Exam Study Guide

What are the four phases of the cycle?

Expansion, Peak, Contraction, Trough

What happens to output, employment, money, prices, wages, and interest rates in each phase of the cycle?

During the upturn, output, prices, and employment rose. During the downturn, output, prices, and employment fall

What triggers a downturn?

There is no demand for New Capital in the capital goods sector once full employment and full capacity utilization are reacheed

What is the newspaper definition of a recession?

Two successive quarters of negative real growth

What accounts are used when we measure Gross Domestic Product by the Expenditures Method?

Consumption, Gross Private Investment, Government Spending, Net Exports

What is the difference between Gross Domestic Product and Net Domestic Product? - why do we make this distinction? (Capital Consumption Allowance, or depreciation)

NDP is equal to GDP minus consumption of fixed capital

1. What additional adjustments are made to derive Disposable Income from Gross Domestic Product? (Repatriation of earnings, intertemporal adjustments, removal of income taxes)

is the total income the consumer sector has at its disposal after personal income taxes

1. What is the difference between nominal GDP and real GDP?

Real GDP takes inflation into account and Nominal GDP does not

1. Are stocks and bonds included in GDP?

No

1. Calculate a GDP growth rate, either nominal or real, given GDP in two successive years

(GDP2 - GDP1) / GDP1

1. What is the Labor Force Participation Rate? (Civilian Labor Force/Population)

Labor Force / Total Population - Labor Force Participation Rate (x100)

1. What is the foundational requirement for being counted as an unemployed person? 

(Membership in the Civilian Labor Force)

You must be 16 or older, holding or seeking a job, and not in the military or jail

1. Who is helped and hurt by inflation?

Inflation hurts those with large amounts of cash and workers with fixed wages. Inflation benefits those with debt

money supply have to do with inflation?

If the money supply is increased, inflation may occur

1. Why and how do we use a price index? (it aggregates individual prices into one general price level, allows us to deflate nominal values to real values, allows us to calculate the annual inflation rate)

takes prices from similar products and compiles them into one value. This allows for the calculation of inflation and deflates nominal values to real values

1. What is the Capital Utilization Rate? Percentage of physical capital actively used in production.

Actual Output / Maximum Possible Output

1. Kinds of Unemployment

Frictional - moving between jobs, Cyclical - due to recession, Structural - obsolete skills or changes in global demand

1. Calculate an unemployment rate

(Unemployed / Labor Force) x 100 = Unemployment Rate

1. What is the National Income Identity? 

Y = C + Ig + G + Xn

GDI = Consumption + Gross Investment + Government Spending + Net Exports (Exports - Imports)

1. What is the Consumption Function?

Shows demand as a function of disposable income; Consumption x Income [C(Y)]

1. What is the Savings Function?

Shows saving as a function of disposable income; Savings x Income [S(V)]

1. What is the Investment Function?

function of expected profits, given the interest rate on borrowed money I(πe|r); not functionally dependent on income

1. What is included in our measure of Gross Investment? (Buildings and Equipment, New Residential Housing, Changes in Inventory from the previous year)

Gross Investment consists of government investments in fixed assets, production of fixed assets, and net purchases of fixed assets

1. When does a Government budget deficit occur?

when the government is spending more money than they have in revenue

1. When does a Government budget surplus occur?

when government spending is below the revenue

1. What events will shift the supply side in this market? (change in Savings, change in Federal Reserve policy, change in inflationary expectations)

A decrease in interest rate will cause demand in the market for loanable funds to increase

1. How will the nominal interest rate change with a left shift in supply? With a right shift?

A left shift in supply causes the interest rate to increase, and a right shift causes the interest rate to decrease

1. What events will shift the demand side in this market? (change in demand for physical capital, change in government budget, change in debt-financed consumption, change in inflationary expectations)

caused by businesses wanting more capital and expected inflation. A decrease can be caused when government deficits are reduced and consumers pay off credit card balances.

1. How will the nominal interest rate change with a left shift in demand? With a right shift?

will lower the interest rate, will increase the interest rate

1. What is the relationship between the real interest rate and the inflation rate? (Fisher Effect)

Real Interest Rate = Nominal Interest Rate (before inflation) - inflation rate

1. What is government crowd-out? When does it happen, i.e. when can government safely borrow without being in competition with private sector consumers and investors?

When the government competes with the private sector for a scarce resource, crowd-out occurs

Fiscal Multipliers. A fiscal multiplier measures the change in GDP that comes from a change in government spending

1. What is the Marginal Propensity to Consume (MPC, or c')?

MPC is the proportion of a raise that is spent on goods and services instead of being saved

1. What is the Marginal Propensity to Save (MPS or s')?

MPC is the proportion of a raise that is saved instead of spent on goods and services

1. What is the arithmetic relationship between the MPC and MPS?

0 <MPC < 1; 0 < MPS < 1; MPC + MPS = 1

1. What is the formula for the simple multiplier?

Reciprocal of savings rate; 1 / s'

1. ∆Y given ∆G and either the MPC or MPS, using the simple multiplier (no tax multipliers)

Change in Income = Change in Government Spending ( 1 / s')

1. How is Potential GDP determined?

Growth of Labor Force x Growth in Productivity = Growth for Potential GDP

1. What is the Natural Rate of Unemployment?

(Frictionally Unemployed / Structurally Unemployed) / Labor Force (x100)

1. How do we measure Aggregate Demand?

Consumption + Investment + Government Spending + Net Exports (C + Ig + G + Xn)

1. How does a change in wealth change the equilibrium? (Which curve is affected? How is it affected?)

shifts the aggregate demand curve to the right, and a decrease in wealth shifts the aggregate demand curve to the left

1. How does a change in taxation change the equilibrium? (Which curve is affected? How is it affected?)

An increase in taxation will shift the aggregate demand curve to the left, and tax cuts will shift the demand curve to the right

1. How does a change in labor or capital productivity change the equilibrium? (Which curve is affected? How is it affected?)

An increase in productivity will shift the aggregate supply curve to the right, and a decrease in productivity will shift the supply curve to the left

1. What are the two tools available to the government as fiscal policy?

Spending and Taxes

1. In what phase of the business cycle should government deficit spend to create a positive change in GDP? (recession, or early in the upturn) What economic indicator is at stake? (unemployment) How does the government create a budget deficit for this purpose? (increase spending or reduce taxes or both)

The government should deficit spend around the end of the recession / early upturn. Unemployment is at stake. To do this, the government can increase spending or reduce taxes

1. In what phase of the business cycle should government begin to run a surplus in order to slow down the growth of GDP? What economic indicator is at stake? How does government create a budget surplus for this purpose?

around the peak / end of acceleration. Inflation is at stake. The government can reduce spending or raise taxes

1. For a given increase in GDP (∆Y) will an increase in spending or a cut in taxes create a larger deficit?

Cut in taxes

1. What is fractional reserve banking?

allows banks to only keep a certain fraction of bank deposits for withdraw

1. What are some of the safeguards needed in a fractional reserve banking system?

Fractional Reserve Banking requires adequate reserve requirements, deposit insurance, transparent accounting rules, security for loans such as collateral requirements and rules against self dealing by bankers

1. What are the three main roles of the Federal Reserve System?

to be the central monetary authority for the country, the banker for the banks, and the banker for the US government

1. What are the three main powers of the Federal Reserve Bank?

setting the discount rate, setting the required reserve ratio, and performing open market operations

1. Who can have a checking account with the Federal Reserve Bank?

Only the US Government

1. Recognize a description of each of the power of the Fed.

Setting the discount rate involves the interest changed to all commercial banks. The requiered reserve ratio involves how much reserve money banks must keep, and open market operation involves buying and selling stocks by the Fed

1. What are the two policy targets of the Federal Reserve Bank?

The current monetary targets are the Federal Funds Overnight Rate and M2

1. What is the difference between the discount rate and the Federal Funds Overnight Rate?

is the rate charged to banks on loans from the Fed, is the rate charged to banks on loans from each other

1. What assets are bought and sold in an Open Market Operation?

Government Bonds

1. What is transactions demand for money?

Medium of Exchange

1. What is asset demand for money?

Asset Demand for Money involves the amount of money people want to hold, involving factors like interest rates

1. How do we measure the liquidity of the banking system?

Bank liquidity is measured by using non-borrowed excess reserves

1. Should the Federal Reserve buy or sells bonds to increase the money supply? To decrease the money supply?

the Fed should buy bonds. they should sell bonds

1. How will the nominal interest rate change if money supply is increased? Decreased?

If the money supply is increased, the nominal interest rate is increased because of its relationship with inflation. If the money supply is decreased, the interest rate is decreased

1. What is the general rule for increases in the money supply if we want to avoid inflation?

To avoid inflation, money must increase at the same rate as GDP

1. When in the business cycle should the Fed increase the money supply?

The Fed should increase money supply during the upturn to meet increasing transactions demand

1. When in the business cycle should the Fed decrease the money supply? (during the downturn, to match falling transactions demand)

to match the falling transactions demand

1. ∆M given ∆B and the required reserve ratio

M = Money Supply, B = Bonds, R = .1

1. When in the business cycle do banks reduce their excess reserves? Increase their excess reserves?

reduce reserves during the Upturn/Peak and increase them during the Downturn/Trough

1. Why does the Fed sometimes increase the money supply at the beginning of a downturn/recession? Who is the target of that policy? (they do it to lower nominal interest rate, investors are the target)

The Fed increases the money supply at the beginning of a downturn to lower the nominal interest rate. The target of this policy is investors

1. Recognize the Equation of Exchange: MV = PQ

M = Money Supply, V = Velocity of Money, P - General Price Level, Q = Quantity Output

1. What is the velocity of money? When in the business cycle does it increase? Decrease?

Velocity of Money is how often a dollar changes hands during a period of measurement. It increases during the upturn and decreases during the downturn

1. What is the relationship between money velocity and bank liquidity?

The banks will adjust how much money they lend out based on the money velocity; if the velocity is higher, they will lend out less, and if velocity is lower they will lend out more

1. Why is monetary policy usually ineffective in a deep recession?

, the banks are unwilling to lend and the investors do not want to take on any loans

1. What is the equation that governs the IBoP? (Current Accounts + Financial Accounts = 0)

Current (flow) accounts + Financial (stock) accounts = 0

1. What is the largest account in the Current Accounts?

Merchandise Trade

1. What is the "balancing account" in the Financial Accounts? (Change in US Reserve Assets Account)

Balancing Account is the change is the US Reserve Assets Account

1. What is a trade surplus?

A trade surplus occurs when a country has more exports than imports

1. What is a trade deficit?

occurs when a country has more imports than exports

1. What is happening to the buying power of a currency when it appreciates?

When a currency appreciates, buying power increases

1. What is happening to the buying power of a currency when it depreciates?

When a currency depreciates, buying power decreases

1. What market changes would cause US currency to appreciate?

Market changes causing appreciation could include low inflation relative to trading partners, high productivity relative to trading partners, Federal Government or Federal Reserve bank actions that causer the domestic interest rate to rise, and a positive change in the US Reserve Assets Account

1. What market changes would cause US currency to depreciate? (high inflation relative to trading partners, low productivity relative to trading partners, Federal Government or Federal Reserve Bank actions that cause the domestic interest rate to fall, a negative change in the US Reserve Assets Account)

could include high inflation relative to trading partners, low productivity relative to trading partners, Federal Government or Federal Reserve Bank actions that cause the domestic interest rate to fall, a negative change in the US Reserve Assets Account