of the Federal Reserve:
I. Board of Governors = central authority. 14-year terms to isolate from political
pressure and give them experience. 7 members are appointed by the President.
II. 12 Federal Reserve Banks
A. Central Bank - one bank split into twelve for practical reasons.
B. Quasi-Public Banks - blend private ownership and public control. Each FRB is
owned by the banks in its district. However, they act in the public interest and are
govt. regulated.
C. Bankers’ Banks - perform for banks what banks do for people. Also issue
currency (FR notes)
III. FOMC (Federal Open Market Committee) = 12 people.
A. Board of Governors (7)
B. President of the NYFRB
C. Presidents of FRBs, rotate every year (4)
IV. Commercial Banks
A. State Banks - private banks authorized by their state to operate within it
B. National banks - private banks authorized by the federal govt. to operate
throughout the US
V. Thrifts (mostly credit unions)
A. Regulated by the Treasury Department’s Office of Thrift Supervision
B. Still subject to control by the Fed because they have required reserves
C. Monetary policy affects them just like banks
Fed Functions
1. Issuing currency
2. Setting reserve requirements and holding reserves
3. Lending to banks and thrifts
4. Providing for check collection - when a check from Bank A is deposited in Bank B,
the Fed adjusts their reserves accordingly
5. Acting as fiscal agent - govt. spending, tax revenues and bond exchanges occur
using the Fed’s facilities
6. Supervising banks
7. Controlling the money supply
****The Fed is independent from the government so that politics will not interfere and it
can do what’s best in the long run without worrying about popularity.
Recent Developments in Money and Banking
• Relative decline of banks & thrifts = although they’re the only institutions that offer
unrestricted checkable deposits, other institutions have expanded their shares of
financial assets (see table below).
• Consolidation among banks & thrifts = many banks have merged with others or
purchased thrifts. The point of merging is to create larger banks that compete better.
• Convergence of services provided by financial institutions = since 1999, banks and
other financial institutions can merge and sell each other’s products, which is more
convenient for consumers and increases competition. However, financial losses could
increase the number of bank failures.
• Globalization of financial markets = major companies (US or foreign) are available all
over the world.
• Electronic payments
• credit cards
• debit cards
• fedwire transfers - banks transfer funds to other banks
• automated clearinghouse transactions (ACHs) - households can send funds to
businesses
• stored value cards (gift cards, prepaid phone cards, etc)
• FUTURE = electronic money (PayPal), smart cards (cards for electronic money)
Major categories of the financial services industry
Institution
Description
Comm. Banks
provide checking/savings accounts, sell CDs, make loans
Thrifts
S&Ls, mutual saving banks, and credit unions
Insurance cos.
offer contracts through which individuals pay to insure
against some loss
Mutual fund cos.
pool deposits by customers to buy stocks/bonds
Pension funds
collect employee savings and buy stocks/bonds with the
proceeds and make monthly retirement payments
Securities firms
stock brokerage firms. Buy/sell stocks/bonds for clients and
offer security advice
Glossary:
• Medium of Exchange = any item accepted by buyers and sellers (money)
• Unit of Account = standard unit in which prices can be stated
• Store of Value = an asset set aside for future use
• M1 = currency (bills +coins) + checkable deposits
• Token money = when the face value of a coin is worth more than the metals in it
• Federal Reserve Notes = bills issued by the Federal Reserve.
• Checkable Deposits = any deposit in a comm. bank or thrift a check may be drawn
against
• Commercial Banks = primary depository institutions
• Thrift Institutions = S&Ls, mutual savings banks or credit unions
• Near-monies = financial assets that are not a medium of exchange that is easily
turned into money
• M2 = M1+ Near monies
• Savings account = a deposit in a comm. bank or thrift on which interest is received
• MMDA = Money Market Deposit Accounts. Bank and thrift provided interest-bearing
accounts that contain short-term securities and have min. balance requirements and
limited withdrawals.
• Time Deposits = interest-earning deposits in comm. banks or thrifts that can be
withdrawn after a certain time for free or before with a large penalty
• MMMF = Money Market Mutual Funds. Interest-bearing accounts offered by insurance
companies that pool depositors’ funds to purchase short-term securities. Depositors
can write checks.
• MZM = Money Zero Maturity. M2 - small time deposits + MMMFs owned by
businesses
• Legal Tender = legal designation of a nation’s official currency.
•
•
•
•
•
Federal Reserve System = composed of 12 Federal Reserve Banks
Board of Governors = monetary authorities
Federal Reserve Banks = collectively serve as the nation’s central bank
FOMC = Federal Open Market Committee
Financial Services Industry = commercial banks, thrifts, insurance companies, mutual
fund companies, pension funds, and securities firms
• Electronic Payments = credit cards, debit cards, PayPal, etc.
Chapter 32
The Fractional Reserve System
Only a portion of checkable deposits are backed by cash in bank vaults or deposits at
the central bank.
This idea originated with the goldsmiths, who were primitive bankers. People realized
gold was unsafe and inconvenient and began to deposit it and use goldsmith receipts
instead. This was the first kind of paper money. The goldsmiths soon realized that
people rarely took out their gold and began making loans with money they didn’t really
have - the beginning of the fractional reserve banking system.
Important characteristics of fractional reserve banking:
• Banks create money by lending (how much they can lend is limited by how much
money they’re required to keep in currency reserves by the law
• These banks are vulnerable to panics where too many people try to withdraw their
money at the same time. Highly unlikely when banks are prudent.
A single Commercial Bank
In the balance sheet, assets = liabilities + net worth.
Transactions:
1. Creating a Bank - get permission from govt. and begin selling stock. Cash obtained is
held as vault cash.
2. Acquiring Property and Equipment - making it physical
3. Accepting Deposits - Receive cash as checkable deposits
4. Depositing Reserves in the FRB reserve ratio = req. res. / checkable dep. liabil.
excess res. = actual - required
*Required reserves’ purpose is to help the Fed control the lending abilities of banks
They also facilitate the clearing of checks.
5. Clearing a Check drawn against the Bank
Money-Creating Transactions:
6. Granting a Loan - when banks lend money, they create checkable deposits that are
actual money. The reserve ratio limits banks’ lending ability
7. Buying Government Securities - when a bank buys bonds from the public, it takes
something that is not money and gives people money (as checkable deposits) in
exchange.
Profits, Liquidity, and the Federal Funds Market
The asset items on a comm. bank’s balance sheet show the banker’s conflict:
• Profit = why the bank makes loans and buys securities
• Liquidity = safety lies in the liquidity of cash and excess reserves.
Bankers must balance by getting assets with high returns and highly liquid assets with
no returns. They can also lend temporary excess reserves to other banks for interest
(Federal Funds Rate).
The Banking System: Multiple Deposit Expansion
The commercial banking system can lend by a multiplier of its excess reserves because
reserves lost by a single bank are deposited in another bank, so they’re not lost to the
banking system.
The monetary multiplier is the reciprocal of required reserve ratio.
m = 1/R
SO....
maximum checkable-deposit creation = excess res. X monetary multiplier (OR)
D=ExM
*Since checkable deposit money is destroyed when loans are repaid, there is a multiple
destruction of money, as well.
Glossary:
• Fractional Reserve Banking System = only a portion of deposits are backed by cash
• Balance Sheet = statement of assets and claims that summarizes the financial
position of a bank at that certain time
• Vault Cash = cash held by a bank
• Required Reserves = amount of funds equal to a specified percentage of the bank’s
deposit liabilities
• Reserve Ratio = ratio of the required reserves a commercial bank must keep
• Excess Reserves = actual - required
• Actual Reserves = total money possessed by the bank
• Federal Funds Rate = interest rate banks charge one another on overnight loans
• Monetary Multiplier = 1/required reserve ratio
Chapter 33
Interest Rates
Price lenders charge borrowers for the use of money. Determined by money supply and
demand.
Why do people demand money?
• Transactions demand = to buy and sell things. Directly related to nom. GDP.
• Assets demand = to keep it as a store of value. Inv. related to interest rates.
Total demand for money = transactions demand + assets demand
*Graphically, changes in nom. GDP will shift the whole curve
The equilibrium interest rate is where demand and supply for money intersect.
The interest rate is inversely related to bond prices.
The Consolidated Balance Sheet of the Federal Reserve Banks
Assets
Securities
short-term: bills
mid-term: notes
long-term: bonds
Loans to Commercial Banks
Liabilities
Reserves of Commercial Banks
Treasury Deposits
Federal Reserve Notes (bills)
Tools of Monetary Policy:
1. Open-Market Operations = exchange of govt. bonds with comm. banks or the public
a. Buying
i. From comm. banks: bank gives Fed bond and pays by increasing excess res.
ii. From the public: person gives Fed bond, Fed gives check against itself, which
is deposited in a bank, increasing checkable deposits. Excess reserves are
increased minus the required reserves.
b. Selling
i. To comm. banks: Fed give bank bond and reduces excess res. as payment
ii. To the public: Fed gives person bond and receives a check drawn against a
bank. Fed reduces that bank’s excess and required reserves and checkable
deposits
2. Reserve Ratio
a. Raised - banks’ excess res. are diminished or depleted, in which case they’ll
need to contract checkable deposits and sell their bonds
b. Lowered - banks gain excess reserves and can loan more. This changes the size
of the monetary multiplier.
3. Discount Rate =
a. Raised - doesn’t want banks to borrow
b. Lowered - wants banks to borrow
**When banks borrow from the Fed, only their excess reserves increase.
1% above Federal Funds Rate
FFR = rate banks charge one another on overnight loans.
Prime interest rate = benchmark rate used by banks as a reference. Higher than FFR.
Disequilibrium
1. Shortage of Money
Need more money = bonds sold --> prices fall --> interest rates up --> less demand
2. Surplus of Money
Need less money = bonds bought --> prices rise --> interest up --> more demand
Monetary Policy
Expansionary
Contractionary
FFR down
FFR up
Interest rates down (Investment up)
Interest rates up (Investment down)
Money supply up
Money supply down
AD up
AD down
Advantages
Disadvantages
Speed
Recognition lags
Flexibility
Operational lags
Unaffected by politics
Cyclical asymmetry (better for inflation)
Management Discretion = Fed should consider and choose what to do
Inflation Targeting = Fed should set goals and be held accountable if it doesn’t reach
them. Some say role is too limited.
Taylor Rule:
GDP 1% > Potential GDP = FFR up 0.5pts
Inflation 1% > ideal (2%) = FFR up 0.5pts
When in balance = FFR 4, Real Interest Rate 2.
Portrayals of the Fed:
• Mechanic (BEST)
• Warrior
• Fall guy
• Cosmic Force
Glossary:
• Monetary Policy = series of changes made by the Federal Reserve to influence total
spending and interest rates. Goal = full-employment GDP without inflation
• Interest = price charged for the use of money. Depends on supply & demand
• Transactions Demand = need for money as a method of exchange
• Asset Demand = need for money as a store of value
• Total Demand for Money = transactions + asset
• Open-Market Operations = the buying and selling of US securities (bonds) in the
open-market (to comm. banks and the public)
• Reserve Ratio = percentage of checkable deposits banks must keep as vault cash or
in the FRB
• Discount Rate = interest the Fed charges banks to loan them reserves
• Federal Funds Rate = interest banks charge one another when loaning reserves
• Expansionary Monetary Policy = monetary policy to expand real GDP
• Prime Interest Rate = used by banks as a benchmark
• Restrictive Monetary Policy = monetary policy to contract real GDP
• Taylor Rule =
GDP 1% > Potential GDP = FFR up 0.5pts
Inflation 1% > ideal (2%) = FFR up 0.5pts
When in balance = FFR 4, Real Interest Rate 2.
• Cyclical Asymmetry = the idea that monetary policy is better at controlling inflation
than getting us out of a recession
• Inflation Targeting = states that the FR should set itself inflation targets and be held
accountable if they’re not met
Chapter 35
Short-run AS curve:
D-P inflation:
Long-run AS curve:
C-P inflation:
Extended AD-AS model:
Recession:
Short-run Phillips Curve:
Long-run Phillips Curve:
PC:
AS shocks and the
Laffer Curve
Glossary:
• Short run - period in which nominal wages and other input prices do not respond to
changes in the price-level.
• Long run - period in which nominal wages are fully responsive to changes in the price
level.
• Phillips Curve = demonstrates the short-run tradeoff between unemployment and
inflation.
• Stagflation = when inflation and unemployment rise simultaneously
• Aggregate supply shocks = sudden, large increases in resource costs that move the
short run AS curve to the left.
• Long-run vertical Phillips Curve
• Disinflation = reductions in the rate of inflation from year to year.
• Supply-side economics = stress that changes in AS are an active force in determining
the levels of inflation, unemployment, and economic growth.
• Laffer Curve = depicts the relationship between tax rates and tax revenues. It argues
that lowering tax rates will increase revenues because people will stop taking taxevasion measures.
Chapter 25
Ingredients of growth:
1. Supply
i. Natural resources
ii. Human resources
iii. Capital goods
iv. Technology
2. Demand
3. Efficiency
a. Productive
i. Using resources in the cheapest way...
b. Allocative
i. ...that provides the best mix of goods
Society can increase its real output and income by:
1. Increasing its inputs of resources
2. By raising the productivity of those inputs
Real GDP = hours of work X labor productivity
Increase in PP:
Increase in LRAS:
Growth in Extended AD-AS model:
The CEA uses growth accounting to figure out what causes economic growth. There are
several factors:
1. Increases in hours of work
2. Increases in labor productivity
3. Technological advances
4. Quantity of capital
5. Education and training
6. Economies of scale and resource allocation
6.1. Economies of scale = the larger a business is, the more efficient
6.2. Resource allocation = workers have been moving to more productive jobs
(trading agriculture for manufacturing, for example)
The New Economy
Caused by significant increases in productivity.
1. The microchip and information technology
2. Start-up firms that are having increasing returns because of:
2.1. More specialized inputs = the bigger, the better machines they can buy
2.2. Spreading of development costs = the more they sell, the less production
costs them
2.3. Simultaneous consumption = for example, softwares can be used by
thousands at once
2.4. Network effects = the more popular a product is, the more people want it
2.5. Learning by doing = workers gain experience and practice = more efficient
3. Global competition
Antigrowth
Pro-growth
our economy is already wealthy, growth
only satisfies trivial wants by destroying
the environment
growth would increase all our
standards of living: people would have
better services and more recreation
we don’t need more money, we need to
distribute it better
this is never gonna happen, so growth
is the only option to reduce poverty
more growth = less time to enjoy what we
are earning by working
the loudest protests against
materialism are heard in the richest
nations
growth is not sustainable. the earth has
finite resources, the quicker we grow, the
quicker they are depleted
growth has allowed economies to find
ways of hurting the earth less
•
Glossary:
• Economic growth = increase in GDP or real output per capita
• Supply factors = changes in the physical and technical agents of production
• Demand factor = consumers must purchase what is produced or no economic growth
will occur
• Efficiency factor = using resources in the least costly way to produce what will be sold
the most.
• Labor productivity = real output per hour of work
• Labor-force participation rate = the percentage of people above working age in the
labor force.
• Growth accounting = the bookkeeping of the supply-side elements that contribute to
changes in GDP
• Infrastructure = highways, bridges, water systems, airports, schools, waste
treatment...
• Human capital = knowledge and skills that make a worker productive.
• Economies of scale = reductions in per-unit cost that result from increases in the size
of markets and firms.
• New economy = an economy with a higher projected trend rate of productivity growth
and therefore greater potential economic growth than before.
• Information technology = connects all parts of the world
• Start-up firms = a new firm focused on creating or producing a new product
• Increasing returns = when a firm’s output increases by more than the increase in its
inputs
• Network effects = increases in the value of the product to each user the more users
there are
• Learning by doing = achieving greater productivity and lower average total cost
through gains in knowledge and skill that accompany the repetition of a task.
Chapter 36
There are two economic perspectives:
Classical view
Keynesian view
created
1776, Adam Smith
1930s, John Maynard Keynes
policy
laissez-faire
laissez-faire leads to recessions. need
active govt
AS
vertical, only determinant of fullemployment output
horizontal because prices and wages
are downwardly inflexible
AD
Classical view
Keynesian view
only determinant of the price level.
Stays stable with a constant money
supply
unstable
prices and wages downwardly
flexible
need fiscal and monetary policy
Classical view of the economy:
Keynesian view of the economy:
What causes macroeconomic instability?
Mainstream
Monetarist
changes in inv.
AS shocks
Milton
Friedman
basic equation:
C+Ig+G+Xn
basic equation:
MV = PQ
Realbusinesscycle theory
Rational
expectations
theory (RET)
New Classical
Economists
changes in
technology,
resource
availability and
productivity
(changed in
LRAS)
A.K.A
coordination
failures.
People
anticipate what
is gonna
happen in the
market and act
accordingly
markets always
move towards
equilibrium
if V stable, changes in M = changes in PQ, or
nom. GDP
(monetarist) -->
the economy is
self-correcting
LR Phillips
Curve
focus on money supply
markets are competitive and provide stability
Monetary rule = M should grow by the amount real GDP is expected
to grow
Does the economy self-correct?
New Classical
Mainstream
monetarists or RETists
downward wage inflexibility
because of contracts, efficiency
wages, and insider-outsider
relationships
the economy self-corrects, policymakers should
do nothing and let it run its course
debate over whether it corrects slowly
(monetarists) or quickly (RETists)
RETists say price-level surprises are the only
thing that may take a while to correct because
they’re unanticipated
Rules or discretion?
Rules
Discretion
monetarists, RETists
monetary rule is flawed because velocity
is very unpredictable
in favor of monetary rule
do not think crowding out is a serious
problem
also favor inflation targeting
feel that fiscal policy is abused by
politicians and should be reserved for
special cases
oppose expansionary fiscal policy
because they say it crowds out private
investment
oppose requirements to balance budget
because it could exacerbate recessions
and inflation
macro stability has increased in recent
years, when policy has been widely used
Glossary:
• Classical view = the AS curve is vertical and the sole determinant of real output
• Keynesian view = product prices and wages are downwardly inflexible, so the AS
curve is horizontal
• Monetarism = focuses on the money supply, holds that markets are highly
competitive, and says this competitiveness gives the economy stability
• Equation of exchange = MV = PQ
• Velocity = average number of times per year a dollar is spent on goods and services
• Real-business-cycle theory = business fluctuations result from significant changes in
technology and resource availability
• Coordination failures = people fail to achieve a mutually beneficial equilibrium because
they lack a way to coordinate their actions
• Rational expectations theory = the idea that people expect changes to have a certain
effect on the economy and act accordingly
• New classical economics = holds that when the economy diverges from its fullemployment output, it will automatically return
• Price-level surprises = unanticipated changes in the price level
• Efficiency wage = minimizes labor costs by paying workers depending on how much
they produce, encouraging them to produce more
• Insider-outsider theory = outsiders may not be able to underbid existing wages
because employers may view the cost of hiring them as useless
• Monetary rule = fixed-rate expansion of the money supply regardless of circumstances
Chapter 37
Reasons to trade:
• More eff. production
• Specialization
• More goods and services
Types of goods:
1.Land-intensive
2.Labor-intensive
3.Capital-intensive
*Good because nations can find their niche
PP curve is now a line because we assume constant costs
Self-sufficient nation = on PP line
Nations that trade = on trading line (to the right of PP)
Absolute advantage = I can produce more than you
Comparative advantage = It costs me less in opportunity costs to produce this
A nation can expand its PP by:
-Improving the quantity and quality of its resources
-Technological progress
-Trade!!!
Pros
Cons
deters monopoly
military self-sufficiency (what if there’s a
war against a steel provider?)
more competition, innovation, choices
diversification for stability (need to
produce more than one thing in case
that industry collapses)
makes nations try to cooperate
Infant industry (protect till grown)
Strategic trade policy
Protection against dumping
Increased domestic employment
Cheap foreign labor
Equilibrium world price = where one nation’s export supply curve intersects another’s
import demand curve
Countries export to gain the means to import
Barriers to free trade:
I. Tariffs
A. Protective
B. Revenue
II. Quotas
III. Nontariff barriers
IV. Voluntary export restrictions
Impact:
1. Tariffs a. decline in consumption
b. increased domestic production
c. decline in imports
d. tariff revenue
e. less exports because there are less imports so there is less foreign currency
2. Quotas - same except no revenues
Glossary:
• Labor-intensive goods = require much skilled labor (laptops)
• Land-intensive goods = require much good land (corn)
• Capital-intensive goods = require a lot of capital (cars)
• Opportunity-cost ratio = the number of two products that can be produced with the
same resources
• Principle of comparative advantage = total output will be greatest when each good is
produced by the nation with the lowest opportunity cost for it.
• Terms of trade = exchange ratio at which two nations will trade
• Trading possibilities line = to the right of the PPline. Shows what nations could gain if
they specialized and traded
• Gains from trade = try to be a sassy scholar and use that brain of yours. Hint: it’s what
was gained from - you guessed it - trade.
• World price = price that equates the quantities supplied and demanded globally
• Domestic price = the price that would prevail in a closed economy
• Export supply curve = shows the amount producers will export at each world price.
Upsloping because there is a direct relationship between world prices and exports.
• Import demand curve = shows the amounts imported at world prices above the
domestic price. Downsloping because world prices and imports have an inverse
relationship.
• Equilibrium world price = occurs when one nations import demand curve intersects
another’s export supply curve
• Tariffs = when the government allows imports for a certain fee
• Revenue tariff = applied on goods not produced internally just to give the government
money
• Protective tariff = applied to shield domestic producers by putting foreigners at a
disadvantage
• Import quota = limit on how much of one product can be imported
• Non-tariff barrier = licensing requirements, bureaucratic red tape...
• Voluntary export restriction = foreign firms “voluntarily” agree to reduce exports in fear
that the government will apply something that will make them reduce them more
• Strategic trade policy = firms protected from foreign competition can grow more
quickly and be better.
• Dumping = selling excess goods in a foreign market at a price below cost
• Smoot-Hawley tariff act = its high tariffs caused a trade war and the Great Depression
• Trade adjustment assistance act = gives workers unemployed by international trade
special benefits like cash assistance for 78 weeks
• Offshoring = taking work away from domestic workers and giving it to foreigners
because they take smaller wages
• World Trade Organization = oversees trade agreements and rules on disputes
• Doha round = latest round of negotiations
Chapter 38
For international trade, one needs different national currencies. This problem is resolved
in foreign exchange markets that facilitate exports and imports.
When the US exports...
1. The foreign buyer figures out how much it has to pay in its currency and sends it to
the US seller
2. The US seller needs to be paid in dollars, so it gives the check to the bank, which
converts the amount into dollars and deposits the dollars in the seller’s account
3. The US bank deposits the foreign currency in its correspondent foreign bank
When the US imports...
1. The US buyer figures out how many dollars he must pay and buys that amount of
foreign currency at the bank.
2. The US buyer sends the check to the foreign seller, who then deposits it in his bank.
US exports create a foreign demand for dollars.
US imports reduce the demand for dollars.
In a way, a nation’s exports pay for its imports.
Demand and supply of a currency also arise from service transactions and the payment
of interest and dividends on foreign investments.
The Balance of Payments
Created by the US Commerce Department’s Bureau of Economic Analysis, shows flows
of inpayments to and outpayments from the US.
Balance of Payments
Find by
US goods exports
X
US goods imports
X
Balance on goods
GE-GI
US exports of services
X
US imports of services
X
Balance on services
SE-SI
Balance on goods and services
(GE+SE)-(GI+SI)
Net investment income
FP-USP
Net transfers
transfers between
US and the world
Balance on current account
ADD ALL
Capital account
Balance on capital account
FFD-FND
Financial account
Foreign purchases of assets in the US
X
Current Account
Capital and financial
account
Balance of Payments
Find by
US purchases of assets abroad
X
Balance on financial account
BAUS-BAF
Balance on capital and financial account
CA+FA
There are several types of exchange rates:
1. Pure exchange rates
a. Flexible- or floating-exchange-rate system
b. Fixed-exchange-rate system
Depreciation and Appreciation
When a currency depreciates, more of it is needed to buy another currency.
When a currency appreciates, less of it is needed to buy another currency.
Remember:
1. If the demand for a currency increases, it will appreciate. If demand decreases, it will
depreciate.
2. If the supply of a currency increases, it will depreciate. If supply decreases, it will
appreciate.
3. If a nation’s currency appreciates, some foreign currency depreciates relative to it.
Determinants of Exchange Rates:
1. Changes in tastes
2. Relative income changes
3. Relative price-level changes = purchasing-power-parity theory
4. Relative interest rates
5. Speculation = speculators are people who buy and sell currencies with an eye
toward reselling or repurchasing them at a profit
Flexible exchange rates = automatically adjust and eventually eliminate balance-ofpayments deficits or surpluses.
Disadvantages of flexible exchange rates:
1. Uncertainty and diminished trade
2. Terms-of-trade changes
3. Instability
Fixed Exchange rates = the problem is that fixing exchange rates cannot stop demand
and supply from changing, and governments will have to intervene whenever a shift
occurs to ensure the rate is maintained.
There are several ways to achieve this:
1. Use of reserves = currency interventions
2. Trade policies = tariffs or quotas to reduce imports and subsidies to increase exports
3. Exchange controls and rationing = objections to exchange controls are...
3.1. Distorted trade
3.2. Favoritism
3.3. Restricted choice
3.4. Black markets
4. Domestic macroeconomic adjustments = monetary and fiscal policy
International exchange-rate systems:
1. Gold standard = has the advantage of maintaining stable exchange rates and
correcting balance-of-payments deficits and surpluses automatically. However, its
critical drawback is that nations must accept inflation and recession. Collapsed
because of the worldwide Depression in the 30s because nations devaluated their
currencies.
2. Bretton Woods system = adjustable-peg system, wanted the advantages of the gold
system (fixed rates) but not the disadvantages (macro adjustments). The IMF was
created for this. Each nation had to define its currency in terms of gold and use their
official reserves to keep it stable. Ended when there were problems with the dollar.
There were three sources of needed currency:
2.1. Official reserves
2.2. Gold sales
2.3. IMF borrowing
3. Current system: Managed Float = managed floating exchange rates. Has worked
much better than expected.
Recent US trade deficits = rising because...
1. The US economy grew more quickly than its trading partners’, resulting in more
imports and less exports.
2. Trade deficits with China
3. Quick rise of the price of oil
4. Declining US saving rate
These trade deficits are good because American consumers have a higher standard of
living now, but they may not be able to consume that much in the future. They’re also
bad because the US technically owes foreigners.
Trade deficits are a mixed blessing.
Glossary:
• Balance of payments = sum of all the transactions that take place between a nation’s
residents and those of all foreign nations.
• Current account = shows US exports and imports of goods.
• Balance on goods and services = difference between US exports of goods and
services and US imports of goods and services.
• Trade deficit = unfavorable balance of trade (e<i)
• Trade surplus = favorable balance of trade (e>i)
• Balance on current account = the sum of all transactions in the current account
• Capital and financial account = consists of two separate accounts, the capital one and
the financial one
• Balance on capital and financial account = sum of the capital and financial account.
• Balance-of-payments deficits and surpluses = a deficit occurs when a nation must
draw on its official reserves to balance the capital and financial accounts with the
current account. A surplus occurs when a nation adds money to its official reserves to
balance the capital and financial accounts with the current account.
• Official reserves = foreign currencies, reserves held in the IMF, and stocks of gold.
• Flexible- or floating-exchange-rate system = demand and supply determine exchange
rates and in which no government intervention occurs.
• Fixed-exchange-rate system = governments determine exchange rates and make
necessary adjustments in their economies to maintain those rates.
• Purchasing power-parity theory = exchange rates equate the purchasing power of
various currencies - they adjust to match the ratios of the nations’ price levels.
• Currency interventions = manipulating the market through the use of official reserves
• Exchange controls = the government can require people to sell all they have of a
foreign currency to them and ration this among importers.
• Gold standard = each nation must define its currency in terms of gold, maintain a fixed
relationship between its stock of gold and its money supply, and allow gold to be freely
imported and exported.
• Devaluation = a deliberate action by government to reduce the value of its currency
• Bretton Woods system = sought to capture the advantages of the gold standard
without the disadvantages.
• International Monetary Fund = made the Bretton Woods system feasible and workable
• Managed floating exchange rates = exchange rates among major currencies are free
to float but governments occasionally intervene.
NOTE:
THIS IS THE FINAL REVIEW. I’M ASSUMING YOU KNOW A LOT OF
THIS STUFF ALREADY. GOOD LUCK, PEOPLE.