ECON 2020 Final Study Set 2025 UVA

The three sources of economic growth are resources, technology, and institutions

Rotunda Principle III

If an economy grows at x% a year, it will take 70/x years for it to double in size

Rule of 70

First economic growth model by Solow; production is a function of resources, specifically capital

Solow I

GDP(Y) = F(labor, capital, natural resources)

Aggregate production function of Solow I

Diminishing Marginal Product

Assumption of Solow I

Steady State, Convergence

Implications of Solow I

When a macroeconomy has no new net investment; growth stops occurring from capital

Steady State

Per capita GDPs across nations equalize as nations approach steady state; all nations to same level of wealth

Convergence

Rich countries became richer, but poor countries stayed poor

Main issue with Solow I

Incorporates technology into the original Solow function to explain continued economic growth in rich nations

Solow II

Y = A*F(Land, Labor, Capital)

Aggregate production function of Solow II

Technological advancements are exogenous, or completely random

Assumption of Solow II

Poor nations can grow economically through aid of capital resources with latest technology

Policy Implications of Solow II

Aid projects failed!

Problem with Solow II

Incorporates the role of institutions as incentives for economic growth

Modern Growth Theory

Y = A*F(Land, Labor, Capital, Institutions)

Aggregate production function of MGT

Significant practices, relationships, or organizations in a society

Institutions

Harm: Corruption, High Taxes, Political Instability

Help: Efficient Taxes, Stable Money and Prices, Private Property Rights, Rule of Law, International Trade/Fund Flows

Institutions that affect economic growth

Total demand for all final goods and services in an economy

Aggregate Demand

Total supply of all final goods and services in and economy

Aggregate Supply

AD = C + I + G + NX

AD Equation

Wealth Effect, Interest Rate Effect, International Trade Effect

Why does the AD curve slope downward?

Change in quantity of aggregate demand that results from wealth changes due to price-level changes

Wealth Effect

If price levels rise, you can afford less and thus demand less

Wealth Effect Example

When a change in price level leads to a change in interest rates and therefore in the quantity of aggregate demanded

Interest Rate Effect

When price levels fall, people save less, leading to supply in the loanable funds market shifting left and increasing the interest rate, lowering quantity invested and thus aggregate demand

Interest Rate Effect Example

When a change in price level leads to a change in quantity of net exports demanded

International Trade Effect

When price levels for American vehicles go up, people are incentivized to buy foreign cars, leading to exports falling and imports rising

International Trade Effect Example

Consumption: Change in real wealth (+), Expected future income (+)

Investment: Business Firm Confidence (+), Interest Rates (-), Quantity of Money (+)

Government Spending (+)

Net Exports: Foreign Income (+), Value of the dollar (+)

Shift Factors in Aggregate Demand

Period of time in which all prices can sufficiently adjust

Long Run

Period of time in which some prices are sticky

Short Run

Money Illusion and Long-Term Contracts

Why are some prices sticky?

Same factors that affect economic growth: resources, technology, and institutions

Shifts in Long-Run Aggregate Supply

Sitcky input prices, money illusion, menu costs

Why does the SRAS slope up?

Changes in input prices (+), Supply Shocks (±)

Shifts in SRAS

Temporary exogenous events that change production costs

Supply shocks

Where LRAS = SRAS = AD, or Y = C + I + G + NX

AD-AS Equilibrium

“If prices don’t adjust, output must”

Jackson’s quote

Short-term economic downturn; results in decline in Real GDP Growth and increase in unemployment

Recession

Drop in AD leads to deflation, more unemployment, and lower real GDP (Y < Y*)

AD Induced recession

Drop in SRAS/LRAS leads to inflation, higher unemployment, and lower real GDP (Y < Y*)

AS Induced Recession

Severe drop in AD (caused by decrease in real wealth (stock market crash), expectations in reaction to the crash, and misguided macroeconomic policy)

Why did the Great Depression Happen?

Comprises of US government’s budgeting tools (spending and taxes) to influence macroeconomy

Fiscal Policy

Involves adjusting money supply to influence macroeconomy

Monetary Policy

Reduction of Money Supply, not supporting failing small banks (more money supply shrinking, reducing AD)

ME Policy of Great Depression

Decrease in AD (Fall in real wealth, decline in expected future income), Decline in LRAS (malfunctioning LFM due to real estate crash, Dodd-Frank Act)

Why did Great Recession Happen?

Put regulations on financial institutions, led to reduction in LRAS due to constraints

Dodd-Frank Act

Supply Shock (pandemic, decrease in SRAS), Decrease in AD (Real wealth fell, reduced expected future income)

Why did the Coronavirus Recession happen?

Stresses importance of AS and that economy can adjust on its own; prices are flexible, economy inherently stable/full employment, government intervention not needed (No SRAS Curve)

Classical Economics

Stresses AD and that economy is unstable/cyclical unemployement, needs government intervention; some prices are sticky

Keynesian Economics

Stresses importance of LRAS, SRAS, and AD

Modern Synthesis

part of budget that includes spending and transfer payments

Government Outlays

Go to ongoing programs like Social Security/Medicare, MUST be paid by law

Mandatory Outlays

Spending that is adjustable during budget process

Discretionary Outlays

Government retirement funding program

Social Security

Mandated federal program that funds health care for seniors

Medicare

Not enough population base to pay tax for elders to dissave

Funding Problem for SS/Medicare

Raise retirement age, Adjust benefits for inflation, Means-test for benefits (decrease to wealthier recipients), Grow Population

Solution to funding problem

Income Tax, Social Insurance Tax

Sources of Government Tax Revenue

those with higher incomes pay a larger portion of their income in taxes

Progressive Income Tax System

Tax rate paid on next dollar of income

Marginal Tax Rate

outlays higher than revenues; government must borrow funds which leads to debt

Budget Deficit

revenues higher that outlays

Budget Surplus

total of all accumulated and unpaid budget deficits

Debt

National Debt / GDP (expressed in decimal form)

Debt to GDP Ratio

Highest: 1945

Lowest: 1931 (GD)

When were marginal tax rates the highest?

They went up

What happened to Income tax rates during the GD

1998-2001

When did the US have a Budget Surplus?

% change in nominal growth - % change in price levels - % population change

Economic Growth Equation

Fall in value of a resource over time; destroyer of capital stock

Depreciation

Short Run: u increases, P and Y decrease

Long Run: u and Y don’t change, P goes down

What happens in the AD-AS model after an AD shift left in the short/long run?

AD Shifted down massively

Great Depression Graph

AD and LRAS both shifted left

Great Recession Graph

Small AD shift and Big SRAS shift left, P increases

Covid Recession Graph

Interest Rate of Bond

(FV - IP)/IP * 100

GDP

The market value of final goods and services produced in a country in a year

Inflation

The growth rate of the overall price level in an economy

Economic Growth

Percentage change in real GDP per capita

Shortcomings of GDP

Doesn’t calculate non-market activity, illicit market activity, externalities/environmental impact, leisure time

GDP Growth Rate

(GDP1 - GDP0) / GDP0 × 100

Easterlin Paradox

Income increases happiness to a point

Equilibrium

The price at which quantity supplied and quantity demanded are equal

LFPR Formula

(Labor Force / Work-Eligible Population) * 100

Work-eligible population

Those who are 16+, non-student, nonmilitary, non-institutionalized, and non-jailed

Fisher Equation

Real Interest = Nominal Interest - Inflation

% Growth in Nom. GDP

% Real GDP Growth + % Price Level Growth

Shortcomings of Unemployment Rate

Does not count Marginally attached workers and underemployed workers

Marginally attached workers

Not working, have looked for work in the past 12 months, are willing to work, but have not sought it out in 4 weeks

Price Index

(Basket Price / Base-Year Basket Price) * 100

Inflation Rate

(P1-P0)/P0 * 100

CPI

The measure of the price level based on the consumption patterns of a typical consumer (on average)

Shortcomings of the CPI

Does not easily factor Substitution of Goods, Changes in Quality, New Goods/Services/Locations

Chained CPI

Measure of CPI where the typical consumers’ basket of goods and services is updated monthly

Problems caused by Inflation

Shoe-Leather Costs, Money Illusion, Menu Costs, Price Confusion, Tax distortion, Wealth redistribution, Future Price Level Uncertainty

Shoe-Leather Costs

Resources that are wasted when people change their behavior to avoid holding money

Money Illusion

When people interpret nominal changes as real changes

Menu Costs

Costs of changing price

Future Price Level Uncertainty

Inflation complicates value of future profits that must be garnered to pay back loanable funds, long terms loans seem risky

Wealth Redistribution

Inflation is rising, loan payments and borrowers are better off, banks are worse off (opposite for inflation)

Price Confusion

When price rises from inflations but it’s interpreted as something else, firms make poor decisions