Macroeconomics Midterm #2

based on study guide this time

What is productivity?

The quantity of goods and services produced per unit of labor

• A country’s standard of living depends on its ability to produce goods & services

How do you calculate productivity?

Productivity = Y/L, or output/unit of labor
Y=real GDP

L=quantity of labor

example: if 10 workers produce 500 units:
500 ÷ 10 = 50 units per worker

Key determinants of productivity

Put each determinant (X) over L to calculate X per labor (X/L) (ex: Physical capital per labor→ K/L)

• Physical Capital (K)

  • ex: non-human assets: machinery, buildings, office computers, etc)

• Human Capital (H)

  • Experience that workers takes to a firm in the form of skills, ability, knowledge, interlligence, attitude, values, profesionalism, etc (training, education, etc)

• Natural Resources (N)

  • Inputs into production that nature provides (land, rivers, oil and mineral

    deposits)

• Technological knowledge (A)

  • Society’s understanding of the best ways to produce goods and services

  • Technology refers to the knowledge that allows producers to transform inputs into output. (not just tech stuff)

Human capital vs Physical capital

Human capital: The tools, machines, equipment, and buildings that workers use to produce goods and services.

• Example: A factory's machines or a photographer's camera.

The knowledge, skills, education, training, and experience that workers possess.

• Example: A worker who has been trained to operate complicated machinery.

Easy distinction:

Physical capital = tools workers use
Human capital = skills workers have

Constant return to scale (production function)

Changing all inputs by the same percentage causes output to change by that percentage.

• Doubling all inputs (multiplying each by 2) causes output to double:

  • 2Y = A × F(2L, 2K, 2H, 2N)

• Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10%:

  • 1.1Y = A × F(1.1L, 1.1K, 1.1H, 1.1N

What is diminishing return of capital?

Diminishing returns to capital means that as you add more physical capital while holding other inputs constant, the additional output from each additional unit of capital eventually decreases.

Example:

Imagine one worker in a factory:

• 1 machine → 10 units produced

• 2 machines → 18 units

• 3 machines → 24 units

• 4 machines → 28 units

Each additional machine adds less output than the previous machine.

More capital → more output, but eventually smaller increases in output

Catch-up Effect

Poorer countries can “catch up” to richer countries because they can get bigger gains from additional capital.

Foreign direct investment (FDI)

Capital investment that is owned and operated by a foreign entity

example: An American company builds and operates a factory in Mexico.

Foreign portfolio investment

Investment in foreign financial assets, such as stocks and bonds, without directly managing the foreign business.

Example: An American investor purchases shares in a Japanese company.

What is the trade-off between current consumption and future consumption when a country encourages saving?

Encouraging saving means sacrificing some current consumption. However, greater saving provides more funds for investment, increasing physical capital and potentially productivity and future consumption.

What is private saving, and how do you calculate it?

The income households have left after paying taxes and purchasing goods and services.

Y=GDP/income

T=taxes

C=consumption

What is public saving, and how do you calculate it?

The tax revenue the government has left after paying for government purchases.

T= Taxes

G=Government purchases

What is national saving, and how do you calculate it?

The total income remaining in an economy after consumption and government purchases.

What is the financial system?

• The system of financial markets and financial intermediaries through which borrowers (firms) acquire funds from savers (households)

• Financial Markets and financial intermediaries together comprise the financial system

Financial intermediaries

Institutions through which savers can indirectly provide funds to borrowers

• Banks

Banks

Primary role for banks

• Take in deposits from savers (small interest rate)

• Use these deposits to make loans to borrowers (charge a higher interest rate)

• banks earn profit from interest rate margin

• for banks to make profit, they must make more than they give

interest rate margins= i₁-i₂

Financial Markets

Financial institutions through which savers can directly provide funds to borrowers

The bond market

• A bond is a form of loan

The stock market

• A stock is a claim to partial ownership in a firm

How do liquidity, default risk, and taxes affect bond interest rates?

• Lower liquidity generally means higher interest rates.

• Higher default risk generally means higher interest rates.

• Taxable bonds generally need higher interest rates than comparable tax-exempt bonds.

Investors demand higher returns to compensate for reduced liquidity, increased risk, or additional taxes.

The bond market

• A bond is a form of loan

  • which specifies the amount borrowed, interest/coupon rate, maturity, etc.

• Issuers of bonds: debtors, people who take out loans

• Buyers of bonds: bond holders, creditors, money lenders

• Bonds can be issued not only by firms, but also state, local, and sovereign governments

• A bondholder (person who lends the money) can hold the bond until maturity, or can sell the bond at an earlier date to someone else

• Debt finance: sale of bonds to raise money

Parts of a bond

• Principal/face value/par value: the amount borrowed

  • a bond with $10,000 face value represents a $10,000 loan to the issuer ($10,000 of principal)

  • Face value/principal is the amount that bondholder expects to receive on the bond’s maturity date

• Date of maturity: The time at which the principal/loan will be repaid

• Rate of interest/coupon rate: that the borrower will pay periodically until the loan matures

• Bond issuer:

  • Issued by the federal government: U.S treasuries

  • Issued by the state and local government: municipal bonds

  • Issued by corporations: corporate bonds

Coupon/interest rate (bonds)

The borrower will pay periodically until the loan matures

Annual coupon rate=annual coupon rate/principal ($ borrowed) X100

How to read a bond

U.S. Treasuries (bonds)

Treasury bills: <1 year (also called T-bills) (lowest risk)

Treasury notes: 3-10 years

Treasury bonds: >10 years (highest risk)

bonds have higher interest rates to help compensate for higher risk

four characteristics of a bond

1. Term/term to maturity

2. Credit risk

3. Liquidity

4. tax treatment

Term/Term to Maturity (Bond characteristics)

Length of time until the bond matures

• Short terms or long terms

• If we look at U.S treasuries

  • Treasury bills: <1 year (also called T-bills) (lowest risk)

  • Treasury notes: 3-10 years

  • Treasury bonds: >10 years (highest risk)

  • Treasury bonds are riskier than T-bills because a lot can happen in 10-30 years (inflation, government changes, economic collapse potential, etc).

    • Bonds have higher interest rates to help compensate for higher risk

Credit risk (bond charecteristics)

Probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

• Such a failure to pay is called default

  • U.S. Treasuries are considered default-free

  • Risk premium: the spread between the interest rates on bonds with default risk and interest rates on (same maturity) Treasury bonds

• How to determine credit risk?

  • Credit rating agencies

Credit risk cont. (bonds charecteristics)

• Investment grade bonds: bonds with ratings of at least Baa (or BBB)

• Junk bonds (issued by financially shaky corporations) pay very high interest rates

  • ratings are below BBB or Baa

Liquidity (bond characteristics)

The relative ease with which an asset can be converted into cash

• U.S. Treasuries are more liquid than corporate bonds

  • Most bondholders are risk-averse

  • Number of buyers/sellers in a bond market

  • Corporate bondholders require higher compensation→ higher interest rates

Tax treatment (bond characteristics)

way the tax laws treat the interest earned on the bond

• interest on most bonds is taxable income

• Municipal bonds (issued by state and local government): are exempt from federal income tax

  • that’s why municipal bonds are popular with the rich

  • Holding everything else constant, municipal bonds have lower interest rates than U.S. Treasury bonds

The stock market

Another way to borrow money is issuing stocks

• Equity finance: sale of stock to raise money

• A share of stock: ownership in a firm

  • Therefore, it is a claim to some of the profits that the firm makes

  • Stocks pay dividends, not periodic interest payments

  • Stockholders are residual claimants

    • After firms earn revenue, bondholders get paid the predetermined interest payment first

    • Stockholders get paid after bondholders are paid

Debt financing

Raising money by borrowing, such as issuing bonds. The borrower must repay the money with interest.

Equity financing

Raising money by selling ownership shares in a company (stocks). Shareholders receive a share of the company's residual profits and value.

Stockholders are residual claimants. What does that mean?

• After firms earn revenue, bondholders get paid the predetermined interest payment first

• Stockholders get paid after bondholders are p

Who are bond buyers and bond sellers?

• Bond buyers (bondholders) are savers/lenders who provide money.

• Bond sellers (issuers) are borrowers who receive money and promise to repay it with interest.

What is the market for loanable funds?

A market that coordinates the supply of savings with the demand for investment funds through the interest rate.

Why does the demand curve for loanable funds slope downward?

Higher interest rates make borrowing more expensive, discouraging investment. Therefore, borrowers demand fewer loanable funds at higher interest rates.

Source of demand for loanable funds

Investment is the source of demand for loanable funds.

Why does the supply curve for loanable funds slope upward?

Higher interest rates provide greater rewards for saving, encouraging people to save more and supply more loanable funds.

The slope of the supply curve graph

The slope of demand curve graph

Source of supply for loanable funds

Saving is the supply for loanable funds.

How does a shift from an income tax to a consumption tax affect the market for loanable funds? (policy 1)

Moving from income tax to consumption tax increases the return to saving.

• The supply of loanable funds increases.

• A consumption tax increases the incentive to save because people are taxed only when they spend their income.

• The after-tax return to saving increases.

• The supply of loanable funds shifts right.

• Equilibrium interest rate decreases.

• Equilibrium quantity of loanable funds increases.

• Both saving and investment increase.

Remember: Saving incentives → Supply right → Interest rate ↓ → Investment ↑

How do investment tax incentives (such as reducing corporate taxes) affect the market for loanable funds? (policy 2)

• Lower corporate taxes encourage businesses to invest.

• The demand for loanable funds increases.

• The demand curve shifts right.

• Equilibrium interest rate increases.

• Equilibrium quantity of loanable funds increases.

• Both saving and investment increase.

Remember: Investment incentives → Demand right → Interest rate ↑ → Investment ↑

How does a government budget deficit affect the market for loanable funds? (policy 3.1)

• A budget deficit occurs when government spending exceeds tax revenue (G > T).

• Public saving decreases.

• National saving decreases.

• The supply of loanable funds shifts left.

• Equilibrium interest rate increases.

• Equilibrium quantity of loanable funds decreases.

• Private investment decreases due to crowding out.

Remember: Budget deficit → Supply left → Interest rate ↑ → Investment ↓

How does a government budget surplus affect the market for loanable funds? (policy 3.2)

• A budget surplus occurs when tax revenue exceeds government spending (T > G).

• Public saving increases.

• National saving increases.

• The supply of loanable funds shifts right.

• Equilibrium interest rate decreases.

• Equilibrium quantity of loanable funds increases.

• Private investment increases.

Remember: Budget surplus → Supply right → Interest rate ↓ → Investment ↑

What happens when the government runs a budget deficit?

Public saving decreases, reducing national saving and the supply of loanable funds. This increases the equilibrium interest rate and decreases investment.

What happens when the government runs a budget surplus?

Public saving increases, increasing national saving and the supply of loanable funds. This decreases the equilibrium interest rate and encourages investment.

What is the crowding-out effect?

A fall in firms’ investment due to government spending.

What happens when taxes encourage people to consume more and save less?

National saving decreases, shifting the supply of loanable funds left. Interest rates increase and investment decreases.

Who is considered employed by the Bureau of Labor Statistics (BLS)?

• Someone who worked for pay or profit during the reference week, even if only part-time.

• Certain unpaid family workers who work at least 15 hours per week in a family business also count as employed.

Who is considered unemployed by the BLS?

• Does not currently have a job.

• Has actively searched for work during the previous four weeks.

• Is available to work.

Who is considered outside the labor force?

People who are neither employed nor actively looking for work.

Examples: retired people, full-time students not seeking work, and discouraged workers.

How do you calculate the labor force?

Labor force= Employed + Unemployed

How do you calculate the unemployment rate (u-rate)?

How do you calculate the labor force partcipation rate (LFPR)?

What is a discouraged worker?

Discouraged workers would like to work but have given up looking

for jobs. Classified as “not in the labor force” rather than “unemployed”

What is the natural rate of unemployment?

Natural rate of unemployment refers to the unemployment that would occur in an economy if there were no cyclical unemployment.

What types of unemployment are included in the natural rate of unemployment?

• Frictional unemployment

• Structural unemployment

What is frictional unemployment?

Short-term unemployment that occurs when people are searching for jobs or transitioning between jobs.

Examples:

• Recent college graduates searching for jobs.

• Workers voluntarily leaving jobs to find better opportunities.

• People moving to new locations and searching for employment.

What is structural unemployment?

A persistent mismatch between job skills or attributes of workers and the skills/requirements of the jobs

Examples:

• Technological changes eliminating certain jobs.

• Minimum-wage laws.

• Unions negotiating wages above equilibrium.

• Efficiency wages.

What is cyclical unemployment?

Unemployment caused by a recession

• Insufficient demand for goods/services creates insufficient demand

for labor

• For example, Ford laid off workers during the recession of 2007-2009.

What is seasonal unemployment?

Unemployment is connected to the seasonal factors not business cycle

• Seasonal factors: weather, fluctuations in demand for some

products/services during different time of the year (like christmas tree farm employees)

What is collective bargaining?

The process through which labor unions and employers negotiate wages, benefits, and working conditions.

What is the difference between frictional and structural unemployment?

• Frictional: Workers are searching for jobs or transitioning between jobs.

• Structural: Workers' skills or qualifications do not match available jobs, or wages are kept above equilibrium.

What factors could cause frictional unemployment?

The time it takes for workers to find jobs that match their skills, qualifications, and preferences.

Examples:

• People voluntarily leaving jobs to find better opportunities.

• Recent college graduates searching for their first jobs.

• Workers who have been fired and are searching for new jobs.

• Workers moving to a new location and searching for employment.

• Unemployment insurance

How does unemployment insurance (UI) affect frictional unemployment?

Unemployment insurance can increase frictional unemployment because:

• Workers receive temporary income while unemployed.

• They have less incentive to accept unattractive job offers immediately.

• They may spend more time searching for a job that better matches their skills and preferences.

What factors could cause structural unemployment?

A persistent mismatch between workers' skills or qualifications and the requirements of available jobs.

Causes include:

• Technological advancements that make certain skills outdated.

• Foreign competition that reduces demand for certain industries' workers.

• Workers lacking the necessary skills or education for available jobs.

• Minimum-wage laws.

• Labor unions.

• Efficiency wages.

What is a barter economy?

Exchange one good or service for another

• Requires a double coincidence of wants: unlikely occurrence that two people

each have a good the other wants.

• Waste of resources: people spend time searching for others to trade with

Example: Trading a haircut for plumbing services.

What is M1 money stock?

A measure of the money supply consisting primarily of currency held by the public and liquid checkable deposits. In the traditional textbook definition, it also includes traveler's checks.

How to calculate M1 money supply?

M1 money supply = currency + demand deposits + other liquid deposits

Are credit cards considered money?

No. Credit cards are not money; they are a method of borrowing. They allow people to make purchases using borrowed funds that must be repaid later.

Three functions of money

1. Medium of exchange: Used to purchase goods and services.

2. A unit of account: Used to measure and compare prices.

3. A store of value: Allows people to transfer purchasing power into the future.

Which two functions are unique to money?

Medium of exchange and unit of account

Other assets, such as stocks and bonds, can also function as stores of value, so they aren’t unique to money.

Medium of exchange

An Item that buyers give to sellers when they want to purchase goods and services

You can use money to buy stuff!

Eliminates the need for “double coincidence of wants” found with bartering/trading, which can make it harder to acquire goods & services you may want or need

Easy way to remember: BUY (use money to purchase things).

Unit of Account

A standard measure used to express the prices of goods and services.

Easy way to remember: PRICE (use money to measure the value of things).

How does money function as a unit of account?

It gives each good a single price rather than many exchange prices.

In a barter system, each good has many prices:

• A cow = 2 plows = 20 bushels of wheat = 6 axes.

What is a store of value?

Item that people can use to transfer purchasing power from the present to the future.

Being able to “store” value means we have the ability to consume today OR tomorrow…

examples:

• Stocks & bonds

• real estate

• precious metals

• Stable national currencies (like the U.S. dollar)

Easy way to remember: SAVE (use money to transfer purchasing power into the future).

Fiat Money

Money that has no intrinsic value and is accepted because of government designation and public confidence.

Example: U.S. paper currency.

Commodity money

Money that has intrinsic value because the material itself has value.

Examples: Gold, silver, and tobacco.

The Federal Reserve System (Fed)

The central bank of the United States, established in 1913.

Central bank

• An institution designed to oversee the banking system and regulate the

quantity of money in the economy (control money supply)

What are the three key entities of the Federal Reserve System (Fed)?

1. Board of Governors (7 members)

2. 12 regional Federal Reserve Banks.

3. Federal Open Market Committee (FOMC).

When was the Fed established?

1913

What are the Fed’s jobs?

BIGGEST JOB: Control the money supply: the quantity of money available in the economy

• Conducting the nation’s monetary policy

  • The Fed conducts monetary policy, NOT fiscal policy

• helping maintain the stability of the financial system

• Supervising and regulating financial institutions

• Fostering payment and settlement system safety and effiency

• Promoting consumer protection and community development

Does the Fed conduct monetary policy? Does the Fed conduct fiscal policy?

The Fed conducts monetary policy, which involves controlling the money supply and influencing interest rates, NOT fiscal policy

How many members are in the Board of Governors?

7 members, each serving a 14-year term.

How many regional Federal Reserve Banks are there?

There are 12 regional Federal Reserve Banks located around the U.S

The Federal Open Market Committee, FOMC

FOMC: The committee responsible for making decisions about open market operations and setting the federal funds target rate.

• All 7 members of the Board of Governor

• And 5 of the 12 regional bank presidents

• All 12 regional presidents attend each FOMC meeting, but only 5 get to vote

What is a fractional reserve banking system?

A banking system in which banks keep a fraction of deposits as reserves and use the rest to make loans.

How does money supply change under a fractional reserve banking system?

The money supply increases because banks lend out some of their deposits.

When a bank makes a loan, the borrower receives money while the original depositor still has money in their bank account. This creates additional deposits and increases the money supply.

How does money supply change under a 100% reserve banking system?

The money supply does not increase.

Banks hold 100% of deposits as reserves and make no loans. Therefore, banks do not create additional money.

If someone deposits $100 in currency into a bank, how does the bank's balance sheet change if it takes no action with the money?

Both the bank's assets and liabilities increase by $100.

• Assets: Reserves increase by $100.

• Liabilities: Deposits increase by $100.

The bank holds the entire $100 as reserves and makes no loans.

What are bank reserves?

Money that banks keep available for depositors, held as a combination of:

• Cash in the bank's vault.

• Deposits held at the Federal Reserve.

What are required reserves?

The minimum amount of reserves that banks are legally required to hold, based on their deposits.

What are excess reserves?

Reserves that banks hold above the legally required minimum.

What is the reserve ratio (R)?

=fraction of deposits that banks hold as required reserves

=total required reserves as a percentage of total deposits

What is the relationship between required reserves and excess reserves?

Total reserves = Required reserves + Excess reserves.

What is the money multiplier (simple deposit multiplier)?

The amount by which an initial deposit can potentially increase the total amount of deposits in the banking system.

Where R is the required reserve ratio expressed as a decimal.

How do you calculate the money multiplier if the required reserve ratio is 10%?

If the required reserve ratio is 20%, what is the money multiplier?

How does an increase in the required reserve ratio affect the money multiplier and money supply?

An increase in the required reserve ratio:

• Decreases the money multiplier.

• Requires banks to hold more reserves.

• Reduces the amount banks can lend.

• Decreases the potential money supply.