econ 2

What is inflation?

Inflation is the growth in the overall level of prices in the economy.

What is deflation?

Deflation occurs when overall prices fall, representing negative inflation.

What is the average inflation rate in the U.S. since 1947?

The average inflation rate in the U.S. since 1947 is about 3.5%.

How is inflation measured in the U.S.?

Inflation is measured using the Consumer Price Index (CPI), which tracks the price of a typical 'basket' of goods and services purchased by consumers.

What does the Bureau of Labor Statistics (BLS) do to measure inflation?

The BLS determines the prices of goods and services purchased by a typical consumer and calculates the CPI to measure inflation.

What is the Consumer Price Index (CPI)?

The CPI is a measure of the price level based on the consumption patterns of a typical consumer and is used to calculate inflation.

What is the GDP deflator, and how does it differ from the CPI?

The GDP deflator measures the price level of all final goods and services in GDP, while the CPI only includes goods and services purchased by consumers.

What are the three steps to computing a price index?

1. Define the basket of goods and services and their weights; 2. Determine the prices of goods and services across periods; 3. Convert to the index number for each period.

How do you calculate inflation from the CPI?

The inflation rate is the percentage change in the CPI from one period to another.

What are 'shoe-leather costs'?

Shoe-leather costs refer to the resources wasted when people change their behavior to avoid holding money, such as going to the bank more often.

What is 'money illusion'?

Money illusion occurs when people mistake nominal price changes (e.g., inflation) for real price changes and make decisions based on these mistaken perceptions.

What are 'menu costs'?

Menu costs refer to the costs businesses incur when they have to change prices, such as printing new menus or adjusting labels.

How does inflation create 'price confusion'?

Inflation makes it harder for consumers and businesses to distinguish between price changes caused by inflation and those caused by changes in demand or supply.

What are tax distortions caused by inflation?

Inflation can distort tax calculations, such as capital gains taxes, due to tax laws often not adjusting for changes in the price level.

What is the equation of exchange?

The equation of exchange is M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is real GDP.

What is the relationship between money supply growth and inflation?

Inflation typically occurs when the growth rate of the money supply exceeds the growth rate of real GDP.

What are two reasons governments might inflate the money supply?

Governments might inflate the money supply due to large government debts or for short-term economic stimulation.

What is hyperinflation?

Hyperinflation is an extremely high and typically accelerating rate of inflation, often associated with a collapse of a country's currency.

What causes inflation according to Milton Friedman?

Milton Friedman stated that inflation is always and everywhere a monetary phenomenon caused by increases in a nation's money supply relative to real goods and services.

How does inflation affect borrowers and lenders?

Inflation benefits borrowers because they repay loans with less valuable money while harming lenders who receive less valuable repayments.

What is 'chained CPI' and how does it differ from traditional CPI?

Chained CPI is an updated measure that accounts for changes in consumer behavior, providing a more accurate reflection of inflation for the typical consumer.

Why is the CPI not always accurate?

The CPI may overstate inflation due to substitution effects, changes in quality, and not reflecting new goods and services.

What are the economic effects of high inflation?

High inflation leads to uncertainty, resource misallocation, and can reduce purchasing power.

What can be the long-term impact of inflation on savings and investments?

Inflation erodes the purchasing power of savings, necessitating higher returns to maintain value.

What is the difference between nominal wages and real wages?

Nominal wages are measured in current dollars, while real wages are adjusted for inflation.

What is the loanable funds market?

The loanable funds market is where savers supply funds for loans to borrowers, including institutions like banks.

What is the role of the loanable funds market in an economy?

It facilitates financing for firms and governments through borrowing, supported by household savings.

What is the 'price' of loanable funds?

The interest rate is the price of borrowing or lending funds, expressed as a percentage.

How is the interest rate related to the supply of loanable funds?

There is a direct relationship; as interest rates increase, the supply of loanable funds increases.

What is the law of supply in the loanable funds market?

The quantity of savings rises when the interest rate rises and falls when the interest rate falls.

How is the interest rate related to the demand for loanable funds?

There is an inverse relationship; as interest rates rise, borrowing decreases.

What is the law of demand in the loanable funds market?

The quantity of borrowing falls when interest rates rise and rises when interest rates fall.

What is the difference between nominal and real interest rates?

Nominal interest rates do not consider inflation, while real interest rates are adjusted for inflation.

How does inflation affect the real interest rate?

The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate.

What is the Fisher equation?

The Fisher equation is used to calculate the real interest rate: Real Interest Rate = Nominal Interest Rate - Inflation Rate.

What factors shift the supply of loanable funds?

Factors include income and wealth, time preferences, and consumption smoothing.

How does income and wealth affect the supply of loanable funds?

An increase in income leads to more savings, shifting the supply of loanable funds to the right.

How do time preferences influence the supply of loanable funds?

Stronger time preferences reduce savings, while weaker preferences increase savings.

What is consumption smoothing?

It refers to saving and borrowing to maintain a stable standard of living throughout life.

What factors shift the demand for loanable funds?

Factors include productivity of capital, investor confidence, and government borrowing.

How does the productivity of capital affect the demand for loanable funds?

Increased productivity raises expected returns, leading to greater demand for loanable funds.

What is investor confidence and how does it impact the demand for loanable funds?

Investor confidence reflects businesses' expectations about future economic activity, influencing their borrowing behavior.

How does government borrowing affect the demand for loanable funds?

Increased government borrowing raises demand for loanable funds, while decreases lower demand.

What happens in the loanable funds market when the demand for loanable funds decreases?

A decrease in demand leads to lower interest rates and less borrowing.

How does the supply of loanable funds change when a large portion of the population starts retiring?

As people retire and begin dissaving, supply decreases, leading to higher interest rates if demand remains constant.

How does a decrease in the supply of loanable funds affect the economy?

It leads to higher interest rates, making borrowing expensive, reducing investment and economic growth.

How can compound interest influence savings for retirement?

Starting early allows savings to grow exponentially due to compound interest.

What is compound interest?

Compound interest is interest earned on both the original amount and previously accumulated interest.

How does starting to save early affect wealth accumulation?

It maximizes wealth accumulation over time due to compounding.

How does a decrease in the interest rate affect the supply and demand for loanable funds?

A decrease increases demand (cheaper borrowing) and decreases supply (less rewarding to save).

How do financial markets help the economy?

They bring borrowers and lenders together, facilitating economic activities.

What are financial intermediaries?

Firms that channel funds from savers to borrowers, like banks.

What is the difference between direct and indirect financing?

Indirect financing uses intermediaries, while direct financing involves borrowers selling securities directly to savers.

What is a security in the context of direct finance?

A security is a tradable contract that entitles its owner to rights, like stocks or bonds.

How do financial markets contribute to the macroeconomy?

They provide funding for firms, driving economic activity; failures can lead to contractions.

What are the key financial tools for the macroeconomy?

Bonds, stocks, treasury securities, home mortgages, and private-sector securities.

What is a bond?

A bond is a security that represents a debt to be paid by the issuer to the bondholder.

What three pieces of information are contained in a bond?

The name of the borrower, repayment date (maturity), and amount due (face value).

What is the maturity date of a bond?

The date when the loan repayment for a bond is due.

What is the face value of a bond?

The amount due at repayment, fixed when the bond is issued.

How is the interest rate of a bond determined?

It is based on the rate of return comparing the bond's price at inception with its face value at maturity.

What is the relationship between bond price and interest rate?

An inverse relationship; price falls, interest rate rises.

What is default risk in bond markets?

The risk that the borrower will fail to pay the bond's face value.

How does increased default risk affect bond prices?

It leads to lower bond prices and higher interest rates.

What is the role of bond ratings?

Bond ratings assess default risk and help inform investors.

What are stocks?

Ownership shares in a firm and a tool of direct finance.

Why might a firm sell stocks instead of bonds?

To avoid debt repayments which are required for bonds.

How do stockholders differ from bondholders?

Stockholders own part of the firm, while bondholders are creditors entitled to repayments.

What is a secondary market in financial securities?

A market for trading securities after their initial sale.

How do secondary markets affect security prices?

They increase demand by making reselling easier, potentially raising prices.

What are the Dow Jones Industrial Average (DJIA) and the S&P 500?

Both are stock market indices indicating overall performance; DJIA tracks 30 major U.S. companies, S&P 500 tracks 500.

What are treasury securities?

Bonds issued by the U.S. government to finance national debt.

What role do foreign holders play in U.S. Treasury securities?

They hold a significant portion, helping finance the U.S. national debt.

What are home mortgages and why are they important?

Loans used for home purchases, key for homeownership and the housing market.

What is securitization?

Creating a new security by combining separate loans into a tradable asset.

What are the benefits and drawbacks of securitization?

It increases loanable funds and reduces costs but can create evaluative risks.

What is the long-run return for financial assets like stocks?

Stocks generally earn more than other assets long-term, though returns are volatile.

What was a key takeaway from this lecture?

The importance of saving, lending, and financial markets in the macroeconomy.

Why does economic growth matter?

It improves living standards, increases wealth, and enhances human welfare.

What was life like in the U.S. in 1900?

Life expectancy was 47 years; 140 of every 1,000 children died before one year; income under $5,500.

What has changed in the U.S. since 1900?

Economic growth has led to higher living standards and life expectancy.

How is economic growth measured?

It is measured by the percentage change in real per capita GDP.

What correlation does per capita GDP have with human welfare?

Higher per capita GDP typically correlates with better human welfare.

What was the state of global wealth before the Industrial Revolution?

Most people were poor; significant income increases began after the Industrial Revolution.

What role did the Industrial Revolution play in economic growth?

It increased the rate of technical progress, raising income growth.

How does economic growth compound over time?

Small consistent growth leads to large wealth differences over time due to compounding.

What is the Rule of 70?

If the growth rate is x%, it will double in approximately 70/x years.

How does a 2% annual growth rate affect income over time?

At 2% growth, it takes 35 years for income to double.

How do resources and technology contribute to economic growth?

They increase productivity and output, fostering economic growth.

What are the three key factors contributing to economic growth?

Resources, technology, and institutions.

What are the types of resources that contribute to economic growth?

Natural resources, physical capital, and human capital.

What is natural capital?

Natural resources like land and minerals that contribute to economic wealth.

Why are natural resources not always sufficient for economic growth?

Countries can remain poor despite rich resources due to poor institutions.

What is physical capital?

Tools and infrastructure used in the production of goods and services.

Why is physical capital important for economic growth?

It enhances productivity, allowing more output with the same resources.

What is human capital?

The knowledge and skills of the workforce contributing to productivity.

How does education affect human capital and economic growth?

Education improves worker skills and productivity, increasing economic growth.

What is technology's role in economic growth?

It improves efficiency by introducing methods that enhance output.

How does technology improve agricultural output?

Advancements boost crop yields, as seen in U.S. agriculture.

What role do institutions play in fostering economic growth?

They create an environment conducive to investment and innovation.