Intro to Economics B

Macroeconomics

concerned with the study of aggregate changes in the economy and business cycles (short-run fluctuations)

Keynesian Economics

posits that active government intervention is necessary to stabilize economies — free-markets are volatile and not self-correcting

Monetarist Economics

economies are inherently stable and crises happen because of poor monetary policy

Fiscal Policy

use of government spending and taxation to influence a nation’s economy — responds to fluctuations in the business cycle and unemployment

Monetary Policy

the set of actions taken by the central bank in order to affect the money supply — responds to economic state, inflation, unemployment

Stock Value

a measure that captures a quantity at a specific point in time

Flow Value

a measure that captures a quantity over a period of time

GDP (gross domestic product)

market value of all final goods and services produced within a country in a given period of time

Components of GDP (4)

(1) Private Consumption, (2) Investment, (3) Government/Public Consumption, (4) Net Exports

Limitations of GDP (3)

(1) Non-measured goods, (2) Non-market goods, (3) Perverse Goods / Bads

Perverse Goods

items that are counted as goods in GDP because they involve market transactions, even though they may reduce overall welfare

GNP (gross national product)

value of all income earned by a nation’s residents over a period of time, no matter where it was earned

GNI (gross national income)

the sum value of all income earned by a nation’s residents minus income sent to foreign residents over a period of time

GDP Formula

GDP = C + I + G + NX

GNP Formula

GNP = C + I + G + NX + NFIA (net factor income from abroad)

Nominal GDP

production is measured based on the quantity of goods and their value at current prices

Real GDP

production is measured based on the quantity of goods while holding their value at fixed base-year prices

GDP Deflator

(nominal GDP / real GDP) x 100 — measures inflation

Inflation Rate Formula

[(Deflator 2 - Deflator 1) / Deflator 1] x 100

Consumer Price Index

measures changes in the cost of a typical basket of goods and services over time within one country — measures inflation

Purchasing Power Parity

method that compares different countries’ currencies through a basket of goods to ensure that exchange rates represent the purchasing power of each currency

Basket of Goods

a fixed representative set of consumer products used to track inflation and cost of living over time

Big Max Index

informal basket of goods meant to measure purchasing power parity: found almost everywhere and is generally the same everywhere

GDP Per-Capita

measures a country’s economic output per person; captures typical living standards

GDP Growth (g) Formula

g = [(new GDP - old GDP) / old GDP] x 100

Malthusian Theory

populations are self-correcting to new technology; population grows geometrically whereas food grows arithmetically, resulting in a carrying capacity overshoot and subsequent catastrophe

Malthusian Trap

when resources become insufficient to sustain growing population, positive checks occur to bring population back to sustainable levels

Causes of the Industrial Revolution (2)

(1) Good Institutions, (2) Economic Conditions Were Rights (i.e. trade networks, production inputs, low energy costs + high wages, urbanization)

Total Factor Productivity (A)

measures an economy’s or a firm’s efficiency in generating output from combined inputs (labor and capital)

Production Function Formula/s

Y = AK^a*L^B

Y = A*F(L,K)

Elasticity of Output Returns to Scale

a + B = 1: constant returns to scale

a + B > 1: increasing returns to scale

a + B < 1: decreasing returns to scale

Production Function Properties (2)

(1) Diminishing Marginal Product, (2) Constant Returns to Scale

Diminishing Marginal Product

while holding capital fixed, adding additional units to labor will increase output by smaller and smaller amounts

Constant Returns to Scale

if labor and capital are increased by the same proportion then output will also increase by that proportion

Production Function Per-Capita Formula

Y/L = y = A*f(k)

Solow Growth Model

the change in capital is savings (investment) minus depreciation — capital per worker will move to some ‘steady state’ along the production function

Business Cycles

non-periodic sequence of changes in economic activity, consisting of expansion and recession phases

Key Facts About Business Cycles (3)

(1) irregular, unpredictable, & reverse frequently, (2) major economic variable move together, (3) when output falls, unemployment rises

Demand

what consumers are willing and able to buy

Supply

what producers are willing and able to sell

Aggregate Demand (AD)

shows the quantity of goods that firms/households/government want to buy at each price level

Aggregate Supply (AS)

shows the quantity of goods producers choose to produce and sell at each price level

AD-AS Model

plots prices and output/income — used to assess overall effects of monetary/fiscal policy on AD (through impact on elements of GDP)

Why is the Short-Run AS Curve Upward Sloping? (3)

(1) Sticky Wage Theory, (2) Sticky Price Theory, (3) Misperceptions Theory

Sticky Wage Theory + causes (3)

nominal wages are slow to adjust to changes in labor market conditions —if wages don’t increase as fast as prices, workers become cheaper for firms, so firms hire more and overall output increases

causes: (1) contracts, (2) wage laws, (3) resistance to pay cuts

Sticky Price Theory

firms do not immediately adjust prices to changes in the economy to avoid annoying regular customers and menu costs

Misperceptions Theory (wage ver.)

prices in the economy rise and firms raise workers’ nominal wages; workers lack perfect information, so they’re under the impression their real wage increased and are willing to work more hours (in reality purchasing power decreased and they’re paid the same)

price levels increase = more output

Misperceptions Theory (price ver.)

producers observe their specific product price increasing and, lacking perfect information on general inflation, incorrectly assume their product's relative value has risen and produce more

price levels increase = more output

Why is the Long-Run AS Curve Vertical?

prices do not determine output → real factors of production — changing prices don’t increase the economy’s true capacity to produce

AD Shifts (2)

(1) components of GDP, (2) changes in the money supply

SRAS Shifts (2)

(1) anything that changes potential output, i.e. factors of production, (2) expected price levels

LRAS Shifts (1)

anything that changes potential output, i.e. factors of production

Inflation

the sustained rise in price for goods and services over time

Nominal

monetary values that are not adjusted for inflation

Real

adjusted for inflation

Wealth (stock)

any value that is stores up — assets

Income (flow)

money coming in from work or investments

Real Economy

focuses on flows: GDP, income, wages, etc.

Financial Economy

focuses on stocks: wealth, bonds, assets, etc.

Financial Markets

a direct connection between savers and borrowers

Financial Intermediaries

an indirect connection between savers and borrowers

Interest Rate Spread

the difference between the interest rate the bank pays on deposits and the interest rate it charges on loans

Forms of Financial Wealth (4)

(1) property and real estate, (2) equities, (3) bonds, (4) cash

Money

the set of assets in an economy that people regularly use to buy goods and services (fraction of total wealth)

Functions of Money (3)

(1) medium of exchange, (2) unit of account, (3) store of value

Medium of Exchange

offers liquidity; enables you to turn your stock of wealth into everyday goods and services

Unit of Account

standard measuring stick for value: costs, debts, wealth, etc.

Store of Value

can use it to transfer purchasing power from the present to the future (inflation decreases effectiveness)

Fractional Reserve Banking

system where banks hold only a fraction of customer deposits in reserve and lend out the remainder, allowing them to create money and expand the money supply

Reserves

bank deposits that are not lent out

Reserve Ratio

the fraction of deposits that banks hold internally as reserves

Real Money Balances

the value of money adjusted for inflation, representing actual purchasing power

→ nominal money supply / price level (M/P)

Cash Trade-off

the price of holding money is the interest rate you give up by not investing it

Why Demand isn’t Infinite

opportunity cost

1. when interest rates are up you want to hold less cash

2. when interest rates are down the cost of being liquid is cheaper

Primary Central Banks (3)

(1) Federal Reserve, USA, (3) European Central Bank, (3) Bank of England

Central Bank Tools (3)

(1) changing the reserve ratio, (2) changing the refinancing rate, (3) open-market operations

Changing the Reserve Ratio

higher reserve ratio = reduced creation of new money

Changing the Refinancing Rate

the rate at which the commercial banks borrow from the central bank — increased rate = less borrowing = decreased money supply

Open-Market Operations

central bank can take money out of circulation by selling government bonds for cash → buying back bonds = increased money supply

CB buys = banks have big amounts of cash (lower IR)

CB sells = banks have small amounts of cash (higher IR)

Why Increase the Money Supply (4)

(1) to fight unemployment or a recession, (2) to encourage consumer spending, (3) to prevent deflation, (4) to provide liquidity during crises

Why Decrease the Money Supply (4)

(1) to fight inflation, (2) to prevent an asset bubble, (3) to protect the currency value, (4) to calibrate post-crisis

Monetary Policy: Investments

most business investments are financed through debt — increased interest rate decreases investment (more expensive to take out loans)

Monetary Policy: Consumption

saving vs. spending channel: interest rate goes up so opportunity cost of consuming increases → consumption decreases

Monetary Policy: Net Exports (2)

*exchange rate channel: interest rate increases, so foreign investors buy domestic assets → domestic currency appreciates

• exports decrease as domestic goods become more expensive to foreigners

• imports increase as foreign goods become cheaper to domestic consumers

demand channel: interest rate increases, so consumption decreases → imports decrease and net exports increase

Dual Mandate

three primary federal policy objectives: maximum employment, price stability, bank regulation (may create conflict in the short run)

Securitization

financial process of pooling illiquid assets and converting them into tradable securities — allows banks to transfer risk & free up capital for new lending

Credit Crunch

sudden severe decrease in the availability of loans and a tightening of