Macro-Economics Review

Readings, Lectures, Homeworks

Macroeconomics focuses on national economies while seeking answers to large-scale economic questions including:

* Why are some countries really rich while others are poor?
* Why do all countries - even the richest - go through alternating boom and bust periods?
* Can governments do anything to improve living standards or fight recessions?

What does macroeconomics study?

It studies the behavior of the economy as a whole

What is macroeconomics concerned with?

* Long-run economic growth
* Short-run fluctuations in output and employment that comprise the business cycle

Rate of growth is not constant

True

Most economies enjoy a distinct growth trend that leads to higher output and higher standards of living in the long run

True

Recession

Sometimes rate of growth proceeds rapidly, sometimes slowly, but in this case it turns negative for awhile

* Sticky wages - wage goes down, you will be upset

What do economists do?

They collect and analyze economic data and more to understand how economies operate and how to improve their performance

What 3 key statutes do macroeconomists focus on, when assessing an economy’s health and development?

* Real GDP
* Unemployment
* Inflation

Real Gross Domestic Product

* Measures the value of the final goods and services produced within a country’s borders during a specific period of time, typically a year
* Stands for the whole pizza
* Tells us whether an economy’s output is growing

How do you calculate the value of real GDP?

First calculate the value of real GDP

Nominal GDP

The dollar value of all goods and services produced within a country’s borders using their prices during the year they were produced.

* Wage right now = nominal wage

What is nominal GDP’s major problem?

It can increase from one year to the next even if there is no increase in output

* Real GDP avoids this problem by accounting for price changes

More output means more consumption possibilities

True

Unemployment

Occurs when a person cannot get a job despite being willing to work and actively seeking work

Why are high unemployment rates undesireable?

* They indicate that a nation is not using a large portion of its most important resource - the talents and skills of its people
* It is wasteful because we lose all the goods and services that unemployed workers could have produced if they were working

Higher unemployment rates lead to more major social problems such as higher crime rates, political unrest, higher rates of depression, and heart disease.

True

Inflation

Increase in the overall level of prices

What are the problems with inflation?

* Families won’t be able to purchase as much as it used to
* A surprise jump in inflation reduces the purchasing power of people’s savings
* Their savings will buy less than expected due to the higher-than expected prices

Rapid and sustained economic growth is a modern phenomenon

True

Industrial Revolution

* Lead to Modern Economic Growth
* People started to work in factories - therefore they had more leisure time
* Output began to grow faster than the population, and living standards began to rise as the amount of output per person increased

In countries, experiencing modern economic growth, output per person rises.

True

Modern Economic Growth

Output grows faster than population, living standards rise over time

What are vast differences in living standards due to?

* They are almost entirely the result of the fact that different countries began modern economic growth at different rates.
* The countries that have been at it the longest have ended up far richer than those that began modern economic growth only recently.

How should an economy devote its time if it wants to raise living standards over time?

* They must devote at least some part of its current output to increasing future output.
* This process requires both saving and investment

Saving

Occurs when current consumption is less than current income; the difference between them is savings

Investment

Happens when resources are directed toward increasing future output - either by paying for research to develop more efficient production technologies or by paying for the production of newly created capital goods (such as machinery, tools, and infrastructure) that will increase future output.

The amount of investment is ultimately linked by the amount of saving

True

The only way that more output can be directed at investment activities is if saving increases

True

What is the only way to pay for more investment?

To increase present saving

Increase saving comes at what cost?

It can only come at the price of reduced current consumption

What do economists mean when they say “investment"“?

They mean economic investment

Financial Investment

Captures what ordinary people mean when they say investment, namely, the purchase of assets like stocks, bonds, and real estate in the hope of reaping a financial gain.

Economic Investment

Relates to the expansion of the economy’s productive capacity

* Includes spending that pays for the production of newly created capital goods like factories and wireless networks as well as the costs of developing new technologies like solar powered helicopters or a cure for cancer

Economists do not see pure financial transactions as “investment” because they do not increase the economy’s productive capacity - therefore not an “investment”

True

What is the principal source of savings?

Households

Who are the main economic investors?

Businesses

How does the pool of savings generated by households get transferred to businesses?

Banks and other financial institutions (mutual funds, pension plans, and insurance companies) act as intermediaries between households and businesses.

Banks and other financial institutions

* Collect households’ savings, rewarding savers with interest, dividends, or capital gains (increases in asset values)
* Lend funds to businesses, which invest in equipment, factories, and other capital goods as well as research and development

What does a well functioning system promote?

It promotes economic growth and stability by encouraging saving and by directing that saving into the most productive possible investments

What does a poorly functioning financial system do?

It causes serious problems for an economy

Firms spend considerable time trying to predict future trends so that they invest only in projects that are likely to succeed

True

Why do expectations have a large effect on economic growth?

Because increased pessimism leads to less current investment and, subsequently, less future consumption

Expectations are important because…

* Involves the effects of changing expectations on current behavior
* Concerns what happens when expectations are unmet
* Huge when it comes to investments
* Drive businesses decisions whether its a firm or consumers

Firms are often forced to cope with the shocks

True

Shocks

Situations in which they were expecting one thing to happen but something else happened instead.

Economies experience both demand shocks

True

Demand Shocks

Unexpected changes in the demand for good services

* Sales unchanged
* Can have positive (answer) shocks like masks and toilet paper during Covid-19 pandemic

Positive demand shock

Refers to a situation in which actual demand is higher than expected

A negative demand shock

Refers to a situation in which actual demand is lower than expected

* They make less and put it into inventory

Supply Shocks

Unexpected changes in the supply of goods and services

* Sales change
* Business cycle

The word “shock” does not tell us whether what has happened is unexpectedly good or bad.

True

What do economists believe that most short-run fluctuations in GDP and the business cycle are the result of?

Demand Shocks

Supply shocks do happen in some cases and are very important when they do occur

True

Why are demand shocks such a big problem?

* Prices of many goods and services are inflexible (slow to change, or “sticky”) in he short run
* Implies that price changes do not quickly equalize the quantities demanded of such goods and services with their respective quantities supplied
* Because the prices are inflexible - economy forced to respond in the short run through changes in output and employment rather than through prices

If the prices of goods and services can always adjust quickly to unexpected changes in demand, then…

the economy can always produce at its optimal capacity because prices will adjust to ensure that the quantity demanded of each good and service always equals the quantity supplied.

If prices are fully flexible, then…

There will be no short-run fluctuations in output. Production levels will remain constant, and unemployment levels will not change because firms will always need the same number of workers to produce the same amount of output.

In reality, many prices in the economy are inflexible and do not change rapidly when demand changes unexpectedly.

True

One way to deal with these unexpected shifts in quantity demanded is to try to adjust the factory’s output to match them. However what is its negative?

This flexible output strategy is very expensive because factories operate at their lowest costs when they are producing constantly at their optimal output levels.

* Operating at either a higher or lower production rate results in higher per-unit production costs.

Manufacturing firms typically attempt a deal with unexpected changes in demand by maintaining an inventory

True

Inventory

A stock of output that has been produced but not yet sold.

Why are inventories useful?

Because companies can allow them to grow or decline in periods when demand is unexpectedly low or high - thereby allowing production to proceed smoothly and constantly at the optimal output level even when demand is variable

What do constantly rising inventories do?

They hurt profits and management will want to reduce output if it sees inventories rising week after week due to unexpectedly low demand.

* As output falls, the firm will have to lay off workers, and unemployment will increase

What do economists believe is the key to understanding the short-run fluctuations that affect real-world economies?

A combination of unexpected changes in demand and inflexible prices

If demand falls off for many goods and services across the entire economy for an extended period of time, then…

The firms that make those goods and services will be forced to cut production

As both manufacturing and service output decline, what happens to GDP and unemployment?

Real GDP will fall and unemployment will rise.

If demand is unexpectedly high for a prolonged period of time, what will the economy and unemployment do?

Economy will boom and unemployment will fall

Inflexible prices

Economists call these “sticky” prices

Sticky Prices

Help to explain how unexpected changes in demand lead to the fluctuations in GDP and employment that occur over the course of the business cycle.

Not all prices are sticky

True

Flexible Prices

The markets for many commodities and raw materials such as corn, oil, and natural gas feature extremely flexible prices that react within seconds to changes in supply and demand

* Allow prices to move freely
* Ex. Corn, Oil, Natural Gas

Most consumer products are rather sticky

True

Firm try to maintain stable prices because…

* Consumers would be annoyed if the prices changed everyday
* Consumers would feel like they are being taken advantage of if the price were high

Why may a firm fear cutting prices?

A firm might feel this because they might think it will be counterproductive because its rivals might simply match the price cut - a situation often referred to as a “price war”

Price War

Rivals matching the price cut

Ex. Coca Cola and Pepsi

Firms that face this often have sticky prices

Price stickiness moderates over time

True

What will firms do if unexpected changes in demand begin to look permanent?

Firms will allow their prices to change so that price changes (in addition to quantity changes) can help to equalize quantities supplied with quantities demanded.

Economist speak of “sticky prices” rather than “stuck prices”

True, because it moderates over time

As time passes on, what happens to prices

Prices are fully flexible and inflexible for a short amount of time

Differences in behavior result from the fact that prices go from completely stuck immediately after a shock to what?

To fully flexible in the long run

GDP

How big is the pizza

GDP Per Capita

Best way to evaluate an economy

* How big is each person’s slice

If you want to compare prices do you use nominal GDP or real GDP?

Real GDP

Fiscal Policy

Government controls this

Monetary Policy

Federal reserve controls this

* adjust interest rates
* currently the Fed is trying to slow us down due to inflation

What can you do with money?

* Spend it
* Save it

We (consumers and businesses) have a tradeoff between spending and saving money

True

Firms do not like shocks but they are inevitable, that is why expectations are a huge thing

True

Big Businesses Expectations

5-20 year expectations and/or goals

Small Business Expectation

1-3 year expectations and/or goals

When expectations are broken, what happens?

Chaos ensues

When you are uncertain, what do you do with your money?

You save your money

Domino Ripple Effect

Less money you are spending, less money the employers take in

When would you want to take out a loan?

Now because it makes the loan more expensive because the interest rates are high

Covid-19 caused both a demand and supply shock

True, our GDP went significantly down in 3 months

Flexible Demand Shocks

Price changes due to demand shocks

Sticky Demand Shocks

Quantity changes due to demand shocks

Menu Costs

Refers to the costs of changing listed prices

* Sticky prices are also called this

Services take about a year to change (so like a plumber or barber shop)

True because they take longer to adjust because they are more complicated

* If they raise prices, people will react

Finance takes about 7 months to change

True because they are usually on salary

Manufacturing takes about 3 months

True