ECO 303 Study Guide

What does macroeconomics study?

Aggregate economic behavior, including growth, employment, business cycles, inflation, policy, trade, and exchange rates.

Why is productivity growth important?

It is the main source of sustained increases in real output per person and long-run living standards.

How does U.S. unemployment usually behave over time?

It has little long-run trend and is mostly cyclical, rising sharply during recessions.

What is a business cycle?

A short-run fluctuation in economic activity, including expansions and recessions, usually visible in output and employment.

What does GDP measure?

The market value of newly produced final goods and services within a country during a given period.

What are the three equivalent approaches to measuring GDP?

The product approach, income approach, and expenditure approach.

What is value added?

The value of a firm's output minus the value of intermediate goods used to produce it; using value added prevents double counting.

What is the GDP expenditure identity?

Y = C + I + G + (X − M), where net exports equal exports minus imports.

What is included in consumption, C?

Household spending on durable goods, nondurable goods, and services.

What is included in gross private investment, I?

Nonresidential investment, residential investment, and changes in inventories.

Why are government transfer payments excluded from G?

Transfers redistribute income but are not direct government purchases of newly produced goods or services.

What is the difference between GDP and GNP?

GDP measures production within a country's borders; GNP measures production by factors owned by that country's residents.

What is the difference between nominal and real GDP?

Nominal GDP uses current prices; real GDP adjusts for changes in the price level to measure changes in actual output.

How is real GDP calculated from nominal GDP?

Real GDP = Nominal GDP ÷ GDP deflator, when the deflator is expressed as an index relative to the base year.

What does the CPI measure, and why may it overstate inflation?

The CPI measures the cost of a fixed consumer basket; it may overstate inflation because of substitution, quality improvements, and new goods.

What is the inflation-rate formula?

π(t+1) = [P(t+1) − P(t)] ÷ P(t). A negative result is deflation.

What is a representative household?

A simplified household used to stand in for the aggregate behavior of households in the economy.

What are the household's two main choice variables?

Consumption, c, and leisure, l; labor supplied is the time not used for leisure.

What is the household time constraint?

N = h − l: labor supplied equals total available time minus leisure.

What is the household budget constraint?

c = Nw + π − T = (h − l)w + π − T.

Why is the real wage the opportunity cost of leisure?

One more hour of leisure means giving up one hour of work and therefore w units of consumption.

What does an indifference curve show?

Combinations of consumption and leisure that give the household the same level of utility.

Why do indifference curves slope downward and tend to be convex?

More leisure requires less consumption to keep utility constant, and diminishing marginal utility makes the willingness to trade change along the curve.

What is MRS(l,c)?

The marginal rate of substitution of leisure for consumption: the amount of consumption the household is willing to give up for one more unit of leisure.

What condition holds at an interior household optimum?

MRS(l,c) = w; the household's subjective tradeoff equals the market tradeoff.

When does non-participation occur?

When MRS(l,c) > w at the full-leisure corner, so the household values leisure more than the wage offered.

What is a normal good?

A good whose desired quantity rises when income rises; the model assumes both consumption and leisure are normal goods.

How does higher non-labor income affect labor supply?

It creates a pure income effect: consumption and leisure rise, so labor supply falls.

What is the substitution effect of a higher wage?

Leisure becomes more expensive, so the household chooses less leisure and supplies more labor.

What is the income effect of a higher wage?

The household becomes richer and may demand more leisure, reducing labor supply.

Why is an individual's labor-supply response to a wage increase ambiguous?

The substitution effect raises labor supply while the income effect lowers it; the stronger effect determines the result.

What is the reservation wage?

The lowest wage at which a household is willing to work.

What are the intensive and extensive margins of labor supply?

The intensive margin is hours worked by current workers; the extensive margin is entry into or exit from the labor force.

Why is aggregate labor supply usually upward sloping?

Across households, substitution effects and labor-force entry generally dominate, so higher wages increase total labor supplied.

What is a utility function?

A function u(c,l) that assigns a utility level to each consumption-leisure bundle; indifference curves are its level sets.

What are u_c and u_l?

u_c = ∂u/∂c is marginal utility of consumption; u_l = ∂u/∂l is marginal utility of leisure.

How is the MRS of leisure for consumption calculated?

MRS(l,c) = u_l/u_c.

What does diminishing marginal utility mean?

As consumption or leisure increases, the extra utility from another unit falls: u_cc < 0 and u_ll < 0.

What problem does the household solve analytically?

Maximize u(c,l) subject to c = (h − l)w + π − T.

What is the first-order condition after substituting the budget constraint?

−u_c w + u_l = 0, which rearranges to u_l/u_c = w.

What does MRS(l,c) > w imply?

The household values additional leisure more than its market cost, so it wants more leisure and less work.

What does MRS(l,c) < w imply?

The wage is high relative to the value of leisure, so the household wants less leisure and more work.

For u(c,l) = log c + γ log l, what are the marginal utilities?

u_c = 1/c and u_l = γ/l.

For u(c,l) = log c + γ log l, what is the MRS?

MRS(l,c) = γc/l.

What is optimal labor supply in the log-utility example with T = 0?

N* = (wh − γπ) ÷ [(1 + γ)w].

How does higher unearned income π affect labor supply in the example?

It lowers labor supply: ∂N*/∂π = −γ ÷ [(1 + γ)w] < 0.

How does a stronger preference for leisure, higher γ, affect labor supply?

It reduces optimal labor supply because leisure receives more weight in utility.

What happens to labor supply when π = 0 in the log-utility example?

N* = h/(1 + γ), so wage income and substitution effects exactly offset and labor supply is wage-invariant.

What happens when π > 0 in the log-utility example and the wage rises?

The substitution effect dominates the partial income effect, so labor supply rises.

What causes a movement along versus a shift of labor supply?

A wage change causes movement along the curve; preferences, unearned income, taxes, demographics, or work costs shift the curve.

What changes shift labor supply left?

Stronger preference for leisure, higher unearned income, lower lump-sum taxes, or better leisure technology.

What does θ represent in u(c, θl)?

The productivity or quality of leisure; a higher θ makes leisure more valuable and reduces labor supply.

What is the firm's general production function?

Y = zF(K,N), where z is total factor productivity, K is capital, and N is labor.

What is the Cobb-Douglas production function used in the lecture?

Y = zK^αN^(1−α), with 0 < α < 1.

What does constant returns to scale mean?

Multiplying both capital and labor by the same factor multiplies output by that factor; doubling both inputs doubles output.

What is the marginal product of labor?

MPN = zF_N(K,N): the extra output created by one additional unit of labor.

What is Cobb-Douglas MPN?

MPN = (1−α)zK^αN^(−α).

Why does MPN fall as labor rises when capital is fixed?

Diminishing marginal product: each additional worker has less capital to work with and adds less output.

What is the firm's profit function?

π = zF(K,N) − rK − wN.

What is the firm's profit-maximizing hiring rule?

Hire labor until MPN = w.

What should a firm do if MPN > w?

Hire more labor because the next worker adds more output than the worker costs.

Why is the MPN curve also the labor-demand curve?

The firm sets w = MPN, and diminishing MPN means a lower wage is required to make hiring more labor profitable.

What is Cobb-Douglas labor demand?

N^d(w) = [((1−α)z)/w]^(1/α) K.

What shifts labor demand right?

Higher total factor productivity z or more capital K, because either change raises workers' marginal product.

What condition defines labor-market equilibrium?

N^s(w) = N^d(w), determining equilibrium employment N* and real wage w*.

What happens after a positive productivity shock?

Labor demand shifts right, causing equilibrium employment, the real wage, and output to rise in the basic model.

What are the household and firm optimality conditions?

The household sets MRS = w; the firm sets MPN = w.

What efficient condition follows in competitive equilibrium?

MRS = MPN.

What does a negative productivity shock do in the basic model?

It shifts labor demand left and lowers employment, the real wage, and full-employment output.

Why is an oil-price increase modeled as a negative productivity shock?

More costly energy makes existing capital and labor less productive, reducing output for given inputs.

What key labor-market problem is missing from the basic competitive model?

Involuntary unemployment; employment declines are interpreted as voluntary choices of more leisure.

What are three reasons wages may differ from current marginal productivity?

Sticky long-term contracts, search and matching frictions, and efficiency wages used to encourage effort.

What is the government's balanced-budget condition in the static model?

G = T.

What is goods-market clearing in the static closed economy?

Y = C + G because investment and net exports are zero.

What does the consumption-leisure PPF show?

The maximum consumption feasible at each leisure choice, given technology, capital, time, and government spending.

What is the slope of the consumption-leisure PPF?

dC/dl = −MPN; one more unit of leisure sacrifices the output from one unit of labor.

In what order should N, Y, and C* be solved?

First use MRS = MPN to find N; then Y = zF(K,N); then C = Y* − G.

What is Pareto optimality?

An allocation is Pareto optimal if no one can be made better off without making someone else worse off.

What problem does the social planner solve?

Maximize u(C,l) subject to C + G = zF(K,h−l), producing the condition MRS = MPN.

What does the First Welfare Theorem say?

Under appropriate assumptions, a competitive equilibrium is Pareto optimal.

What does the Second Welfare Theorem say?

Under appropriate assumptions, a Pareto-efficient allocation can be decentralized through lump-sum redistribution followed by competitive markets.

What creates a proportional labor-tax wedge?

MRS = (1−τ)MPN rather than MRS = MPN, so private and social tradeoffs differ.

Why did Hayek criticize central planning?

Economic knowledge is dispersed across people, while market prices help communicate and coordinate that information.

What four conditions characterize general equilibrium?

Household optimality MRS = w, firm optimality MPN = w, labor clearing N^s = N^d, and goods clearing Y = C + G.

Why is an undistorted competitive equilibrium efficient?

Because MRS = w and MPN = w imply MRS = MPN, aligning household and technological tradeoffs.

Does Pareto efficiency guarantee fairness?

No. Pareto optimality is an efficiency concept and does not guarantee equality or a desirable distribution.

What can cause the First Welfare Theorem to fail?

Distortionary taxes, externalities, imperfect competition, asymmetric information, incomplete markets, and bounded rationality.

How does a proportional labor-income tax cause inefficiency?

It makes the household respond to (1−τ)w while society's productive tradeoff is MPN, creating MRS ≠ MPN.

What happens to the PPF when TFP rises?

It rotates outward because more consumption can be produced from any given amount of labor.

How does higher TFP affect consumption, wages, and labor?

Consumption rises and the real wage usually rises; labor is ambiguous because substitution and income effects oppose each other.

How does higher G financed by lump-sum taxes affect the household?

It reduces resources for private consumption, creating a negative income effect that lowers consumption and leisure and raises labor.

What happens to output and welfare when G rises in the baseline model?

Labor and output rise, but consumption, leisure, and household welfare fall.

Why can GDP rise while welfare falls?

Higher output may come from working more while both private consumption and leisure decline.

What does crowding out mean in this model?

Additional government spending uses resources that otherwise could support private consumption.

What two major World War II features does the baseline model miss?

Debt financing, which spreads taxes over time, and wartime productivity gains.

In the worked example, what is equilibrium labor when G = gY?

N* = 1/[2(1−g)].

In the worked example, what are equilibrium output and consumption?

Y* = √[1/(2(1−g))] and C* = √[(1−g)/2].

What is the government-spending multiplier?

ΔY/ΔG: the change in output divided by the change in government spending.

Why might the fiscal multiplier be larger in a recession?

Idle resources and constrained monetary policy, such as at the zero lower bound, allow spending to raise output without fully crowding out private activity.

What is the difference between lump-sum and proportional taxes?

A lump-sum tax does not depend on choices; a proportional tax takes a fraction of income and changes the marginal reward to working.