MACROECONOMICS

What is Macroeconomics?

The study of the economy as a whole, focusing on broad aggregates like national output, employment, and price levels.

What are the main goals of Macroeconomic Policy?

1. Economic Growth: Sustained increase in real GDP.2. Full Employment: Low unemployment rate.3. Price Stability: Low and stable inflation.

Define Gross Domestic Product (GDP).

The total market value of all final goods and services produced within a country's borders in a specific time period (usually a year).

What are the two main approaches to calculating GDP?

1. Expenditure Approach: Sum of all spending on final goods and services: GDP = C + I + G + NX
   • C: Consumption
   • I: Investment
   • G: Government Purchases
   • NX: Net Exports (Exports - Imports)
2. Income Approach: Sum of all income earned from producing goods and services (wages, rent, interest, profit).

What is Macroeconomics?

The study of the economy as a whole, focusing on broad aggregates like national output, employment, and price levels.

What are the main goals of Macroeconomic Policy?

1. Economic Growth: Sustained increase in real GDP.2. Full Employment: Low unemployment rate.3. Price Stability: Low and stable inflation.

Define Gross Domestic Product (GDP).

The total market value of all final goods and services produced within a country's borders in a specific time period (usually a year).

What are the two main approaches to calculating GDP?

1. Expenditure Approach: Sum of all spending on final goods and services: GDP = C + I + G + NX- C: Consumption

   • I: Investment
   • G: Government Purchases
   • NX: Net Exports (Exports - Imports)

2. Income Approach: Sum of all income earned from producing goods and services (wages, rent, interest, profit).

Differentiate between Nominal GDP and Real GDP.

1. Nominal GDP: GDP measured in current prices, not adjusted for inflation.
2. Real GDP: GDP measured in constant prices (from a base year), adjusted for inflation, reflecting actual production changes.

How is the GDP Deflator calculated, and what does it measure?

Calculated as: \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100
The GDP Deflator is a measure of the overall price level of goods and services produced domestically. It is used to convert nominal GDP to real GDP.

What is Inflation?

A general increase in the overall price level in an economy over time, resulting in a decrease in the purchasing power of money.

How is the Consumer Price Index (CPI) calculated, and what does it measure?

Calculated as: \frac{\text{Cost of Market Basket in Current Year}}{\text{Cost of Market Basket in Base Year}} \times 100
CPI measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

What are the types of unemployment?

1. Frictional Unemployment: Short-term unemployment due to the time it takes for workers to search for new jobs or enter the labor force (e.g., recent graduates).
2. Structural Unemployment: Unemployment resulting from a mismatch between the skills workers have and the skills employers demand, often due to technological changes or shifts in industry.
3. Cyclical Unemployment: Unemployment caused by a downturn in the business cycle or insufficient aggregate demand (e.g., during a recession).
4. Seasonal Unemployment: Unemployment due to seasonal changes in employment throughout the year (e.g., lifeguards in winter).

Define the Natural Rate of Unemployment (NRU).

The unemployment rate that would exist in a healthy economy, encompassing only frictional and structural unemployment. Cyclical unemployment is zero at the NRU. It is associated with potential output (or full employment output).

What is the formula for the Unemployment Rate?

Unemployment Rate = \frac{\text{Number of Unemployed}}{\text{Labor Force}} \times 100
Labor Force = \text{Unemployed} + \text{Employed}

What is Aggregate Demand (AD)?

The total demand for all final goods and services in an economy at various price levels. It is represented graphically as a downward-sloping curve.

What are the components of Aggregate Demand (AD), and what shifts the AD curve?

AD components are Consumption (C), Investment (I), Government Spending (G), and Net Exports (NX).

Factors that shift AD (e.g., to the right for an increase):

• Consumption: Increased consumer wealth, optimism, lower taxes, lower interest rates.
• Investment: Business optimism, lower interest rates, technological advancements.
• Government Spending: Increased government purchases.
• Net Exports: Increased foreign income, depreciation of domestic currency.

Differentiate between Short-Run Aggregate Supply (SRAS) and Long-Run Aggregate Supply (LRAS).

1. SRAS: An upward-sloping curve showing the total quantity of output that firms are willing and able to produce at various price levels in the short run. Firms may adjust output in response to price changes with sticky wages/prices.
2. LRAS: A vertical line at the economy's potential output or full-employment output. In the long run, all prices (including wages) are flexible, so the quantity of output is determined by factors of production and technology, not price level.

What shifts the SRAS curve?

Factors that shift SRAS (e.g., to the right for an increase):

• Changes in resource prices: Lower wages, lower input costs (e.g., oil).
• Changes in productivity: Technological advances, improved education.
• Changes in business taxes/subsidies: Lower taxes, higher subsidies.

What shifts the LRAS curve?

Factors that shift LRAS (which also shift potential output):

• Changes in factors of production: Increases in labor force, capital stock, natural resources.
• Changes in technology: Advances in production methods.

Describe the AD-AS Model equilibrium.

The equilibrium in the AD-AS model occurs at the intersection of the AD and AS curves, determining the equilibrium price level and real GDP.

• Short-Run Equilibrium: Intersection of AD and SRAS.
• Long-Run Equilibrium: Occurs when AD, SRAS, and LRAS all intersect at the same point, indicating full employment and the natural rate of unemployment.

What is Fiscal Policy?

The use of government spending (G) and taxation (T) to influence macroeconomic conditions, particularly aggregate demand.

Differentiate between Expansionary and Contractionary Fiscal Policy.

1. Expansionary Fiscal Policy: Aims to increase AD and stimulate economic growth. Involves increasing government spending or decreasing taxes.
2. Contractionary Fiscal Policy: Aims to decrease AD and combat inflation. Involves decreasing government spending or increasing taxes.

Explain the Government Spending Multiplier.

The ratio of the change in equilibrium real GDP to the initial change in government spending. It shows how a change in G leads to a larger change in GDP.

Multiplier = \frac{1}{1 - MPC} where MPC is the Marginal Propensity to Consume (\frac{\Delta C}{\Delta Y_D}).

Explain the Tax Multiplier.

The ratio of the change in equilibrium real GDP to the initial change in taxes. It is typically smaller than the government spending multiplier and has an opposite sign.

Tax Multiplier = \frac{-MPC}{1 - MPC}

What are Automatic Stabilizers?

Government spending and taxation policies that counteract economic fluctuations without explicit policy changes. Examples include progressive income taxes (tax revenue falls during recession, moderating the downturn) and unemployment benefits (spending rises during recession, supporting demand).

What is Crowding Out?

A phenomenon where increased government borrowing (to finance deficits from expansionary fiscal policy) increases demand for loanable funds, pushing up interest rates, which can reduce-private sector investment and consumption.

What are the three functions of Money?

1. Medium of Exchange: Accepted as payment for goods and services.
2. Store of Value: Can be held and exchanged for future purchases.
3. Unit of Account: Provides a common measure of value for goods and services.

Differentiate between M1 and M2 money supply.

1. M1: The most liquid forms of money, including physical currency (cash), demand deposits (checking accounts), and traveler's checks.
2. M2: M1 plus less liquid assets such as savings accounts, money market deposit accounts, and small-denomination time deposits.

What are the main tools of Monetary Policy used by a central bank (e.g., the Federal Reserve)?

1. Open Market Operations (OMO): The buying and selling of government securities (bonds) in the open market. Buying bonds increases the money supply; selling bonds decreases it.
2. Discount Rate: The interest rate at which commercial banks can borrow money directly from the central bank. Lowering the discount rate encourages borrowing and increases the money supply.
3. Reserve Requirements: The fraction of deposits that banks must hold in reserve and not lend out. Lowering reserve requirements increases the money supply.
4. Interest on Reserves: The interest rate paid by the central bank on reserves held by commercial banks. Changing this rate influences banks' incentive to lend.

Describe the effect of an Open Market Purchase of bonds by the Fed.

When the Fed buys bonds, it injects money into the banking system. Banks' reserves increase, allowing them to make more loans, which increases the money supply and decreases interest rates. This is an expansionary monetary policy.

Draw and explain the Money Market graph.

The Money Market graph shows the relationship between the nominal interest rate (y-axis) and the quantity of money (x-axis).

• Money Demand (MD): Downward-sloping, showing that people demand more money at lower interest rates.
• Money Supply (MS): A vertical line, as it is controlled by the central bank.
• Equilibrium: Intersection of MD and MS determines the equilibrium nominal interest rate.

Shifts: An increase in MS (e.g., Fed buys bonds) shifts MS to the right, lowering interest rates. An increase in MD (e.g., higher GDP) shifts MD to the right, raising interest rates.

State and explain the Quantity Theory of Money.

The equation is: MV = PY

• M: Money Supply
• V: Velocity of Money (average number of times money is spent)
• P: Price Level
• Y: Real Output (Real GDP)

This theory suggests that if velocity (V) and real output (Y) are relatively stable in the short run, then a change in the money supply (M) will lead to a proportional change in the price level (P).

Differentiate between the Nominal Interest Rate and the Real Interest Rate.

1. Nominal Interest Rate: The stated interest rate on a loan or investment, not adjusted for inflation.
2. Real Interest Rate: The nominal interest rate minus the inflation rate (Fisher Equation: Real : Interest : Rate = Nominal : Interest : Rate - Inflation : Rate). It represents the true cost of borrowing or return on saving.

What is the Balance of Payments (BOP)?

A record of all economic transactions between the residents of one country and the rest of the world over a specific period. It consists of the current account and the financial (capital) account.

Define the Current Account and the Financial Account.

1. Current Account: Records international trade in goods and services, investment income, and unilateral transfers. A current account deficit means a country imports more than it exports plus net income/transfers.
2. Financial Account: Records international flows of financial assets (like stocks, bonds, real estate). A financial account surplus means more foreign assets are bought by domestic residents than domestic assets bought by foreign residents (net capital inflows).

Key Relationship: Current : Account + Financial : Account = 0

What is an Exchange Rate?

The price of one currency in terms of another currency.

Differentiate between Currency Appreciation and Depreciation.

1. Appreciation: An increase in the value of a currency relative to other currencies, meaning it can buy more of another currency.
2. Depreciation: A decrease in the value of a currency relative to other currencies, meaning it can buy less of another currency.

How does a currency appreciation affect Net Exports (NX)?

Currency appreciation makes a country's exports more expensive to foreigners and imports cheaper to domestic consumers, leading to a decrease in net exports (a movement toward a trade deficit or a larger deficit).

What factors determine a country's economic growth?

Key factors include:

• Physical Capital: Amount and quality of tools, machines, factories.
• Human Capital: Education, skills, and health of the labor force.
• Technology: Advances in production methods.
• Natural Resources: Availability of land, mineral deposits, etc.
• Institutions: Property rights, rule of law, political stability.

Draw and explain the Short-Run Phillips Curve (SRPC).

The SRPC shows an inverse relationship between inflation and unemployment in the short run. As unemployment decreases, inflation tends to increase, and vice versa. It is downward-sloping.

Shifts: Supply shocks (e.g., oil price increase) or changes in inflationary expectations can shift the SRPC.

Draw and explain the Long-Run Phillips Curve (LRPC).

The LRPC is a vertical line at the Natural Rate of Unemployment (NRU). In the long run, there is no trade-off between inflation and unemployment. Any attempts to lower unemployment below the NRU through monetary or fiscal policy will only lead to higher inflation, with unemployment returning to its natural rate.

What is the difference between GDP and GNP?

1. GDP (Gross Domestic Product): Total market value of all final goods and services produced within a country's borders.
2. GNP (Gross National Product): Total market value of all final goods and services produced by a country's citizens and businesses, regardless of where they are located. GNP = GDP + Net : Factor : Income : from : Abroad

What is GDP per capita, and why is it important?

GDP per capita = \frac{\text{GDP}}{\text{Population}}. It's a measure of average economic output per person and is often used as an indicator of a country's standard of living, though it has limitations.

Describe the phases of the Business Cycle.

The business cycle refers to the economy-wide fluctuations in economic activity over several months or years. Its phases include:

1. Expansion/Recovery: Period of economic growth, rising employment, and increasing output.
2. Peak: The highest point of economic activity before a downturn.
3. Contraction/Recession: Period of economic decline, falling employment, and decreasing output.
4. Trough: The lowest point of economic activity before a recovery begins.

What are the main causes or types of Inflation?

1. Demand-Pull Inflation: Occurs when aggregate demand outpaces aggregate supply, pulling prices up (too much money chasing too few goods).
2. Cost-Push Inflation: Occurs due to an increase in the cost of production (e.g., rising wages, oil prices), pushing prices up.

Who is hurt and who is helped by unexpected inflation?

• Hurt: Savers (value of savings decreases), Lenders (loans repaid with less valuable money), Fixed-income earners (purchasing power decreases).
• Helped: Borrowers (debts repaid with less valuable money), Consumers with certain durable goods (asset value may rise).

Define Deflation and Disinflation.

• Deflation: A general decrease in the overall price level.
• Disinflation: A slowdown in the rate of inflation (prices are still rising, but at a slower pace).

What is the Labor Force Participation Rate?

Labor Force Participation Rate = \frac{\text{Labor Force}}{\text{Adult Population}} \times 100
It measures the percentage of the adult population that is either employed or actively looking for work.

Who are discouraged workers and underemployed workers?

• Discouraged Workers: Individuals who would like to work but have given up looking for a job, often due to a lack of opportunities. They are not counted in the labor force.
• Underemployed Workers: Individuals who are working part-time or in jobs below their skill level, but would prefer full-time or more suitable employment. They are counted as employed.

What is a Recessionary Gap in the AD-AS model?

A recessionary gap (or output gap) occurs when the economy's short-run equilibrium output (intersection of AD and SRAS) is below its potential output (LRAS). This indicates high unemployment and underutilized resources.

What is an Inflationary Gap in the AD-AS model?

An inflationary gap (or output gap) occurs when the economy's short-run equilibrium output (intersection of AD and SRAS) is above its potential output (LRAS). This indicates low unemployment but upward pressure on the price level due to resources being overutilized.

Explain Stagflation.

Stagflation is a condition of slow economic growth (stagnation) and relatively high unemployment, accompanied by rising prices (inflation). It is often caused by a negative supply shock that shifts the SRAS curve to the left.

What is the role of self-correction in the AD-AS model?

The self-correction mechanism suggests that, in the absence of government intervention, wages and other resource prices will adjust to move the economy from a short-run disequilibrium back to long-run equilibrium (potential output).

• In a recessionary gap: Wages fall, SRAS shifts right.
• In an inflationary gap: Wages rise, SRAS shifts left.

Differentiate between Government Budget Deficit and National Debt.

• Budget Deficit: Occurs when government spending exceeds tax revenues in a single fiscal year.
• National Debt: The accumulation of all past government budget deficits minus surpluses.

What is the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)?

• MPC: The fraction of an additional dollar of disposable income that consumers spend. MPC = \frac{\Delta C}{\Delta Y_D}
• MPS: The fraction of an additional dollar of disposable income that consumers save. MPS = \frac{\Delta S}{\Delta Y_D}

Relationship: MPC + MPS = 1

What is the formula for the Simple Money Multiplier?

Simple Money Multiplier = \frac{1}{Required : Reserve : Ratio}
This formula indicates the maximum amount of new money that can be created by a single deposit in the banking system through the process of lending.

Draw and explain the Loanable Funds Market graph.

The Loanable Funds Market graph shows the relationship between the real interest rate (y-axis) and the quantity of loanable funds (x-axis).

• Supply of Loanable Funds (SLF): Upward-sloping, representing savings by households, firms, and the government that are available for lending. Higher real interest rates encourage saving.
• Demand for Loanable Funds (DLF): Downward-sloping, representing borrowing by firms for investment and by governments for deficits. Lower real interest rates encourage borrowing for investment.
• Equilibrium: Intersection determines the equilibrium real interest rate and quantity of loanable funds.

Shifts: Changes in saving behavior, investment opportunities, or government borrowing shift the curves.

How does expansionary fiscal policy affect the Loanable Funds Market and interest rates?

Expansionary fiscal policy (increased government spending or decreased taxes) often leads to increased government borrowing to finance deficits. This increases the demand for loanable funds, shifting DLF to the right, which raises the real interest rate (leading to crowding out).

How does expansionary monetary policy affect real interest rates in the short run and long run?

• Short Run: Expansionary monetary policy (increasing money supply) typically lowers nominal and real interest rates, stimulating investment and consumption.
• Long Run: According to the Quantity Theory of Money and principles of monetary neutrality, in the long run, an increase in the money supply primarily leads to inflation, and real interest rates return to their natural rate (determined by saving/investment in the Loanable Funds Market).

What is comparative advantage and absolute advantage?

• Absolute Advantage: The ability to produce a good using fewer inputs than another producer (or produce more output with the same inputs).
• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer. Countries benefit from trade by specializing in goods for which they have a comparative advantage.

What are common trade barriers and their effects?

• Tariffs: Taxes on imported goods. They increase import prices, making domestic goods more competitive, but reduce overall trade and can lead to higher consumer prices.
• Quotas: Limits on the quantity of goods that can be imported. They also restrict trade, raise domestic prices, and protect domestic industries.

Both generally lead to higher domestic prices and reduced consumer choice.

How does the value of a country's currency respond to its interest rates?

Higher domestic interest rates (relative to foreign rates) attract foreign financial capital seeking higher returns. This increases demand for the domestic currency, leading to its appreciation.

What is Purchasing Power Parity (PPP)?

Purchasing Power Parity is a theory that states exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. It suggests that identical goods in different countries should eventually cost the same when expressed in a common currency.

Briefly describe the Classical view of the economy.

The Classical view emphasizes that markets naturally self-correct to full employment in the long run. They believe in minimal government intervention, flexible wages and prices, and that changes in money supply primarily affect the price level, not real output. The LRAS curve is vertical.

Briefly describe the Keynesian view of the economy.

The Keynesian view argues that the economy can get stuck in a recessionary gap due to insufficient aggregate demand and sticky wages/prices. They advocate for active government intervention (fiscal and monetary policy) to stabilize the economy and stimulate demand, especially during recessions.

What is the Production Possibilities Curve (PPC), and how does it relate to economic growth?

The PPC (or PPF) illustrates the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed. It is typically bowed out.

Economic growth is represented by an outward shift of the PPC, meaning the economy can produce more of both goods, often due to technological advancements or an increase in resources.