Macroeconomics Review

Scarcity and Opportunity Cost

• Scarcity: Unlimited wants and limited resources.

• Opportunity Cost: Every decision or production choice has a cost, meaning something must be given up.

Production Possibilities Curve (PPC)

• Definition: Graph showing combinations of two goods that can be produced using all resources efficiently.

• Efficiency: Points on the curve indicate full resource utilization.

• Inefficiency: Points inside the curve indicate underutilization of resources.

• Impossibility: Points outside the curve are unattainable with current resources.

• Shapes:

  • Straight Line: Constant opportunity cost, similar resources.

  • Bowed-Out (Concave to the Origin): Increasing opportunity cost, dissimilar resources. This illustrates the law of increasing opportunity cost where producing more of one good requires giving up increasingly larger amounts of the other.

• Shifts:

  • More/Less Resources (Land, Labor, Capital): Shifts the entire curve outward or inward.

  • Better Technology: Can shift the curve outward, especially towards the technologically improved good.

  • Trade: Doesn't change production capacity, but allows consumption beyond the PPC.

Comparative Advantage

• Definition: Specialize in producing goods with a lower opportunity cost.

• Absolute Advantage: Producing more of a good (easy to determine).

• Comparative Advantage: Requires calculations to determine lower opportunity costs.

• Terms of Trade: Mutually beneficial exchange rate between goods.

Economic Systems

• Free Market System (Capitalism): Focus of the course.

• Command Economy.

• Mixed Economy.

Circular Flow Model

• Components: Businesses, individuals, and government.

• Business Role: Sell products, buy resources in product and resource markets.

• Individual Role: Buy products, sell resources.

• Government Role: Interacts with both businesses and individuals.

Economic Vocab

• Transfer Payments: Government payments to individuals (e.g., welfare) without direct exchange for goods/services.

• Subsidies: Government payments to businesses to encourage production.

• Factor Payments: Payments to individuals for their resources.

Demand and Supply

• Law of Demand: As price increases, quantity demanded decreases (downward sloping curve).

• Law of Supply: As price increases, quantity supplied increases (upward sloping curve).

• Equilibrium: Where supply and demand curves intersect.

• Price Effects: Price changes cause movement along the curve, not shifts.

  • Shortage: Price is below equilibrium.

  • Surplus: Price is above equilibrium.

• Individual Shifts:

  • Demand Increase/Decrease: Shifts the entire demand curve.

  • Supply Increase/Decrease: Shifts the entire supply curve.

Macroeconomic Goals

• Economic Growth: Expanding production over time.

• Low Unemployment: Limiting the number of people seeking work.

• Stable Prices: Limiting inflation.

Gross Domestic Product (GDP)

• Definition: Dollar value of all final goods produced within a country's borders in a year.

• GDP per Capita: GDP divided by population.

• Percent Change Calculation.

What's Not Included in GDP

• Intermediate Goods: Goods used to produce final goods (e.g., computer chips in laptops).

• Non-Production Transactions: Financial transactions like stocks and bonds.

• Non-Market Transactions: Illegal goods or labor.

GDP Calculation Approaches

• Expenditures Approach: Adds up spending on all goods and services.

• Income Approach: Adds up all income earned from producing goods and services.

• GDP Equation (Expenditures Approach): $GDP = C + I + G + XN$ where:

  • C = Consumption

  • I = Investment (business spending, not stocks/bonds)

  • G = Government Spending

  • $XN$ = Net Exports (Exports - Imports)

• Income Approach Equation: Rent + Wages + Interest + Profit (Factor Payments)

Nominal vs. Real GDP

• Nominal GDP: Not adjusted for inflation.

• Real GDP: Adjusted for inflation, used for accurate economic analysis.

Business Cycle

• Phases:

  • Peak: Highest point of economic activity.

  • Recession: Economic downturn.

  • Trough: Lowest point of economic activity.

  • Expansion: Economic recovery and growth.

• Economic States:

  • Full Employment: Optimal economic performance.

  • Recessionary Gap: High unemployment, economy underperforming.

  • Inflationary Gap: Overheated economy, rising inflation.

Unemployment

• Definition: People in the labor force who are actively seeking work but cannot find it.

• Unemployment Rate: $(<br><br>number<br><br>of Unemployed / Labor Force) * 100$

• Labor Force Participation Rate

• Labor Force: People over 16, non-institutionalized, willing and able to work.

Types of Unemployment

• Frictional: Between jobs, seeking employment.

• Structural: Skills mismatch, replaced by technology.

• Cyclical: Recession-related job losses.

• Natural Rate of Unemployment: Frictional + Structural (around 5% in the U.S.).

Criticisms of Unemployment Rate

• Discouraged Workers: Not counted as unemployed when they stop seeking work.

• Part-Time Workers: Counted as fully employed, even if they desire full-time work.

Inflation

• Definition: Money loses purchasing power.

• Deflation: Falling prices.

• Disinflation: Decreasing inflation rates.

• Nominal vs. Real Wages: Real wages adjust for inflation.

• Unexpected Inflation: Harms lenders, benefits borrowers.

Consumer Price Index (CPI)

• Definition: Measures price changes over time using a market basket of consumer goods.

• CPI Equation: $(Market<br><br>Basket<br><br>Value<br><br>in<br><br>Current<br><br>Year / Market<br><br>Basket<br><br>Value<br><br>in<br><br>Base<br><br>Year) * 100$

GDP Deflator

• Definition: Like CPI, but measures price changes for everything in the economy.

• GDP Deflator Equation: $(Nominal<br><br>GDP / Real<br><br>GDP) * 100$

Causes of Inflation

• Quantity Theory of Money: $M * V = P * Y$ where:

  • M = Money Supply

  • V = Velocity of Money

  • P = Price Level

  • Y = Real Output

• Demand-Pull Inflation: Increased demand bids up prices.

• Cost-Push Inflation: Rising production costs increase prices.

Aggregate Demand (AD)

• Definition: Total demand for goods and services in the economy at different price levels (downward sloping).

• Reasons for Downward Slope:

  • Wealth Effect: Higher price levels reduce the value of assets, decreasing spending.

  • Interest Rate Effect: Higher inflation leads to higher interest rates, reducing borrowing.

  • Foreign Trade Effect: Higher price levels reduce exports.

• Shifters: Anything that changes what people want to buy (e.g., consumer spending, investment).

Aggregate Supply (AS)

• Short Run Aggregate Supply (SRAS): Upward sloping, producers increase output as price level rises.

• Long Run Aggregate Supply (LRAS): Vertical at full employment GDP, no relationship between price level and real GDP.

• Shifters of SRAS: Resource prices, technology, government regulations.

• Shifters of LRAS: Increase in resources or technology

Macroeconomic Equilibrium

• Full Employment: Economy operating at its potential.

• Recessionary Gap: AD is too low, unemployment is high.

• Inflationary Gap: AD is too high, inflation is rising.

• Stagflation: Leftward shift of SRAS, causing both inflation and low output.

Long Run Adjustment

• Inflationary Gap: Wages rise, SRAS shifts left back to LRAS.

• Recessionary Gap: Wages fall, SRAS shifts right back to LRAS.

• Economic Growth: Increase in GDP, LRAS shifts right.

Phillips Curve

• Short Run Phillips Curve (SRPC): Downward sloping, trade-off between inflation and unemployment.

• Long Run Phillips Curve (LRPC): Vertical, no long-run trade-off between inflation and unemployment.

Fiscal Policy

• Definition: Changes in government spending and taxes to influence the economy.

• Expansionary Fiscal Policy: Increase government spending or cut taxes (used during recessions).

• Contractionary Fiscal Policy: Decrease government spending or raise taxes (used during inflation).

Spending Multiplier

• Marginal Propensity to Consume (MPC): Proportion of new income spent.

• Marginal Propensity to Save (MPS): Proportion of new income saved.

• Spending Multiplier Equation: $1 / MPS$

• Tax Multiplier: One less than the spending multiplier.

Debt and Deficits

• Deficit: Amount by which government spending exceeds tax revenue in a year.

• Debt: Accumulation of all past deficits.

• Crowding Out: Government borrowing increases interest rates, reducing private investment.

Money and Banking

• Functions of Money: Medium of exchange, unit of account, store of value.

• Commodity Money: Has intrinsic value.

• Fiat Money: No intrinsic value.

• M1 Money Supply: Currency, checking accounts (demand deposits).

• Fractional Reserve Banking: Banks hold a portion of deposits as reserves, loan out the rest.

Bank Balance Sheets

• Assets: Reserves, loans.

• Liabilities: Deposits.

• Required Reserve Ratio: Percentage of deposits banks must hold.

• Excess Reserves: Reserves banks can loan out.

Money Multiplier

• Money Multiplier Equation: $1 / Reserve<br><br>Requirement$

Money Market

• Axes: Interest rate and quantity of money.

• Demand for Money: Downward sloping, for transactions and as an asset.

• Supply of Money: Vertical, set by the Federal Reserve (the Fed).

• Monetary Policy: Fed actions to control the money supply.

Monetary Policy

• Expansionary Monetary Policy: Increase money supply, lower interest rates, increase AD.

• Contractionary Monetary Policy: Decrease money supply, raise interest rates, decrease AD.

Monetary Policy Tools

• Reserve Requirement: Percentage of deposits banks must hold (set by the Fed).

• Discount Rate: Interest rate the Fed charges banks to borrow money.

• Open Market Operations: Fed buys or sells government bonds.

• Federal Funds Rate: Interest rate banks charge each other for borrowing reserves.

Loanable Funds Market

• Axes: Real interest rate and quantity of loanable funds.

• Demand for Loanable Funds: Borrowers.

• Supply of Loanable Funds: Lenders.

• Crowding Out: Government borrowing increases demand for loans, raising interest rates and reducing private investment.

International Trade and Foreign Exchange

• Balance of Payments: Records all transactions between countries.

Accounts

• Current Account: Balance of trade (exports - imports), investment income, net transfers.

  • Trade Surplus: Exports > Imports

  • Trade Deficit: Imports > Exports

• Financial Account: Inflow and outflow of financial assets.

Foreign Exchange

• Appreciation: Currency increases in value.

• Depreciation: Currency decreases in value.

• Effect on Net Exports: Appreciation decreases net exports, depreciation increases net exports.

Foreign Exchange Market

• Axes: Quantity of currency and exchange rate.

• Demand: By those who want to buy the currency (e.g., Europeans demanding dollars).

• Supply: By those who are selling the currency (e.g., Americans supplying dollars).

Shifters of Exchange Rates

• Tastes and Preferences: Increased demand for a country's goods increases demand for its currency.

• Income: Higher income leads to increased demand for imports and foreign currency.

• Inflation: Higher inflation reduces demand for a country's goods and currency.

• Interest Rates: Higher interest rates attract foreign investment, increasing demand for a country's currency.

Exchange Rate Systems

• Floating Exchange Rates: Supply and demand determine exchange rates.

• Fixed Exchange Rates: Government manipulates currency to maintain a target exchange rate.

Key Graphs and Formulas

Key Graphs with Axes

1. Production Possibilities Curve (PPC)

   • Axes: Good A (X-axis), Good B (Y-axis). Curve is bowed outward or a straight line.

2. Demand and Supply

   • Axes: Price (Y-axis), Quantity (X-axis). Demand curve is downward sloping, supply curve is upward sloping.

3. Money Market

   • Axes: Interest Rate (Y-axis), Quantity of Money (X-axis). Demand curve is downward sloping, supply curve is vertical.

4. Loanable Funds Market

   • Axes: Real Interest Rate (Y-axis), Quantity of Loanable Funds (X-axis). Demand curve is downward sloping, supply curve is upward sloping.

5. Foreign Exchange Market

   • Axes: Exchange Rate (Y-axis), Quantity of Currency (X-axis). Demand and supply curves slope normally.

6. Aggregate Demand and Supply

   • Axes: Price Level (Y-axis), Real GDP (X-axis). Aggregate demand is downward sloping, short-run aggregate supply is upward sloping, long-run aggregate supply is vertical.

7. Phillips Curve

   • Axes: Inflation Rate (Y-axis), Unemployment Rate (X-axis). Short-run Phillips curve is downward sloping, long

Key Formulas

Key Formulas

1. GDP Equation (Expenditures Approach): $GDP = C + I + G + XN$

2. Unemployment Rate: $(\frac{Number\ of\ Unemployed}{Labor\ Force}) * 100$

3. CPI Equation: $(\frac{Market\ Basket\ Value\ in\ Current\ Year}{Market\ Basket\ Value\ in\ Base\ Year}) * 100$

4. GDP Deflator Equation: $(\frac{Nominal\ GDP}{Real\ GDP}) * 100$

5. Quantity Theory of Money: $M * V = P * Y$

6. Spending Multiplier: $1 / MPS$