Econ test 2

What does the production function show?

The relationship between labor and real GDP. As we increase labor, real GDP goes up. If we increase capital GDP increases without adding labor.

Why does the marginal product of labor eventually fall?

If we add labor and keep capital constant, each additional worker will produce less extra output because the amount of available resources stays the same.

What does equilibrium in the labor market mean?

0 cyclical unemployment, full employment. Potential GDP = Real GDP

Why does the labor supply curve slope upward

the substitution effect

Substitution effect

When wages rise, workers substitute out of leisure and into labor to make more money

Income effect

People spend more time in leisure rather than labor once they’ve made money during the substitution effect

Gross investment

the amount of money spent on capital goods

Net Investment

gross investment without depreciation

Investment demand shifters

1) taxes: corporations are taxed on profits (can have high or low tax rates)

2) expected future profits: if firms expect higher/ lower profits they will increase/ decrease investment demand

Savings supply shifters

1) Disposable income: the income you have after you pay your taxes

2) Wealth: If something happens to your wealth, people will save more to bring their wealth back up

3) expected future income: a) if you expect your income to increase, you will save less and spend more. b) if you expect your income to decrease, you will save more and consume less

The capital stock increases with an increase in…

Net investment/ physical and human capital

Crowding out effect

Large government deficits subtract from the savings supply. This decreases savings, increases interest rates and decreases investments.

Ricardo-Barro effect

Citizens know that in the future they will have to pay more taxes to help the deficit, so they begin saving now for higher taxes.

Real interest rate equation

(Nominal interest rate) - (inflation)

What are the prerequisites for economic growth?

Markets, property rights, and system of monetary exchange

Markets

they facilitate economic exchange. Buy/ sell goods and services. They are secure and efficient in rich countries.

Property rights

• laws, customs, traditions that govern the acquisition used and dispose of …

• when purchasing goods rights are exchanged

• stealing only exist because of this

• supply/ demand would not exist if we did not own anything

System of monetary exchange

without this we would have a barter exchange (trade)

What does the productivity curve show?

Economic growth in long term and short term. It considers GDP and capital per hour of work while keeping labor fixed.

Classical growth theory

Increase in technology → increase in demand for labor → increase in wages → increase in population → increase in supply of labor → decrease in wages

• could explain why poverty never goes away

• didn’t see the importance in capital

Subsistance wage

minimal money to get you by

Neoclassical growth theory

increase in technology → increase in profits → increase demand for investments → increase the equilibrium → adding capital to the economy

** as long as as long as return > target return, keep adding adding capital until r = target r

New growth theory

increase in technology → increase in profits → increase demand for investments → increase the equilibrium → adding capital to the economy

** return will never fall it is always above target r

** always adding capital to the economy

What shifts the aggregate demand curve?

1) consumer wealth. 2) intempural substitution effect. 3) international substitution effect. 4) Government spending

Consumer wealth effect

  when prices go up, people see the value in their wealth go down. Therefore, their money has less purchasing power, so they buy less. Vice versa.

Intemporal substitution effect

when prices go up, that causes inflation, which causes interest rates to rise. When interest rates rise, people borrow less money because it costs more to pay back (therefore people stop taking out loans/ using credit cards)

International substitution effect

when prices rise for domestic goods and services people will substitute out of domestic and turn to international products. Therefore, shifts the curve of the domestic AD

Government spending

if government increases spending then AD increases, if government spending decreases, then so does AD

Why does the aggregate demand curve slope downward?

1) Real-balances effect. 2) Interest Rate effect. 3) Foreign Purchases effect

Real-balances effect

everyone has a nominal income (what they make), but their real income determines their purchasing power. If price index is low, their purchasing power is high, and they can buy more output

Interest-rate Effect

drives up price index which reduces investment spending. This increases the demand for money. More money to pay back.

Foreign Purchases Effect

when a country’s exports fall, but imports rise. Other countries have lower, more affordable price index

Taxation

Our government can either raise or lower our taxes

If gov lowers taxes, we will have more money ( raise AD)

If gov raises taxes, we will have less money (lower AD)

Fiscal Policy

Policy done by government on all levels

Monetary Policy

Conducted by a central bank

Inflationary gap

where AD intersects SAS real GDP will be higher than potential → prices in economy will be higher. Interests LAS and SAS at different places

Recessionary Gap

AD shifts down where real GDP is below potential and gets rid of the gap. 1) AD curve to shift back up. 2) SAS curve could shift down. Economy returns to LAS