ECO 211 EXAM 2

Describe and illustrate the various stages of the business cycle.

Demonstrates the GDP over time (peaks, troughs, like a wave)

Recession - movement from peak to trough, significant decline in economic activity (not only GDP, includes income, employment, production, retail sales) 

Explain what national income accounting is and why it is important.

Includes developing and analyzing measures of economic output and performance at a point in time, change policies to improve economy performance

Can measure performance using GDP

Provide the basic definition of GNP and GDP.

GDP - Gross Domestic Product: attempt to measure (always includes measurement error) market value (adding dollar value of products) of all final goods and services (purchased by consumers, firms, gov for final use, doesn’t include raw materials and avoids double counting) produced by an economy during a given time period (counts things the year they were produced as output)

GDP - includes everything produced within geographic boundaries of the U.S., includes foreign companies

GNP(Gross National Product) - includes anything produced by American companies anywhere, but nothing by foreign companies

Explain what we mean by "final goods and services."

Includes goods and services purchased by consumers, firms, government for final use and consumption, not for resale and excludes raw materials

Explain why the focus on production leads to the exclusion of certain transactions.

GDP focuses on current produced final goods and services. Some of the transactions are excluded because it would lead to double-counting because it does not include new product creation

List and describe the specific exclusions from GDP/GNP.

Security transactions (swap of financial assets), public transfers (grants to groups/individuals), private transfers (gifts/allowances from parents), and secondhand sales (reselling house or car) are excluded

Explain how the time period is relevant to the calculation of GDP/GNP.

GDP/GNP includes rate of production over time (a specific interval) which can help identity economic expansion or recession

Explain how we get around the problem of adding apples and oranges.

Add the dollar value of the products since they are different products which can’t be tracked. GDP is a dollar value.

Describe several ways in which GDP/GNP likely underestimates the size of the economy.

Misses home production (work people do to take care of themselves and kids), structural differences make international comparisons difficult (growing in your own garden in developing countries is not counted), misses illegal activity (drugs production example)

List and explain several other significant potential drawbacks to using GDP/GNP as a measure of economic or social well-being.

• Counts bads (guns) and goods (vaccines)

• Does not account for current assets (houses/businesses wiped out by hurricane does not get added because they were built in the past, but rebuild counts which increases GDP)

• Fails to account for population -> GDP per capita (divide GDP by population but just an average)

• Doesn't account for distribution of income (could have high GDP while people have low incomes)

• Does not directly measure leisure, liberty, life expectancy, infant mortality, environmental quality (ignores well-being factors which means people could be in poverty despite having high GDP)

Explain how GDP and GNP differ, and provide several reasons why we use GDP predominantly.

GDP - all production within geographical regions of United States, includes foreign companies

GNP - any production by American companies in the United States and anywhere in the world, but excludes foreign companies

Explain how net domestic product is calculated, along with its pros and cons.

Net Domestic Product = GDP - depreciation

Depreciation is measure of nation’s capital stock that has worn out (consumption of fixed capital, physical wear of machinery, buildings, vehicles)

NDP is measure of how much nation’s output is available for consumption or adding to nation’s net wealth

Difficult to measure depreciation

List the 3 ways of looking at GDP.

Basic Definition: Sum of market values of all final goods and services produced by the economy during a given time period

Expenditures Approach: Sum of spending on final goods and services by households, firms, gov, and foreign people

Income Approach: Sum of all incomes earned by domestic resource owners (finances, savings, assets produced within the U.S.)

Explain what we mean by the “expenditures approach” to GDP.

Method for calculating GDP by summing up all money spent on final goods and services

List the 4 components of GDP under the expenditures approach.

Consumption - households spending

Investment - firms spending

Government - government spending

Foreign citizens - exports - imports, includes spending by foreign people

GDP = C + I + G + (X-M)

Explain what we mean by national income.

Amount of incomes earned by U.S. resource owners

List the 4 types of income and explain who receives each type of income.

Wages (w): Labor

Interest (i): Capital

Rent (r): Land

Profit (pi): Entrepreneurial ability

GDP = w + i + r + pi

Explain what we mean by the “incomes approach” to GDP.

Method of measuring GDP by adding up money earned by everyone instead of adding up spending

Explain what we mean by personal income and why it isn’t the same as national income.

Gross income people actually receive (total income actually received by people  from all sources), while national income measures all income earned by country's residents for their contribution to production

Some earned income is never received by people, some received income is not earned

Personal income = National income - social security taxes - corporate taxes - retained earnings + transfer payments

Income earned but not received is subtracted from national income (corporate taxes, retained earnings, social security taxes)

Income received but not earned is added to personal income (transfer payments like government benefits)

Explain what we do and what we do not mean by disposable income. Explain how it differs from personal income.

After tax income

Disposable income = Personal income - personal income taxes 

DI = PI - T

Money left to spend or save after paying income taxes: DI = Consumption(C) + Savings (S)

Explain the conceptual equivalence between output and income.

GDP = Net Domestic Product = National income = Personal income

Total market value of all goods and services produced (output) = total income earned by people who produced those goods and services

Explain how living standards are linked to productivity.

Better living standards (more productive) = higher real wages, higher income, more public services, leisure time, cheaper and better goods

Opposite = poverty, poor conditions, etc

Explain how disposable income is basically determined by output and taxes.

Money that people get their hands on and take home. (output - taxes)

Explain who is and who is not included in the following groups:

Institutionalized - people in long term care, hospitals, prisons

Under 16 can’t work in labor force

Members of armed forces are not part of NICAP

NICAP

Non Institutionalized Civilian Adult Population (eligible to have a job)

The Labor Force

Interested in working in labor 

NILFs

Not interested in working in labor force

The Employed

Has a job in the labor force

The Unemployed

Looking for a job, but does not have one

Explain how the unemployment rate is calculated. Provide the formula.

Unemployment rate = (# of unemployed) / (size of labor force)

Captures % of those who want to work but does not have a job

Determines how close we are to production possibilities frontier

Describe two forms of underemployment.

Employed in a job that does not fully use your skills and education

Working part-time/less hours when working fulltime is wanted

Explain what it means to be a discouraged worker and what effect discouraged workers have on the unemployment rate.

No longer part of labor force since they used to be looking for a job but gave up

Unemployment rate drops when they quit looking for a job

Explain how we calculate the LFPR.

Labor Force Participation Rate = (Labor force) / (NICAP) 

Determines location of PPF

% of those who are eligible is interested in working

Explain how the unemployment rate and the LFPR relate to the PPF.

Full employment is on PPF (using all resources)

Cyclical (repeating intervals) unemployment inside PPF (not using all resources)

Increase in LFPR pushes PPF out (new resources to work)

Decrease in LFPR pushes PPF back (leaving labor force)

Define frictional, structural, and cyclical unemployment.

Frictional: short-term, time in between choosing leaving one job and looking for another (switching job)

Structural: longer, involuntary, skills no longer useful for a job, has to retrain to take on a new job (change in technology, different structure to labor market)

Cyclical: economic downturns from business cycles (recessions & depressions), falls during economic recoveries

Explain why it is important to understand which type of unemployment exists at a point in time.

Determines effective economic policies, prevents government overspending and errors, see which methods would help

Explain what we mean by the term "full employment" and the "natural rate of unemployment."

Full employment: everyone who is eligible and is willing to work is able to find a job

Lack of cyclical unemployment, sustainable level of employment without triggering inflation

Natural Rate of Unemployment = frictional + structural rates for a country

Unemployment rate != 0 because frictional and structural unemployment exists

Rate may change over time between countries

Explain what "potential GDP" represents.

Level of output possible at full employment

Explain the costs associated with unemployment.

Lost output and reduced living standards (failure to achieve potential GDP, losses are cumulative over time)

Unhappy people, riots

State Okun's Law.

Okun’s Law: For every 1% increase in unemployment rate, lose 2% of Potential GDP

Describe the origins of unemployment insurance.

No real role for government intervention before Great Depression, but unemployment rose to 25% during the Great Depression

Insurance started in 1935 with Social Security Act

Explain how unemployment insurance is funded.

Employer taxes, government revenue

Explain why we have unemployment insurance in the first place.

Altruism: care for citizens

Self-interest: possibility of becoming employed some day

Economic stabilization

Helps prevent recessions from becoming depressions

Props up aggregate demand

Direct injection of cash into economy

Automatic stabilizer

Describe the limitations on collecting unemployment.

Strict eligibility rules, time limit on benefits, requires job searching, not particularly generous

Explain the potential drawbacks of unemployment insurance.

Lack of incentive for rapid re-employment, higher employer taxes, strain on government budget

Define and recognize the following from data and graphs: inflation, deflation, and disinflation.

Inflation: sustained increase in general/average price level

Deflation: sustained decrease in general/average price level

Deflation: decrease in rate of inflation

Explain what we mean by purchasing power.

Quantity of goods and services that a given amount of money will buy (money isn’t important)

Describe how inflation, deflation, and disinflation affect purchasing power.

Inflation ruins purchasing power of a given amount of money (less goods with that amount)

Deflation increases purchasing power

Disinflation erodes purchasing power at a slower rate

Distinguish between nominal and real salary/wages/income/wealth.

Nominal: refers to number of dollars you receive (unimportant)

Real: refers to purchasing power of nominal wage

Explain how inflation affects individuals on fixed incomes and how COLAs can counteract these effects.

Hurts those with fixed incomes

COLAs (Cost of Living Adjustment) increases fixed payments to match rising inflation

Explain how inflation affects trade deficits.

Imports become more attractive (imports > exports) creating deficit

Describe how inflation leads to bracket creep.

Rising prices because of inflation → wages increase (nominal income increases, real income is the same) → tax brackets stay fixed → higher nominal salary pushes earnings into next tax bracket → need to own higher tax based on income → real disposable income drops

Explain how high and variable rates of inflation affect shopping behavior.

Takes longer to shop for less expensive products (having to search for it)

Explain the relationship between real interest rates, nominal interest rates, and the rate of inflation.

Nominal interest rate: stated interest rate on a loan, additional number of dollars need to be repaid

Real interest rate: Lender doesn’t want just more dollars back, wants more purchasing power back

Real interest rate = Nominal interest rate - rate of inflation

Calculate real interest rates given data on inflation and nominal interest rates.

Explain the differences between creeping, galloping, and hyperinflation.

Creeping: a relatively low stable rate

Galloping: Higher, but usually stable and nonaccelerating, damaging to the economy, not tolerated well in the U.S.

Hyperinflation: 1000’s % per year, collapse of financial system, people barter (trade without money), some choose dollarization (a country uses the U.S. dollar instead of their own currency ), result of printing too much money

Explain how hyperinflation occurs and why countries make the decisions that lead to hyperinflation.

Result of printing too much money (money grows while stuff doesn’t which changes prices) because government needed money (taxes and borrowing money is not easy in developing countries)

Political independence of central bank is key to preventing hyperinflation (U.S. can’t print more money because printing is controlled by central bank not legislative/executive branches)

Price Indices

Tools designed to measure the average price level

Distinguish between the consumer price index, producer price index, and GDP deflator.

Consumer: measures effect of inflation on average urban family of 4, tracks prices of final goods and services consumed that households buy

Producer: measures effect of inflation on businesses, tracks prices of raw materials, intermediate goods and services, and final goods and services  that firms typically buy

GDP Deflator: broadest measure of price level, tracks prices of all final goods and services

Explain how a fixed basket index is constructed.

Select base year (reference point against which changes will be measured) when CPI of that year is 100

Select a representative market basket (sample of goods that people you are interested in typically consume CPI (consumer), PPI (producer), etc)

CPI_{base year}(current year) = (cost of market basket current year) / (cost of market basket base year) * 100

Cost of basket = sum of current price * fixed quantity

Interpret the meaning of a given price index number.

On average, prices of goods and services in the basket (rose/fell) (#(subtract 100 from CPI value) %) between (year 1) and (year 2)

Calculate the rate of inflation between the base year and the current year for a price index.

CPI_{base year}(current year) = (cost of market basket current year) / (cost of market basket base year) * 100

Calculate the rate of inflation between two non-base years given two price indices.

Change in prices between two years when neither is base year

Rate of inflation % change = (CPI year 1 - CPI year 2) / (CPI year 1) * 100

Compare prices, incomes, and other dollar figures from different years by calculating equivalent purchasing powers.

Equivalent dollar value in (year Y) = Dollar value (year X) * (CPI year Y / CPI year X)

Year X cancels out and becomes Year Y

Inflation affects purchasing power of a dollar over time

List some of the potential uses for price indices.

Challenging to develop representative basket (survey consumers not fully representative)

Sampling errors while collecting data, difficult to sample people, many possibilities

Cost of goods vs. cost of living measures

Describe some of the difficulties with calculating all fixed basket indices.

New goods appear, technological change, goods change over time (cell phones)

Old goods disappear (typewriters)

Quality changes (car is very different now compared to 1965, it’s more complex so it makes sense that price goes up)

Consumption pattern changes over time (red meat, alcohol)

Explain why the CPI may overstate the effects of inflation.

Upper limit on effect of inflation

Fails to fully account for changes in quality (cars are more advanced and expensive today, not due to inflation)

Systematically misses new good price drops, not capturing decreases but captures increases (after a new iPhone comes out, price of previous one drops)

Describe the fundamental difference in how NGDP and RGDP are calculated.

Nominal GDP uses current year prices

NGDP(year) = sum of (quantity year  * price of the year)

NGDP(1998) > NGDP(1997) tells nothing about output or inflation effect

Real GDP uses base year

RGDP_{base year}(current year) = sum of (quantity current year * price base year)

RGDP(1998)>RGDP(1997) shows output increases, accounts for inflation

Explain why we tend to focus on RGDP for most of our work.

Accounts for inflation

Output can fall though prices rose

Convert back and forth between RGDP and NGDP using the GDP deflator.

RGDP(year y) = (NGDP year y) / (GDP deflator year y) * 100 

GDP deflator (all price of final goods and services) removes inflation from NGDP

Illustrate demand-pull and cost-push inflation.

Demand-Pull Inflation - increased demand for goods and services by households, government, firms, and foreign people (shifts AD curve out)

Cost-Push Inflation = Stagflation - Supply shock where event increases cost of production (shifts AS curve back)

Stagflation has rising prices and falling outputs/income

Use aggregate supply and demand diagrams to predict changes in output, the price level, and unemployment.

AD = C + I + G + (X-M)

Aggregate demand = consumption by households + investment (spending by businesses on capital goods) + government spending (infrastructure, education, etc) + (exports - imports)

Explain the meaning of the term stagflation and its origins.

Cost-push inflation, where income/output drops but prices of goods and services rise. Cost of production increases

Explain the wealth effect.

Includes stocks, bonds, savings deposits

Inflation affects purchasing power of these (purchase less)

Decrease in price level increases real wealth

C in consumption increases -> AD increases

Explain the net export effect.

Buying foreign vs. domestic goods

High/low inflation rates in U.S. affects whether other countries want U.S. products

Decrease in price level makes goods wanted by us and other countries, exports increase, imports decrease due to choosing domestic vs. foreign, AD increases (X-M) 

Draw and label the money market graph.

Money Supply is a vertical line where quantity does not change, but money demand is negatively sloped

Shows nominal interest rate (does not account for inflation

Y-axis: Nominal interest rate = real + inflation rate

X-axis: Quantity of Money

Explain the interest effect using the money market graph.

Lower price level -> less money to buy goods and services

Left shift in money demand curve which lowers equilibrium interest rate

Lower price level leads to less demand for money, which lowers interest rate, increases investment (I) and increases AD (shifts AD out)

AD = C + I + G + (X-M)

Interest Rate: Percent charge in money borrowed by anyone

List and explain the AD shifters for each component of AD.

Consumption shifters

• Changes in real wealth (stocks, bonds, savings deposits, stock gains lead to greater real wealth) (higher consumption, more investment)

  • Investment: businesses spending, buying more to expand 

• Indebtedness: owing money to another party. Households take on more money and debt which leads to greater purchasing power in the economy (increases consumption), increases aggregate demand

• Expectations: Greater consumption if households expect a good economic future. 

• Taxes: Increased taxes on households cut into income, which leads to less consumption and therefore decreases demand for goods and services (shifts AD back)

Investment shifters

• Interest rates: Higher interest rates decreases borrowing by businesses, which decreases investments and therefore decreases aggregate demand

• Expectations regarding profitability: Businesses that are expecting good profits in future increase their investments which shifts AD out

• Technological change: Technological advancements encourage businesses to invest more, but AD could shift back if it causes short-term job losses

• Degree of excess capacity: High capacity for businesses to expand with unused resources reduces encouragement for investments which shifts AD curve back. Low capacity forces more investments, which increases AD

• Business taxes: Higher taxes reduce investments, while lower taxes increase it. Higher taxes lead to AD shifting back

Explain what we mean by the short-run.

• Period of time where resource prices are fixed

• Wage rate and prices of other inputs are often fixed by long term contracts

• Higher prices of final goods and services lead to greater profitability for businesses if input costs are fixed, leads to businesses producing more

• SRAS has positive slope

Describe what the short-run aggregate supply curve shows us.

Production buy businesses based on prices of final goods and services

Explain why the slope of the SRAS curve is important for analyzing the effects of policy.

Steepness of slope affects outcome of policy changes (shifting AS by same amount can affect price levels and outcome differently based on how steep it is)

List the 3 SRAS curve shifters.

Input prices & wages: affects cost of production, higher ones lead to less production which shifts AS back

Changes in productivity: new technology allows greater output at same cost of production

Legal/institutional environment: Tax structure (higher taxes reduce productivity), regulations (more regulations reduces productivity)

Explain what is meant by supply-side economics.

Policies that shift AS out

Tax cuts, reduced regulations on businesses

Higher growth and income without inflation

May not do much to fix short-term problems because policies are long-term

Demand side effects

Explain the limitations of the short-run aggregate supply and demand model.

Can see how events affect economy, but does not show how we are doing at a point in time

Problems with Short-Run Model

Not informative, equilibrium (SRAS = AD intersection), does not tell whether level of output is high or low

Need a benchmark to judge performance of economy against

Explain what we mean by potential GDP.

Being on the point of the Production Possibilities Frontier, where it includes productive efficiency (full use of resources)

Potential GDP -> this level of output

Illustrate an economy achieving PGDP using a PPF.

Y_p is illustrated on the x-axis (RGDP) as a benchmark

If Y_E⁰ (the equilibrium output) is below the benchmark, then the output is not enough, lower incomes

Explain how potential GDP and full employment are related.

Potential GDP = Full employment

Not at Potential GDP = Not full employment

Illustrate recessionary/contractionary gaps using an AS & AD model with an LRAS curve and PGDP.

Output Equilibrium < Potential GDP (gap in between)

High levels of unemployment

Illustrate inflationary/expansionary gaps using an AS & AD model using the LRAS curve and PGDP.

Output Equilibrium > Potential GDP (gap in between)

Very low levels of unemployment

Illustrate an economy in long-run equilibrium using an AS & AD model with an LRAS curve and PGDP.

Long Run equilibrium happens with SRAS intersects AD at Potential GDP benchmark

Full employment achieved

Explain and illustrate what a recessionary gap tells us about the current wage rate.

Recessionary gap = high unemployment = current wage rate > wage equilibrium in labor market (quantity supplied > quantity of labor demanded)

Explain and illustrate what an inflationary gap tells us about the current wage rate.

Inflationary gap = very low unemployment = current wage rate < wage equilibrium in labor market (quantity supplied < quantity of labor demanded)

SRAS curve shifts back as wages fall -> reaching Long-Run equilibrium

Explain what the self-correcting mechanism is.

Deals with shifts in SRAS curve

Shifts are result of changes in wages and input prices

Wages and input prices change as result of shortages and surpluses in resources markets

Economy goes into long-run equilibrium -> full employment, Potential GDP

No government intervention

Illustrate and explain how the self-correcting mechanism closes both an inflationary and recessionary gap.

Recession gap: SRAS shifts out until it intersects AD on the LRAS curve (at Potential GDP) -> long-run equilibrium

Inflationary gap: SRAS shifts back until it intersects AD on the LRAS curve (at Potential GDP) -> long-run equilibrium

Economy at full employment (no gaps): SRAS intersects AD at LRAS (Y_E=Y_P), achieve PGDP at full employment

Classical vs. Keynesian

Classical: 

• Dominant view of how the economy worked before 1930’s

• Say’s Law

• Still can have recession/inflationary gaps despite being in short-run equilibrium

Keynesian:

• Started from Great Depression

• Classical model said economies fix on its own quickly, but the Great Depression lasted for so long

• Potential role exists for government intervention fiscal and monetary policy (taxing, spending, changing interest rates, money supply)

• Policies can have side-effects 

State Say's Law and explain what it means.

“Supply creates its own demand”

Act of production creates incomes (supply) needed to purchase goods and services just produced (demand)

Incomes approach to GDP

Says we’re always in short run equilibrium (SRAS = AD)

List the other assumptions that the Classical School makes.

Assumes wages and input prices are flexible to let markets clear quickly -> SRAS shifts often, and self correcting mechanism quickly closes the gaps

Explain the role of economic stabilization policy under the Classical School.

Economy remains close to Potential GDP/full employment/long-run equilibrium

No real role for government intervention (taxing, spending, changing interest rates, money supply)

Laissez-faire (hands-off)

Explain which Classical assumption Keynesians disagree with.

Couldn’t explain high unemployment and low output, the problem was that wages and input prices are not super flexible enough for markets to clear quickly (assumption was that wages and input prices were very flexible)

Explain why they disagree with this assumption.

Wages and input prices may be sticky (not flexible) in downward direction (recession gap) caused by:

• Minimum wage laws (set a lower limit on what wage rate can be)

• Unions (resist decrease in wage rates)

• Resistance by employers with cutting wages

Great Depression did not recover for so long