ECO2013 - Exam 2 Review (Study Edge)

Stages of business cycle

1. expansionary gap

2. peak

3. recessionary gap

4. trough

Gross Domestic Product (GDP)

is the market value of all the final goods and services produced in an economy during a given time period (usually a year). it measures the overall production in a country. it is sometimes thought of as the income for a country. the higher it is, the wealthier the country.

Final goods

are what we get when we buy a good from the store.

• We account for the value of these goods in GDP.

Intermediate goods

are all the things we use to make a final good.

• not in GDP

Since these will be counted as part of a final good, we don’t count

them in GDP.

C – Private Consumption.

• All the final goods and services that we buy are included.

• This accounts for about 70% of U.S. GDP.

Used goods

Since these have already been bought once as final goods, we don’t count them in GDP.

Fixed Business Investment

new factories for a company, new machinery, new equipment.

• This includes any money that firms spend to maintain or expand their business.

• This is also known as business spending.

Residential Investments

AKA, new homes. Considered an investment because they generally grow in value.

• If a home is resold, it does not add to the value of GDP.

Stocks and bonds

These are not counted in GDP because they don’t create value.

G – Government Spending

• Almost all money that the government spends.

• This accounts for about 20% of U.S. GDP.

• This includes federal, state, and local and spending.

• The government must receive something in return for what they are paying.

I – Investment

This accounts for about of 17% U.S. GDP.

• fixed business investment

• residential investments

Transfer payments (TR)

money that the government distributes to people but gets nothing in return.

• Examples: Social Security, unemployment benefits, etc.

Trade surplus

When exports are greater than imports. X>M

Trade deficit

When exports are less than imports. X<M.

net domestic income at factor prices =

= proprietors’ income + corporate profits + employee compensation + net interest income + rental income

net domestic income at market prices =

= net domestic income at factor prices” + indirect taxes less subsidies

GDP using the income approach =

= net domestic income at market prices + depreciation

statistical discrepancy

if GDP using expenditure approach and income approach do not result in the exact same number

Limitations of GDP as a method for measuring total production

• Does not account for the underground economy

  • Not necessarily illegal activities. Could be people trying to avoid taxes or government regulations.

• Black Market is part of the underground economy. We obviously wouldn’t want to report our earnings if we were making and distributing LSD for music festivals.

• Household Production

  • GDP does not take into account stuff that people produce for their own homes.

  • Child-care, mowing your own lawn, carpentry like good ole Jesus.

Limitation of GDP as a measure of standard of living

• Leisure is not considered in GDP.

• Crime is a huge cost to society that is not considered in GDP.

• Pollution of natural resources isn’t really considered (environmental impacts).

Gross National Product (GNP)

is the market value of all the final goods and services produced by a country’s citizens during a given time period (usually a year).

• A car produced by Ford in the middle of Asia would be included in the US GNP, but not in the US GDP. Good thing to keep straight!

Investment

companies spending money to make their business better

Gross investment

• the purchase of physical capital.

• stuff used to make stuff

Net investment

the purchase of physical capital LESS depreciation

Depreciation

the change in the market value of physical capital.

Net Investment for the year (formula)

Gross Investment for the year – Depreciation for the year.

Nominal

uses current prices and quantities (to that time period).

Real GDP

accounts for price changes over time!

• Uses a base year.

Population

everyone in the entire country

Working age population

anyone 16 years and older not in an institution (jail, hospital, or some other institution).

Employed

Someone who has worked for pay within the last week

• Or someone who works at least 15 unpaid hours per week at a family business.

• This includes part time or full time.

Unemployed

Someone who does not have a job but wants one AND

1. has applied for a job in the last 4 weeks.

2. has signed a contract to start a new job in the next 30 days.

3. has been laid off and expects to be rehired by previous employer.

Marginally Attached Workers

someone who is available for work but is NOT looking or work. They may have looked in the past year, but not now. They are somewhat close to being unemployed but not quite (applied for a job in the last year vs 4 weeks)

Discouraged Workers

someone who is available for work but gave up on wanting to work.

These guys want nothing to do with the Labor Force. They are NOT included in

unemployment rate.

Employment-to-population ratio

the percentage of working-age people who have jobs

Frictional Unemployment (“good”)

when someone leaves a job it takes time to match our skills with employer’s needs or find a job that will make us happy

Structural Unemployment (“good”)

this refers to those of us who have lost their jobs due to new technology or businesses. The economy no longer needs our skills.

• Often caused by overly high wages or industries becoming unneccessary.

• Seasonal unemployment is a specific type of structural unemployment.

Cyclical Unemployment (“bad”)

unemployment that happens due to changes in business cycle.

• Cyclical Unemployment > 0 when the economy is in a recession

• Cyclical Unemployment < 0 when the economy is in a expansion

• Example: the economy is a little rough right now so more people are unemployed.

Full Employment

when the economy is at the natural rate of unemployment

Natural Rate of Unemployment

the rate of unemployment when cyclical unemployment is zero.

• This leaves frictional and structural unemployment

Inflation

increasing prices

CPI up

Deflation

decreasing prices

CPI down

economy collapses

Hyperinflation

rapid inflation

50% inflation every month

Problems associated with unexpected inflation.

• It redistributes income from workers to employers.

• It redistributes wealth from lenders to borrowers.

• It reduces production and employment.

• It diverts resources from production.

New Goods Bias

new goods have high prices and push up the price level.

• Overstates CPI

Quality Improvement Bias

many goods increase in quality over time.

• Overstates CPI

Commodity Substitution Bias

when prices of goods go up, we tend to buy other products.

• Overstates CPI

Outlet Substitution Bias

• people change where they buy from (Amazon vs local store).

• Purchasing things at “big box stores” rather than urban retailers.

• Overstates CPI.

Chained CPI

• CPI alternative

• mathematical manipulation to remove these biases.

• Updates the basket of goods over time.

Core inflation rate.

• CPI alternative

• Calculated after eliminating price changes in food and fuel.

• Food and fuel prices fluctuate more wildly than prices of other things.

GDP Deflator

• CPI alternative

• Ratio of nominal GDP to real GDP. (Nominal GDP/Real GDP) x 100.

Personal Consumption Expenditure Deflator

• CPI alternative

• not really covered in class, but it’s in the book

Economic Growth

• we try to calculate overall growth rates in a country’s potential GDP or in a country’s potential GDP per capita (fancy way of saying per person)

• sustainable increases in the potential GDP

Potential GDP (Potential Output)

• Basically, if all firms were producing at capacity, what would the GDP of our economy be?

• When we are producing at our potential GDP, we are productively efficient and operating on our PPF.

• There ARE times when our actual GDP is greater than our potential GDP though.

• Per Capita is used because it’s most closely associated with the standard of living of the average person in that economy/country.

Policies that foster economic growth

• Stimulate savings - savings are used by firms to fund investments which promote growth.

• Promote research and development.

• Investment in Education and Health Care – the uneducated/sick don’t produce as much.

• Promote/encourage international trade – remember the benefits of comparative advantage and specialization from Exam 1.

• Increase developmental aid.

Production Function

• how much stuff we can produce using a certain amount of capital and labor.

• Y – real GDP.

• L – representation of number of hours worked by laborers (people).

Diminishing Returns

production increases at a decreasing rate.

• The size of the increase in production gets smaller the more labor we add.

Growth rate

is found as the slope of the production function

Increase in Labor Supply

As more people work, the amount of total production increases.

• Increase in the # of hours worked per worker.

• Increase in the working age population.

• Increase in the employment to population ratio.

• Immigration.

Note: This is a movement along the production function! Notice the change in wages too!

Increase in Labor Productivity

Workers can produce MORE goods and services over a given amount of time.

• Things that increase labor productivity:

  • Increase in human capital.

  • Better healthcare, better education, etc.

  • Increase in physical capital: machines and equipment

  • Increase in technology.

  • Increased savings and increased Research and Development (R&D).

Note: This is a shift of the production function! Notice the change in wage too!

Classical Growth Theory

Economic growth results from population growth.

Neoclassical Growth Theory

new tech due to random chance

New Growth Theory

profit driven

Real interest rate (formula)

nominal interest rate - inflation

Demand for Loanable Funds

shows the relationship between interest rates and the quantity of funds that firms/individuals want to borrow

• Downward sloping – as interest rates decrease, firms are more willing to borrow money for

  new projects.

• Firms will want to borrow money as long as they believe the returns from new projects will be

  greater than the cost of borrowing (Rate of Return > Interest Rate).

Supply of Loanable Funds

the tendency of individuals and firms to save money

• Upward sloping – as interest rates increase people are more willing to save.

Where do companies get their money to be able to start up or expand their businesses?

Financial Intermediaries

Types of Financial Intermediaries

Commercial Banks

• Normal banks that accept deposits, provide payment services, and make loans.

Government-backed mortgage companies

• Fannie Mae and Freddie Mac ß companies that buy mortgages, package them into mortgage-backed securities, and sell them.

Pension funds

• Financial institutions that use the pension contributions of companies and workers to buy bonds and stocks.

Insurance companies

• Enable households and firms to cope with risks.

• They use the money they have received, but not paid out as insurance claims, to buy bonds and stocks to earn interest.

Federal Reserve

• Central Bank of the United States.

Mutual Funds

• More on this in later chapters. Mostly just know that it exists!

Financial Instruments (or Financial Markets)

tools firms and individuals use to raise money

Loans

• Bank gives you (or your firm) money, you pay them interest.

• type of instruments/markets

Bonds

• You give the government or a company money, they say IOU.

• type of instruments/markets

Stocks

• You give money to a company and hope the company gets bigger.

• type of instruments/markets

Bank Run

when clients of a bank all pull their money out of the bank because they think the bank will fail soon

Wealth

the value of the assets you have.

• examples: your house, the money in your bank, your vintage Pokémon cards.

• Capital gains- when the market value of an asset rises.

• Capital losses- ...the opposite of that ^.

Income

money you have earned over a period of time (ex: annual income)

Disposable income

• Money you earn (after paying taxes)

• Income - Taxes

Savings

• the money you don’t spend on consumption or taxes.

• Often denoted Y – C – T (GDP minus consumption spending minus taxes).

Long Run Aggregate Supply (LRAS)

the (fixed) quantity of real GDP supplied at full employment

Short Run Aggregate Supply (SRAS)

the quantity of domestic goods/services that businesses are willing to sell at a given price and wage rate level.

Sticky wages

most of us sign contracts when we get a job. This means that our wage is set at a specific level and cannot change quickly with a change in price levels. So if price levels increase, real wages DECREASE . This means it the cost of labor has gone down for firms.

Sticky prices

Long term contracts. Increasing price means our fixed inputs are now effectively cheaper

• Essentially, firms can take advantage of short-lived increases in profits.

Aggregate Demand (AD)

the total amount of goods/services that all consumers, businesses, and government organizations are willing to buy at a given price level (Very similar to our demand curve from the first exam).

• this curve is downward sloping

Wealth effect

as price levels go up, the real value of our savings/income decreases

Intertemporal Substitution Effect - “the interest rate effect”.

• If the price level increases, the value of money falls.

• Then, the real interest rate rises.

• Finally, demand for final goods/services in the economy falls.

Aggregate Expenditure Model (AE)

a model explaining short-run fluctuations in spending and production.

• Measures all the spending in the economy

• Price levels are held constant so we are only measuring fluctuations in spending and production

Macroeconomic Equilibrium

where real GDP (Y) is equal to spending (AE)

Autonomous (consumer spending)

the level of consumer spending that is not affected by changes in real GDP (it’s fixed)

• will shift the AE curve

Induced (consumer spending)

the level of consumer spending that is induced by changes in disposable income

Marginal Propensity to Consume (MPC)

the percentage of a change in income that a person will spend. Change in spending divided by change in disposable income

Marginal Propensity to Save (MPS)

the percentage of a change in income that a person will save. Change in spending divided by change in disposable income.

Actual Investment (I)

• production

• AE

• Includes unplanned changes in inventories

Planned Investment (PI)

• spending on stuff

• real GDP