Microeconmics test 2

What is a business cycle?

refers to reoccurring upswings and downswings in an economy's GDP over time. also known as alternating rises and declines in the level of economic activity.

What are the 4 phases of the business cycle?

peak, recession, trough, expansion

What happens to income, employment, and out in each phase of the business cycle?

1. peak: when economic activity, that is real GDP, employment and total income, is at a temporary maximum

2. recession: when real GDP, employment, and total income decline

3. trough: when output income and employment "bottom out" at their lowest level

4. expansion: a period when real GDP, income and employment rise

What are several possible sources of shocks that can cause business cycles?

1. irregular innovation: new products and production methods occur unexpectedly which contribute to variability of economic activity

2. productivity changes: unexpected changes in output per unit of input leads to unexpected changes in resource availability.

3. monetary factors: unexpected changes in the money supply by the central bank of a nation could cause unexpected changes in output, income, and employment.

4. political events: election of an unexpected presidential candidate, unexpected terrorist attacks, like 9/11, may cause shocks to the economy,

5. financial instability: unexpected financial bubbles or abrupt bursts can spillover to the general economy

What do most economist agree that the immediate cause of cyclical changes in the level of output and employment is?

is the unexpected level of total spending in the economy

Which industries and/or sectors are most likely and least likely to be affected by business cycles?

most likely to be affected: capital goods (machinery, equipment, and tools used in the production process) and durable goods (items that have a life expectancy of 3 years or more)

least likely to be affected: service industries (healthcare, lawyers) and industries that produce nondurable consumer goods (food, clothing)

How do we measure unemployment rate?

Unemployment Rate = (# of unemployed / labor force) × 100

What are types of unemployment?

1. frictional unemployment: consists of workers who are either searching for jobs or waiting to take jobs in the near future (voluntarily quit old jobs to find better ones, recently graduated college students)

2. structural unemployment: refers to changes over time in consumer demand and in technology that later the "structure" of the total demand for labor, both occupationally and geographically (work moves to another location but the person does not want to follow, talent that is now obsolete needs to learn new talent and can't work until then)

3. cyclical unemployment: refers to unemployment that is caused by a decline in total spending in the economy and it typically begins in the recessionary phase of the business cycle, as the demand for goods and services decreases, employment falls and unemployment rises. Thus, it results from insufficient demand for goods and services in the economy.

What is the formula for GDP gap and Okun’s law?

GDP gap= -2.0 x (actual unemployment rate - natural unemployment rate)

for every 1 percent of unemployment above the natural rate, a negative GDP gap of about 2 percent occurs

What is the measurement of inflation in the United States?

measurement of inflation in the U.S. is Consumer Price Index (CPI).

How do we measure the rate of inflation (or deflation)?

Inflation (deflation) = [(CPI current year – CPI last year) / CPI last year] × 100

What is the rule of 70?

measures how long it would take for a variable, like inflation to double in value
(70/2 = 35 years to double)

What are types of inflation?

1. demand pull inflation: caused by too much spending relative to output or production in the economy

2. cost-push inflation: initiated by increases in resource prices, such as labor and capital, as well as increase in per-unit production costs

How do we measure per unit production cost?

Per-unit production cost = total input cost / units of output

What is the difference between real income and nominal income?

nominal income: refers to the number of dollars received as wages, rents, interest, and profit.

real income: is a measure of the amount of goods and services nominal income can buy; it is the purchasing power of nominal income, or income adjusted for inflation.

Who is hurt by unanticipated inflation and how?

1. fixed income receivers: such as elderly living on a private pension or annuity that provides a fixed amount of nominal income each month; or landlords who receive lease payments of fixed dollar amounts will be hurt by inflation as they receive dollars of declining value over time.

2. savers: as prices rise, the real value, or purchasing power, of an accumulation of savings deteriorates; paper assets such as savings accounts, insurance polices, and annuities that were once adequate to meet rainy-day contingencies decline in real value during inflation.

3. creditors or lenders: are also harmed by unanticipated inflation, since each dollar they receive back from the borrower would purchase less and less goods.

If inflation is anticipated, what can lenders do to avoid the loss in real value of money?

they can increase the nominal interest rate they charge accordingly

What is the difference between nominal and real interest rate?

real interest rate: is the percentage increase in purchasing power that the borrower pays the lender and is stated in constant or inflation adjusted dollars

nominal interest rate: is the percentage increase in money that the borrower pays the lender, including that resulting from the built-in expectation of inflation, if any and is expressed in dollars of current value

What is the income-consumption and income-saving relationship?

the relationship is positive.

when income increase, consumption increase and the savings increases and vice versa.

How do we measure average propensity to consume (APC) and save (APS) as well as marginal propensity to consume (MPC) and save (MPS)?

APS = saving / income = fraction of total income saved

APC = consumption / income = fraction of total income consumed

MPS = change in saving / change in income = proportion of a change in income saved

MPC = change in consumption / change in income = proportion of a change in income consumed

MPC is equal to the slope of the consumption schedule and MPS is equal to the slope of the saving schedule

What is the sum of APC and APS as well as the sum of MPC and MPS?

APS + APC = 1
MPS + MPC = 1

What are non-income determinants of consumption and savings?

1. wealth: a household's wealth is the dollar amount of all the assets that it owns minus all the dollar amount of it liabilities (debts).

2. borrowing: when a household borrows, it can increase current consumption thus borrowing shifts the current consumptions schedule upward and thus current saving schedule downwards

3. expectations: the expectation of higher prices tomorrow may cause households to buy more today while prices are still low; thus consumption schedule shifts up and the current saving schedule shifts down; expectations of a recession and therefore a possibility of lower income in the future may cause households to reduce consumption today and increase saving.

What is the wealth effect?

caused by a sudden increase in wealth, it would shift the consumption schedule upwards and saving schedule downwards

How would a shift in consumption schedule in one direction affect the shift in saving schedule?

It will shift the saving schedule in the opposite direction. (inverse relationship)

How would a change in taxes shift the consumption and savings schedules?

it would shift both the consumption and savings schedules in the same direction. increase in taxes will reduce both consumption and saving, shifting the consumption and saving schedules downward and vice versa.

What are economic investment decisions based on?

it is based on marginal benefit and marginal cost analysis

What is the marginal benefit of an investment? And what is the marginal cost of an investment?

marginal benefit: of an investment is equal to the expected rate of return.

marginal cost: of an investment is equal to the real interest rate that must be paid back for borrowed funds.

How do we calculate expected rate of return of an investment?

expected rate of return= [(net expected revenue-cost of item)/(cost of item) x 100]

Is the investment demand curve positively or negatively sloped and why? (Figure 10.5)

it is negatively sloped

as the real interest rate rises the amount of investment spending declines and vice versa

What are determinants of investment demand curve?

1. acquisition, maintenance, and operating costs: when these costs rise, the expected rate of return from prospective investment projects fall and the investment demand curve shifts to the left and vice versa.

2. business taxes: an increase in business taxes lowers the expected profitability of investments and shifts the investment demand curve to the left and vice versa

3. technological change: the development of a more efficient machine, lowers production costs or improves product quality and increase the expected rate of return from investing in the machine

4. stock of capital goods on hand: when the economy is overstocked with production facilities and when firms have excessive inventories of finished goods, the expected rate of return on new investment declines and vice versa.

5. planned inventory changes: if firms are planning to increase their inventories, the investment demand curve shifts to the right and vice versa.

6. expectations: if business executives become more optimistic about future sales, costs, and profits, the investment demand curve will shift to the right and vice versa.

Why is investment spending unstable in the United States?

it tends to be unstable because expected profits are highly variable, capital goods are durable, innovation occurs at an irregular pace, and expectations vary quickly.

How do we calculate real interest rate?

Real interest rate = nominal interest rate – inflation premium

What is the multiplier effect?

is an effect that is useful in determining the change in GDP from an initial change in spending

indicates that a change in spending will change aggregate income by a larger amount

What is the relationship between MPC and multiplier? MPS and multiplier?

As MPC increases (decreases), the size of the multiplier increases (decreases).

As MPS increases (decreases), the size of the multiplier decreases (increases).

What is the multiplier process? (Figure 10.8)

shows that an initial change in investment spending creates equal income in round 1. Then in each successive spending level people spend some of the income and then will save some. but eventually will produce a total change of income and GDP far greater than the initial change in investment. Depending on what the MPC it will give us the multiplier.

What is the assumption regarding investment spending in the economy in the aggregate expenditure model? (Figure 11.1)

prices are assumed to fixed or "stuck"

also it is assumed that production decisions are made in response to unexpected changes in inventory levels

Assume aggregate expenditures in a private-closed economy. Which two components are included in aggregate expenditures?

consumption (c) and gross investment (Ig)

When the closed-economy is in equilibrium, what can we say about savings and planned investment?

they are equal to one another

What is an injection and what is a leakage?

leakage: is defined as a withdrawal of the spending from the economy's circular flow of income and expenditures (saving)

injection: defined as an addition of spending to the economy's circular flow of income and expenditures (investment)

How do we calculate actual investment given planned investment and unplanned changes in inventories? (Table 11.2)

Actual investment = Planned investment + unplanned changes in inventories

What happens to employment, output and income when the economy is in disequilibrium?

when the economy is in below equilibrium, then employment, output and income increase and when it is above equilibrium it decreases

What happens to employment, output and income, when aggregate expenditures are greater than GDP and when aggregate expenditures are less than GDP?

when aggregate expenditures are greater than GDP, then employment, output and income increase and when it is less than GDP it decreases.

What is the relationship between the expected rate of return, interest rate, investment, consumption, and GDP?

if expected rate of return increases or interest rate decreases than investment would increase, along with consumption, causing GDP to increase.

Changes in aggregate expenditures and the multiplier effect. How would a change (decrease or increase) in investment spending, change equilibrium GDP?

An increase in investment spending would shift the aggregate expenditures line upward and therefore increase GDP and vice versa. The size of the change in GDP would depend on the size of the multiplier in the economy. (if the multiplier is 4 than an investment of 5 would lead to a 20 increase in output and income)

What is the difference between closed economy and an open economy?

open economy: includes trade with other nations. imports and exports are now included

closed economy: is just consumption plus gross investment (planned investment) =DI = GDP

What happens to equilibrium GDP when net exports are positive and when net exports are negative?

when net exports are positive, equilibrium GDP increases.

when net exports are negative, equilibrium GDP decreases.

How would a change in net exports (positive and negative), change equilibrium GDP? (Figure 11.4)

a positive change in net exports will increase domestic aggregate expenditures and therefore increase equilibrium GDP.

a negative change in net exports will decrease domestic aggregate expenditures and therefore decrease equilibrium GDP.

What are some determinants of net exports?

1. propensity abroad:a rising level of output and income among U.S. foreign trading partners enables the United States to sell more goods abroad, thus raising U.S. net exports and increasing U.S. real GDP.

2. exchange rates: depreciation (appreciation) of the dollar relative to other currencies enables people to obtain more (less) dollars with each unit of their own currencies. Thus, the price of U.S. goods in terms of those currencies will fall (rise), stimulating (upsetting) purchases of U.S. exports

3. tariffs and devaluations: tariffs are taxes on imported goods. Therefore, increasing tariffs do increase net exports. However, other nations retaliate with their own tariffs and that may, in fact, reduce net exports.

If a nation imposes tariffs on foreign products, what would be the immediate effect on domestic production and employment?

the immediate effect will be an increase in domestic output and employment

How would adding the public sector (government) alter the aggregate expenditures model?

adding the government can alter the aggregate expenditures model by either causing the line to move up or down. government spending causes it to go up while taxes cause it to go down.

How does taxation effect equilibrium GDP? (Table 11.5)

taxation will cause the equilibrium GDP to fall, but a decrease in existing taxes will cause the equilibrium GDP to rise.

How does taxation effect consumption? (Figure 11.6)

Taxation will cause consumption to fall, but a decrease in existing taxes can cause the equilibrium GDP to rise.

What are further examples of injections and leakages?

leakages: saving, imports, and taxes

injections: investment, exports, and government expenditures.

What is a recessionary and inflationary expenditure gaps? (Figure 11.7)

recessionary expenditure gap: is the amount by which aggregate expenditures at the full employment level of GDP fall short of the amount required to achieve the full employment level of GDP.

inflationary expenditure gap: is the amount by which aggregate expenditures exceed the full-employment level of GDP

How can the government fix the recessionary and inflationary gaps? What are the policy options? How do these policies numerically work?

recessionary gap: increase government spending and/or decrease taxes

inflationary gap: reduce government spending and/or raise taxes

What does the aggregate demand curve show?

shows the various amounts of real domestic output that domestic and foreign buyers desire to purchase at each possible price level. In other words, the total quantity of goods and services (real domestic output) that would be demanded (purchased) at various levels.

What are reasons for the negative slope of the aggregate demand curve?

1. interest rate effect: suggests that an increase in the price level will increase the demand for money, increase interest rates, and decrease consumption and investment spending and vice versa.

2. real-balances effect: indicates that a higher price level will decrease the real value of many financial assets, reducing purchasing power, and therefore reduce spending and vice versa.

3. foreign purchases effect: suggests that an increase in the U.S. price level relative to other countries will increase U.S. imports and decrease U.S. exports and vice versa.

What are factors that would shift the aggregate demand curve, either to the right or to the left?

1. changes in consumer spending
a. consumer wealth
b. consumer expectations
c. household borrowing
d. taxes
2. changes in investment spending
a. interest rates
b. expected returns
expected future business conditions
technology
degree of excess capacity
business taxes
3. changes in government spending
4. changes in net export spending
a. national income abroad
b. exchange rates

What is aggregate supply?

A schedule or curve showing the total quantity of goods and services (real domestic output) that would be supplied (produced) at each possible price level.

How many time horizons are there in economics? What are the characteristics of each time horizon?

there are three time horizons

1. immediate short run: both input and output prices are fixed

2. short run: input price is fixed but output prices can vary

3. long run: when both input and output prices can vary

What is special about immediate short run aggregate supply? What is the shape of it? (Figure 12.3)

it is special because it is perfectly elastic meaning that the economy's output changes but not the price level

the shape of the curve is horizontal.

Insert a downwardly sloping aggregate demand curve to immediate short run aggregate supply and then shift it either to the right or to the left and observe the outcome on GDP as well as the price level.

price would stay the same and GDP would increase if it shifted to the right and would decrease if it shifted to the left

How does aggregate supply look like in the short run and why? (Figure 12.4)

it is positively sloped in the short run because with input prices fixed changes in the price level will raise or lower real firm profits. thus, there is a positive relationship between the price level and the amount of real output that firms will offer for sale. The curve looks relatively flat below the full employment output because unemployed resources and unused capacity allow firms to respond to price level rises with large increase in real output. It looks relatively steep beyond the full employment output because resource shortages and capacity limitations make it difficult to expand real output as the price level rises.

Insert a downwardly sloping aggregate demand curve to short run aggregate supply and then shift it either to the right or to the left and observe the outcome on GDP as well as the price level. Note that the outcome will depend on whether aggregate demand is on the very flat part of the short

if the aggregate curve moved to the left of the full employment level, there would be small changes in price level but large changes in GDP; but if the aggregate curve moved to the right of the full employment level there would be large changes in the price level but small changes in GDP.

What is per unit production cost?

Per-unit production cost = total input cost / units of output

How does aggregate supply look like in the long run and why? (Figure 12.5)

in the long run it looks like a vertical line at the full-employment level of real GDP because in the long run wages and other input rise and fall to match changes in the price level, so price levels do not affect firms profits and thus they create no incentive for firms to alter their output.

Insert a downwardly sloping aggregate demand curve to long run aggregate supply and then shift it either to the right (upwards) or to the left (downwards) and observe the outcome on GDP as well as the price level.

GDP will stay the same and when aggregate demand shifts to the right price will increase and when it shifts to the left price will decrease.

What are the determinants of aggregate supply? (Figure 12.6)

1. changes in input prices
a. Domestic resource prices
b. Prices of imported resources
2. Changes in Productivity
3. Changes in legal-institutional environment
a. Business taxes and subsides
b. Government regulations

How do we measure productivity?

productivity = real output / input

How can we use the aggregate demand and supply model to explain periods of demand-pull inflation, recession, and cost-push inflation?

demand pull inflation: is caused by an increase in aggregate demand

recession: is caused by a decrease in aggregate demand

cost-push inflation: is caused by a decrease in aggregate supply.

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What are some reasons for price stickiness (or inflexibility) in the U.S.? (Fear of price wars, menu costs, minimum wage, etc.)

1. fear of price wars: some large firms may be concerned that if they reduce their price, rivals not only will match their price cuts but may retaliate by making even deeper cuts.

2. menu costs: firms that think a recession will be relatively short lived may be reluctant to cut their prices since doing so could generate additional cuts to the firm

3. wage contracts: since large parts of the labor force work under contracts prohibiting wage cuts for the duration of the contract, firms cannot profit from cutting their product prices

4. morale, effort and productivity: lower wages might impair worker morale and work effort, thereby reducing productivity

5. minimum wage: firms paying those wages cannot reduce that wage rate when aggregate demand declines.

What are efficiency wages?

are defined as wages that elicit maximum work effort and thus
minimize labor costs per unit of output.