Macroeconomics Review Notes

Economics Basics

What is Economics

  • Scarcity: When people want more of something than is available; scarce items tend to have a positive price.
  • Land: Any resource or raw material that comes from nature (e.g., oil, lumber, leather).
  • Labor: The human resource of mental and physical work.
  • Capital: Physical capital; the machines and tools used to produce goods and services.
  • Entrepreneurship: A business person who combines land, labor, and capital, takes risks, and produces a good or service while seeking a profit.
  • Human Capital: The skills and knowledge of labor; more knowledgeable workers are more productive.
  • Command Economy: Government officials answer the three basic economic questions; may achieve social goals but is often inefficient.
  • Market Economy: Individuals answer the three basic economic questions; emphasizes efficiency and the enforcement of property rights.
  • Property Rights: Play a key role in a market economy by creating more efficient outcomes and expanding overall wealth.

Choice and Opportunity Cost

  • Explicit Cost: Money paid out of pocket for a choice (e.g., movie ticket).
  • Implicit Cost: Money not earned as a result of a choice (e.g., income lost from taking a night off work).
  • Opportunity Cost: The value of the best alternative not chosen; includes both explicit and implicit costs.

Production Possibilities Curve (PPC)

  • Illustrates all combinations of two different goods (or categories of goods) that can be produced with fixed resources.
  • Points on the curve represent productively efficient use of resources.
  • Points inside the curve represent inefficient use of resources.
  • Points outside the curve are impossible to reach with current resources.
  • Concave (Bowed Out) PPC: Has increasing opportunity costs; caused when resources used to produce one good are not perfectly adaptable to producing the other good.
  • Straight Line (Linear) PPC: Has constant opportunity costs; caused when resources used to produce one good are perfectly adaptable to producing the other good.
  • Outward Shift of PPC: Caused by an increase in the quality or quantity of resources.
  • Inward Shift of PPC: Caused by a decrease in the quality or quantity of resources.

Comparative Advantage

  • Absolute Advantage: The ability to produce an item in greater quantities or using fewer resources.
  • Comparative Advantage: The ability to produce an item with a lower opportunity cost.
  • Output Problem Formula: To calculating opportunity cost, use "Other Over": Opportunity cost of 1 A = (B/A) B's.
  • Input Problem Formula: To calculating opportunity cost, use "It Over" : Opportunity cost of 1 A = (A/B) B's

Determinants of Supply and Demand

  • Law of Demand: As price goes up, quantity demanded goes down (inverse relationship).
  • A change in price leads to a change in quantity demanded, but does not change demand.
  • Non-Price Determinants of Demand:
    • Consumer tastes and preferences.
    • Market size (number of buyers).
    • Prices of related goods (substitutes and complements).
    • Changes in income (normal and inferior goods).
    • Expectations for the future.
  • Complementary Goods: Goods often used together; if x and y are complements, an increase in the price of x will decrease the demand for y.
  • Substitute Goods: Goods that can be used in place of each other; if x and y are substitutes, an increase in the price of x will increase the demand for y.
  • Normal Goods: Goods that people buy more of when they have larger incomes; if consumers' incomes increase, demand for normal goods will increase.
  • Inferior Goods: Goods that people buy less of when they have more income; if consumers’ incomes increase, demand for inferior goods will decrease.
  • Law of Supply: As price goes up, quantity supplied goes up (direct relationship).
  • A change in price leads to a change in quantity supplied, but does not change supply.
  • Non-Price Determinants of Supply:
    • Prices of resources or inputs.
    • Government tools (taxes, subsidies, regulations).
    • Competition (number of sellers).
    • Technology.
    • Prices of other goods.

Market Equilibrium

  • Equilibrium occurs where supply equals demand.
  • Surplus: When quantity supplied exceeds quantity demanded, price will decrease until it reaches equilibrium.
  • Shortage: When quantity demanded exceeds quantity supplied, price will increase until it reaches equilibrium.
  • Increase in Demand: Equilibrium price and quantity will increase.
  • Decrease in Demand: Equilibrium price and quantity will decrease.
  • Increase in Supply: Equilibrium price will decrease, and equilibrium quantity will increase.
  • Decrease in Supply: Equilibrium price will increase, and equilibrium quantity will decrease.
  • Double Shifts: When both supply and demand shift, the impact on price and quantity will depend on the relative magnitudes of the shifts; one will be indeterminate.

Economic Indicators and the Business Cycle

Circular Flow

  • Economic Actors: Households and Businesses
  • Flows: Resources, Products, and Money
  • Markets: Factor Market and Product Market
  • Government: In a capitalist economy, the government buys resources in the factor market and goods/services in the product market, provides public goods, and charges taxes.

Gross Domestic Product (GDP)

  • The value of all new goods and services produced within a country in a calendar year.
  • Criteria for inclusion in GDP: Final good, new, and made within the country’s borders.
  • Transactions not counted in GDP: Second-hand items, intermediate goods, and financial transactions.
  • Output Expenditure Formula for GDP: GDP = C + Ig + G + Xn (Consumer Spending + Gross Investment + Government Purchases + Net Exports).
  • Components of GDP:
    • Consumer Spending (C): Goods and services purchased by consumers.
    • Gross Investment (I_g): Capital goods (including private buildings) and changes in inventories.
    • Government Purchases (G): Purchases of goods and services by the government (excluding transfer payments).
    • Net Exports (X_n): Exports minus imports (can be a trade deficit or surplus).
  • Reasons why GDP is an imperfect measure of a country’s standard of living:
    • Underground economy (not counted because sales aren’t reported).
    • Home production (not counted because no money is exchanged).
    • "Bads counted as goods" (clean-up of pollution or natural disasters are counted as positive).
    • The distribution of wealth is not accounted for.
  • Unexpected Increase in Business Inventories: A leading indicator of an economic contraction or recession.

Unemployment

  • Unemployment Rate Formula: \frac{\text{Unemployed}}{\text{Labor Force}} \times 100
  • Labor Force Formula: Those working + those looking for work
  • Discouraged Worker: People available and wanting to work but have given up looking (not counted as unemployed).
  • Underemployed: People working part-time but wanting full-time work (counted as employed).
  • Frictional Unemployment: Unemployed workers in between jobs or looking for their first job.
  • Structural Unemployment: Unemployed due to a skills mismatch; training is needed to get a new job.
  • Cyclical Unemployment: Unemployment caused by a decrease in overall spending in the economy
  • Natural Rate of Unemployment: Frictional Unemployment + Structural Unemployment OR Unemployment Rate – Cyclical Unemployment.

GDP Deflator and CPI

  • CPI vs. GDP Deflator: The CPI measures price changes in a market basket of goods, while the GDP deflator measures price changes in all goods.
  • Nominal: Values expressed in current year prices; not adjusted for inflation.
  • Real: Values are in base year prices; inflation has been removed.
  • GDP Deflator Formula: \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100
  • Inflation Rate Formula: \frac{\text{New Value - Old Value}}{\text{Old Value}} \times 100

Business Cycle

  • Inflationary Gap: Inflation; when output exceeds potential, prices rise.
  • Recessionary Gap: Unemployment; when output is less than potential, workers are laid off.
  • Macroeconomic Goals:
    • Economic Growth
    • Full Employment
    • Stable Prices

National Income and Price Determination

Propensities and Multipliers

  • Marginal Propensity to Save (MPS): The percentage of new income consumers save. \frac{\Delta \text{Savings}}{\Delta \text{Income}}
  • Marginal Propensity to Consume (MPC): The percentage of new income consumers spend. \frac{\Delta \text{Consumption}}{\Delta \text{Income}}
  • Spending Multiplier Formula: \frac{1}{\text{MPS}} \text{ or } \frac{1}{1 - \text{MPC}}
  • Tax Multiplier Formula: \frac{\text{MPC}}{\text{MPS}} \text{ or } \text{Spending Multiplier} - 1
  • The tax multiplier is less than the spending multiplier because when citizens receive a tax cut, they will save some of that money.

AS/AD Model

  • Aggregate Demand Downward Sloping:
    • Wealth Effect: At lower price levels, assets buy more goods and services.
    • Interest Rate Effect: At lower price levels, nominal interest rates decrease, causing more gross investment.
    • Net Export Effect: Lower price levels make exports cheaper to foreign consumers.
  • Components (Shifters) of Aggregate Demand:
    • Consumer Spending
    • Gross Investment
    • Government Purchases
    • Net Exports
  • Aggregate Supply Shifters:
    • Prices of resources (especially wages)
    • Productivity and technology
    • Inflation expectations
    • Business taxes or subsidies
    • Business regulations
  • Long-Run Aggregate Supply (LRAS): Vertical at the full employment real GDP; in the long run, wages adjust to price levels, so output doesn’t change with price levels.
  • Things that Shift LRAS:
    • Quantity of resources.
    • Quality of resources.
    • Productivity
    • Technology

Fiscal Policy

  • Expansionary Fiscal Policy: Tax decrease, government spending increase, budget deficit increase.
  • Contractionary Fiscal Policy: Tax increase, government spending decrease, budget deficit decrease.
  • Automatic Stabilizers in Economic Expansion: Taxes increase, transfer payments decrease, deficit decrease.
  • Automatic Stabilizers in Economic Contraction: Taxes decrease, transfer payments increase, deficit increase.

Money and Monetary Policy

Money

  • Functions of Money:
    • Medium of Exchange
    • Unit of Account
    • Store of Value
  • Interest Rates and Bond Prices:
    • Interest Rates Up → Bond Prices Down
    • Interest Rates Down → Bond Prices Up
  • Measures of the Money Supply:
    • M0: (Not all money): Currency and Bank Reserves
    • M1 (Money): Currency, Checkable Deposits, and Savings Deposits
    • M2 (Money + Near Money): M1 plus Small Time Deposits.

Fisher Formula

  • i \approx r + \pi
    • i = nominal interest rate
    • r = real interest rate
    • \pi = inflation rate
  • Higher Than Expected Inflation:
    • Borrowers: Benefit
    • Lenders: Hurt

Bank Balance Sheets

  • Required Reserves: A percentage of checkable deposits (set by the federal reserve) the bank has but cannot be loaned out.
  • Excess Reserves: Funds the bank has available to be loaned out.
  • Total Reserves: All the funds the bank has in its possession. It includes required and excess reserves. AKA Reserves.
  • Checkable Deposits: These are easily spent deposits. The reserve requirement applies only to these deposits. AKA demand deposits.
  • Other Deposits: Savings accounts, CD’s, money markets, etc. These deposits do not have a reserve requirement.

The Money Multiplier

  • Formula: \frac{1}{RR} (1 divided by the reserve requirement)

Money Market

  • Nominal interest rate on the Y-axis.
  • Demand for Money:
    • Asset Demand
    • Transaction Demand

Monetary Tools

  • Open Market Operations: Buying and selling bonds by the Federal Reserve
  • Reserve Requirement: Percentage of checkable deposits that banks cannot loan out.
  • Discount Rate: Interest rate banks are charged when they borrow from the Fed
  • Federal Funds Rate/Policy Rate: Interest rate banks charge each other for overnight loans
  • Interest on Reserves: Interest paid to banks by the central bank for reserves.

Loanable Funds

  • Real Interest Rate: Interest rate that has been adjusted for inflation (Real = Nominal – Inflation).
  • Shifts in Loanable Funds Demand Curve: Expected rate of return on new investments.
  • Shifts in Loanable Funds Supply Curve: Consumer savings and foreign investment

Long-Run Consequences of Stabilization Policies

Fiscal and Monetary Interaction

  • Expansionary/contractionary fiscal and monetary policy impacts on Aggregated Demand, Price Level Output, Unemployment, Interest Rates and Economic Growth.

Monetary Equation of Exchange

  • MV = PY
    • M = Money supply
    • V = Velocity of Money
    • P = Price Level
    • Y = Real GDP

Deficits and Crowding Out

  • Deficit: When tax revenue is less than government spending.
  • Surplus: When tax revenue is greater than government spending.
  • National Debt: The sum of all previous deficits and surpluses.

Economic Growth

  • An increase in potential GDP.
  • Components: Greater Quality or Quantity of Resources, Technology, or Productivity increases.

Phillips Curve

  • Short Run: Inverse relationship between inflation rate and unemployment rate.
  • Long Run: No relationship between unemployment and inflation.
  • Shifts in Short Run Phillips Curve: Supply shocks and inflation expectations
  • Shifts in Long Run Phillips Curve: Changes in structural or frictional unemployment

Open Economy International Trade and Finance

Balance of Payments

  • Current Account: Payments for goods and services, investment income, and transfers of money.
  • National Income and Price Levels: Price level and National income
  • Trade Deficit: Imports are greater than exports
  • Trade Surplus: Exports are greater than imports
  • Financial/Capital Account: Purchases of assets
  • Current Account + Financial Account = 0

Foreign Exchange Markets

  • Foreign Exchange Demand Shifters: Demand for exports and Interest rates
  • Foreign Exchange Supply Shifters: Demand for Imports and Interest rates.
  • Exchange Rates and Net Exports: When the currency appreciates, Exports decrease and Imports increase. When the currency depreciates, Exports increase and Imports decrease.