ECON201 Final Exam v2

Economics

The study of how individuals, firms, and governments make choices under scarcity.

Scarcity

The idea that resources are limited while wants are unlimited.

Opportunity Cost

The value of the next best alternative given up when a choice is made.

Trade-off

A situation in which getting more of one thing requires giving up some of another thing.

Factors of Production

The resources used to produce goods and services: land, labor, capital, and entrepreneurship.

Microeconomics

The study of individual households, firms, and markets, and how they make decisions.

Macroeconomics

The study of the economy as a whole, including topics like inflation, unemployment, and economic growth.

Circular Flow Model

A simplified model showing how money, goods, and services flow between households, firms, and the government.

Demand

The quantity of a good or service consumers are willing and able to buy at different prices.

Supply

The quantity of a good or service producers are willing and able to sell at different prices.

Market Equilibrium

The point where quantity demanded equals quantity supplied.

Shortage

A situation in which quantity demanded is greater than quantity supplied.

Surplus

A situation in which quantity supplied is greater than quantity demanded.

Gross Domestic Product (GDP)

The total market value of all final goods and services produced within a country in a given period.

Real GDP

GDP measured using constant prices to remove the effects of inflation.

Nominal GDP

GDP measured using current prices.

Inflation

A sustained increase in the overall price level.

Deflation

A sustained decrease in the overall price level.

Unemployment Rate

The percentage of the labor force that is jobless and actively seeking work.

Business Cycle

The recurring pattern of expansion and contraction in economic activity over time.

Recession

A significant decline in economic activity, typically marked by falling real GDP, lasting more than a few months.

Aggregate Expenditure Model

A macroeconomic model focusing on the short-run relationship between total spending and real GDP, assuming the price level is constant.

Aggregate Output (Y)

The amount produced in the economy, or real GDP.

Planned Aggregate Expenditure (AE)

The amount people, firms, governments, and foreigners plan to spend on output.

Equilibrium in AE Model

The economy is in equilibrium when planned aggregate expenditure equals output, or AE = Y.

Aggregate Expenditure (AE) Formula

AE = C + I + G + NX.

Consumption (C)

Spending by households on goods and services.

Planned Investment (I)

Planned spending by firms on capital goods and by households on new homes.

Government Purchases (G)

Spending by governments on goods and services.

Net Exports (NX)

Exports minus imports.

Why AE differs from GDP in the model

The model uses planned investment, while GDP uses actual investment.

Inventories

Goods that have been produced but not yet sold.

Planned Investment vs Actual Investment

Planned investment equals actual investment minus unplanned changes in inventories.

Macroeconomic Equilibrium in AE Model

Occurs when planned investment equals actual investment, so there is no unplanned change in inventories.

Current Disposable Income

Personal income minus personal income taxes plus government transfer payments.

Transfer Payments

Government payments to households that are not made in exchange for goods or services, such as Social Security.

Main determinant of consumption

Current disposable income is the most important determinant of consumption spending.

Household Wealth

Assets minus liabilities; greater wealth usually increases consumption.

Expected Future Income

If people expect higher future income, they tend to spend more today.

Consumption Smoothing

The tendency of people to keep consumption relatively stable over time.

Effect of higher price level on consumption

A higher price level reduces the real value of wealth and lowers consumption.

Effect of higher interest rates on consumption

Higher real interest rates encourage saving and reduce consumption, especially of durable goods.

Consumption Function

The relationship between disposable income and consumption spending.

MPC

Marginal propensity to consume, or the fraction of an additional dollar of income that is spent on consumption.

MPC Formula

MPC = change in consumption divided by change in income.

Example MPC

If consumption rises by 1500 and income rises by 2000, MPC = 0.75.

Saving

The part of disposable income that is not consumed.

Income identity with saving

Y = C + S + T.

MPS

Marginal propensity to save, or the fraction of an additional dollar of income that is saved.

MPS Formula

MPS = change in saving divided by change in income.

Relationship between MPC and MPS

MPC + MPS = 1.

Example MPS

If MPC = 0.75, then MPS = 0.25.

Determinants of planned investment

Expected future profitability, interest rates, taxes, and cash flow.

Effect of higher interest rates on investment

Higher interest rates reduce investment spending because borrowing becomes more expensive.

Effect of high corporate taxes on investment

High corporate taxes reduce both funds available for reinvestment and incentives to invest.

Cash Flow and Investment

Firms with higher cash flow are usually more able to invest.

Determinants of net exports

U.S. price level relative to other countries, growth rates at home and abroad, and the exchange rate.

45-Degree Line in AE Model

Shows points where planned expenditure equals real GDP.

Why only points on 45-degree line can be equilibrium

Because equilibrium requires AE = Y.

If AE > Y

Inventories fall unexpectedly, signaling firms to increase production.

If AE < Y

Inventories rise unexpectedly, signaling firms to reduce production.

Potential GDP

The maximum output an economy can produce with full employment of labor, capital, technology, and institutions.

Recessionary Gap in AE Model

Occurs when equilibrium output is below potential GDP.

Policy response to recessionary gap in AE model

Shift AE upward with higher government spending or lower taxes.

Inflationary Gap in AE Model

Occurs when equilibrium output is above potential GDP.

Policy response to inflationary gap in AE model

Shift AE downward with lower government spending or higher taxes.

Autonomous Expenditures

Spending components that do not depend on the current level of GDP, such as planned investment, government purchases, and net exports.

Multiplier Effect

A small change in autonomous spending causes a larger change in equilibrium real GDP.

Why the multiplier happens

One person's spending becomes another person's income, which causes additional rounds of spending.

Multiplier Formula

Multiplier = 1 / (1 - MPC).

Example multiplier

If MPC = 0.75, the multiplier is 4.

Example of multiplier effect

A 100 increase in autonomous spending with a multiplier of 4 raises equilibrium GDP by 400.

Multiplier in reverse

A decrease in autonomous spending causes an even larger decrease in equilibrium GDP.

Why a larger MPC means a larger multiplier

Because households spend more of each extra dollar, creating stronger follow-on spending.

Aggregate Demand (AD) Curve

A curve showing the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

Short-Run Aggregate Supply (SRAS) Curve

A curve showing the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Long-Run Aggregate Supply (LRAS) Curve

A curve showing the relationship in the long run between the price level and the quantity of real GDP supplied.

Short-run macroeconomic equilibrium

Occurs where AD and SRAS intersect.

Why AD slopes downward

A lower price level increases real GDP demanded, while a higher price level decreases real GDP demanded.

Three reasons AD slopes downward

Wealth effect, interest-rate effect, and international-trade effect.

Wealth Effect

When the price level rises, the real value of household wealth falls, reducing consumption.

Interest-Rate Effect

When the price level rises, demand for money rises, interest rates rise, and investment falls.

International-Trade Effect

When domestic prices rise, exports fall and imports rise, reducing net exports.

Movement along AD

A change in the price level causes a movement along the AD curve.

Shift in AD

A change in any non-price-level factor, such as policy or expectations, shifts the AD curve.

Factors that shift AD

Monetary policy, fiscal policy, expectations, foreign income, and exchange rates.

Expansionary monetary policy effect on AD

Lower interest rates increase investment, consumption, and net exports, shifting AD right.

Contractionary monetary policy effect on AD

Higher interest rates reduce investment, consumption, and net exports, shifting AD left.

Expansionary fiscal policy effect on AD

Higher government spending or lower taxes shifts AD right.

Contractionary fiscal policy effect on AD

Lower government spending or higher taxes shifts AD left.

Expectations and AD

If households or firms become more optimistic, consumption or investment rises and AD shifts right.

Foreign GDP and AD

If foreign income rises, foreigners buy more domestic exports and AD shifts right.

Exchange rate and AD

If the domestic currency appreciates, exports fall and imports rise, shifting AD left.

Aggregate Supply

The total quantity of goods and services that firms are willing and able to supply.

Why LRAS is vertical

LRAS depends on labor, capital, technology, and institutions, not the price level.

Potential or full-employment GDP

The level of output represented by the LRAS curve.

Why SRAS slopes upward

In the short run, output prices can rise faster than some input prices, making firms willing to produce more.

Sticky wages and prices

Wages and prices that do not adjust quickly to changes in the economy.

Menu Costs

The costs firms face when changing prices.

Movement along SRAS

A change in the price level causes movement along the SRAS curve.