Macroeconomic Exam 2 Key Concepts Review (CH. 10, 11, & 13)

Income = Expenditure

• Every dollar spent by a buyer becomes income for a seller, so total spending equals total income in the economy.

Circular-Flow Diagram

• Model showing how households spend money on goods/services and firms pay wages, rent, and profit;

• Demonstrates that GDP = total spending = total income.

GDP Inclusion Rule

• GDP includes all final goods/services produced legally within a country during a specific period.

GDP Exclusion Rule

• GDP excludes intermediate goods, illegal goods, home production, and past production.

Consumption (C) Concept

• Household spending on goods/services, excluding purchases of new housing.

Investment (I) Concept

• Spending on business capital, residential capital, and inventory changes.

Government Purchases (G) Concept

• Government spending on goods/services

• Excludes transfer payments like Social Security.

Net Exports (NX) Concept

• Exports minus imports

• Measures foreign spending on domestic goods minus domestic spending on foreign goods.

Nominal GDP Concept

• GDP measured using current prices

• Includes inflation.

Real GDP Concept

• GDP measured using constant base‑year prices

• Removes inflation.

GDP Deflator Concept

• Price index that compares current prices to base‑year prices using the ratio of nominal GDP to real GDP.

GDP as a Well-Being Measure

• GDP is the best single measure of economic well‑being but excludes leisure, home production, environment quality, and income distribution.

Consumer Price Index (CPI) Concept

• Measures the cost of a fixed basket of goods/services bought by a typical consumer.

Inflation Rate (CPI) Concept

• Percentage change in the CPI from one year to the next.

Substitution Bias

• CPI overstates cost of living because consumers substitute toward cheaper goods, but CPI uses a fixed basket.

Introduction of New Goods Problem

• CPI misses new goods that increase consumer choice, causing CPI to overstate inflation.

Unmeasured Quality Change

• CPI overstates inflation because improvements in product quality are hard to measure.

CPI vs GDP Deflator Concept

• CPI uses a fixed basket and includes imports

• GDP deflator uses current production and excludes imports.

Indexation Concept

• Automatic adjustment of dollar amounts for inflation (e.g., COLA, Social Security).

Real vs Nominal Interest Rate Concept

• Real interest rate equals nominal interest rate minus inflation

• Shows true purchasing power.

Financial System Concept

• Network of institutions that match one person’s saving with another person’s investment.

Financial Markets Concept

• Markets where savers directly provide funds to borrowers (bond market, stock market).

Financial Intermediaries Concept

• Institutions that indirectly connect savers and borrowers (banks, mutual funds).

National Saving Concept

• Total income left after paying for consumption and government purchases.

Private Saving Concept

• Household income left after taxes and consumption (Y − T − C).

Public Saving Concept

• Tax revenue minus government spending (T − G).

Budget Surplus Concept

• Occurs when T − G > 0

• Government saves money.

Budget Deficit Concept

• Occurs when T − G < 0

• Government dissaves and borrows.

Market for Loanable Funds Concept

• Model showing supply of saving and demand for investment

• Interest rate adjusts to balance them.

Crowding Out Concept

• Government borrowing reduces national saving, raises interest rates, and decreases private investment.

Time Value of Money

• Money today is more valuable than money in the future because it can earn interest.

• This concept is the foundation of present value and future value calculations.

Compounding Concept

• Interest earns additional interest over time, causing money to grow faster the longer it stays invested.

• Even small interest rate differences create large future value changes.

Present Value Concept

• Tells you how much money today is equivalent to a future payment.

• Higher interest rates reduce present value because future money is discounted more heavily.

Future Value Concept

• Shows how much an amount today will grow after earning interest.

• It increases with higher interest rates and longer time periods.

Discounting Concept

• Future payments discounted to their present value.

• It is the reverse of compounding and is used to evaluate whether future payments are worth their cost today.

Investment Decision Rule (Present Value vs Price)

• If the present value of a future payoff is greater than the price you pay today, the investment is worthwhile.

• If PV is less than the price, you should not buy it.

Risk Aversion Concept

• Risk‑averse individuals prefer safer outcomes and avoid uncertainty.

• They may accept lower returns in exchange for lower risk.

Utility Concept

• Utility measures satisfaction or happiness.

• People make financial decisions to maximize their utility, not just their wealth.

Diminishing Marginal Utility Concept

• Each additional dollar increases utility by a smaller amount as wealth rises.

• This explains why losing money feels worse than gaining the same amount feels good.

Insurance Concept

• Insurance spreads risk across many people.

• It protects individuals from large financial losses but does not eliminate risk entirely.

Adverse Selection Concept

• High‑risk individuals are more likely to buy insurance because they expect to use it more.

• Insurers struggle to identify who is high‑risk versus low‑risk.

Moral Hazard Concept

• After buying insurance, people may behave less carefully because they know losses are covered.

• This increases the insurer’s risk.

Diversification Concept

• Holding many unrelated assets reduces firm‑specific risk.

• Diversification cannot eliminate market‑wide risk because all firms are affected by economic conditions.

Standard Deviation Concept

• Standard deviation measures how much returns fluctuate.

• A higher standard deviation means more volatility and therefore more risk.

Risk-Return Trade-Off Concept

• Riskier assets offer higher average returns to compensate investors for taking on more uncertainty.

• Stocks have historically higher returns than bonds because they are riskier.

Fundamental Analysis Concept

• Evaluates a stock’s true value using financial statements, expected profits, and future prospects.

• Determines whether a stock is undervalued, overvalued, or fairly valued.

Efficient Markets Hypothesis Concept

• Asset prices reflect all publicly available information.

• Because new information is unpredictable, stock prices move unpredictably and cannot be consistently outperformed.

Informational Efficiency Concept

• Stock prices instantly adjust to new information.

• This means no investor has an advantage using publicly available data.

Random Walk Concept

• Stock price changes are unpredictable because they already reflect all known information.

• Future movements depend only on new, random information.

Speculative Bubble Concept

• Asset prices rise far above their fundamental value due to psychological forces like hype, optimism, or “animal spirits.”

• Bubbles eventually burst when prices return to realistic levels.

Market Irrationality Concept

• Stock prices sometimes move due to emotions rather than rational analysis.

• These swings can affect the broader economy and create uncertainty for investors.

Unemployment Measurement Concept

• The BLS divides adults into employed, unemployed, and not in the labor force to calculate labor market statistics.

Labor Force Concept

• Only employed and unemployed individuals are included in the labor force

• People not looking for work are excluded.

Discouraged Worker Problem

• Discouraged workers are not counted as unemployed, which can make unemployment appear lower than it actually is.

Natural Rate of Unemployment Concept

• Some unemployment always exists because workers are constantly changing jobs and industries.

Cyclical Unemployment

• Cyclical unemployment results from recessions and economic downturns and disappears as the economy improves.

Frictional Unemployment Concept

• Frictional unemployment occurs because finding the right job takes time, even in a healthy economy.

Structural Unemployment Concept

• Structural unemployment occurs when workers' skills do not match available jobs or when wages are kept above equilibrium.

Sectoral Shift Concept

• Changes in technology, trade, or consumer preferences create demand for some jobs while reducing demand for others.

Job Search Concept

• Job search improves worker-job matches but also creates temporary unemployment.

Unemployment Insurance Trade-Off

• Unemployment insurance protects workers financially but may increase frictional unemployment by reducing the urgency of job searches.

Minimum Wage and Unemployment

• A binding minimum wage acts like a price floor in the labor market and can create structural unemployment.

Labor Surplus Concept

• When wages are above equilibrium, the quantity of labor supplied exceeds the quantity of labor demanded, creating unemployment.

Union Wage Effect

• Unions often raise wages above equilibrium levels, benefiting union members but potentially causing unemployment.

Insiders vs Outsiders Concept

• Insiders keep high-paying union jobs, while outsiders may struggle to find employment.

Efficiency Wage Concept

• Some firms voluntarily pay above-equilibrium wages because higher pay can increase productivity.

Worker Health Theory

• Higher wages may improve worker nutrition and health, increasing productivity.

Worker Turnover Theory

• Higher wages reduce employee turnover and save firms hiring and training costs.

Worker Quality Theory

• Higher wages attract more skilled and productive job applicants.

Worker Effort Theory

• Employees work harder when losing their job would be costly because wages are above market levels.

Worker Morale Theory

• Workers who feel treated fairly tend to be more productive and motivated.

Three Functions of Money

• Money serves as a medium of exchange, unit of account, and store of value.

Liquidity Concept

• More liquid assets can be converted into spending power more easily.

Commodity Money Concept

• Commodity money has intrinsic value even without being used as money.

Fiat Money Concept

• Fiat money has value because the government declares it legal tender and people accept it in exchange.

Money Stock Concept

• The money stock includes currency and certain types of deposits that can be used to purchase goods and services.

M1 vs M2 Concept

• M2 is broader than M1 because it includes less-liquid assets such as small time deposits and money market funds.

Federal Reserve Concept

• The Fed acts as the central bank and controls the money supply through monetary policy.

Monetary Policy Concept

• Monetary policy involves changing the money supply to influence economic activity.

Banking and Money Creation

• Banks create money when they lend out a portion of deposits rather than keeping all deposits in reserve.

100% Reserve Banking Concept

• When banks keep all deposits as reserves, they cannot create money.

Fractional-Reserve Banking Concept

• When banks keep only a fraction of deposits in reserve, they create new money through lending.

Money Multiplier Concept

• An initial deposit can create a much larger increase in the money supply through repeated lending.

Reserve Ratio Relationship

• A higher reserve ratio leads to a smaller money multiplier and less money creation.

Bank Capital Concept

• Bank capital provides a cushion against losses and protects depositors.

Leverage Concept

• Leverage magnifies both gains and losses for a bank.

Insolvency Concept

• A bank becomes insolvent when its assets fall below its liabilities.

Credit Crunch Concept

• When banks lose capital, they may reduce lending, slowing economic activity.

Open-Market Operations Concept

• The Fed changes the money supply by buying or selling government bonds.

Bond Purchase Effect

• When the Fed buys bonds, reserves increase and the money supply expands.

Bond Sale Effect

• When the Fed sells bonds, reserves decrease and the money supply contracts.

Discount Rate Concept

• Lowering the discount rate encourages borrowing from the Fed and increases the money supply.

Reserve Requirements Concept

• Lower reserve requirements increase the money multiplier and expand the money supply.

Interest on Reserves Concept

• Higher interest on reserves encourages banks to hold reserves, reducing money creation.

Federal Funds Rate Concept

• The federal funds rate is the interest rate banks charge each other for overnight loans.

Federal Funds Rate Relationship

• Lower federal funds rates generally increase the money supply

• Higher federal funds rates generally decrease it.