Macroeconomics Final

Budget deficit — A shortfall of government revenues compared to expenditures
Budget surplus — An excess of government revenues over expenditures
Government debt — Accumulated deficits minus accumulated surpluses over time

Deficit versus debt — Deficit is measured per year while debt is the total accumulated amount

Cyclical deficit — The part of the deficit caused by the economy being below potential output
Structural deficit — The part of the deficit that exists even when the economy is at potential output

Structural deficit formula — Structural deficit equals total deficit minus cyclical deficit

Recession effect on deficit — Tax revenue falls and government spending rises so the deficit increases
Boom effect on deficit — Tax revenue rises and government spending falls so the deficit decreases

Why nominal deficit is misleading — It does not reflect the size or strength of the economy

Why compare deficit to GDP — Because repayment ability depends on economic output

Best way to compare deficits — Deficit as a percentage of government revenues

Debt to GDP ratio — A measure of how large debt is relative to the economy

Keeping debt to GDP constant — Debt must grow at the same rate as GDP

Reducing debt to GDP — Run budget surpluses increase economic growth or allow inflation to raise nominal GDP

How government finances deficit — By issuing bonds

Government bonds — Promises to repay borrowed money in the future

Government debt versus household debt — Governments can roll over debt and much United States debt is owned domestically

Expansionary fiscal policy — Increasing government spending or lowering taxes to increase output

Contractionary fiscal policy — Decreasing government spending or raising taxes to reduce inflation

Automatic stabilizers — Policies that stabilize the economy without new government action

Automatic stabilizers in recession — Taxes fall and government spending rises

Automatic stabilizers in expansion — Taxes rise and government spending falls

Why automatic stabilizers are important — They reduce the severity of recessions and booms

Countercyclical policy — Policy that offsets the business cycle

Procyclical policy — Policy that increases economic fluctuations

Ricardian equivalence — People increase saving because they expect future taxes so deficits do not affect output

Crowding out — Government spending reduces private spending

Labor force — All people who are willing and able to work

Not in labor force — People unwilling or unable to work

Unemployed — People willing and able to work but not working

Part time workers — Included in the labor force

Underemployment — Working part time or below one’s skill level

Discouraged workers — People who stop looking for work but still want a job

Why unemployment rate is inaccurate — It excludes discouraged workers and underemployed workers

Cyclical unemployment — Caused by downturns in the economy

Structural unemployment — Caused by mismatch of skills

Frictional unemployment — Caused by people changing jobs

Okun rule — One percent increase in unemployment leads to about two percent decrease in output

Reverse Okun rule — One percent increase in output leads to about half percent decrease in unemployment

Target rate of unemployment — Lowest sustainable unemployment rate

Natural rate of unemployment — Unemployment at potential output

Inflation — A continual increase in the price level

Deflation — A continual decrease in the price level

Consumer price index — A price index based on a fixed basket of goods

Inflation calculation — New index minus old index divided by old index times one hundred

Consumer price index bias — It overstates inflation because it ignores substitution and quality improvements

Expected inflation — Inflation people anticipate

Unexpected inflation — Inflation that people did not expect

Who benefits from unexpected inflation — Debtors

Who is hurt by unexpected inflation — Creditors

Real wage — Wage adjusted for inflation

If wages rise slower than prices — Real wages fall and purchasing power falls

Inflation rule — Inflation equals wage growth minus productivity growth

Demand pull inflation — Caused by high demand when economy is near or above potential

Cost push inflation — Caused by rising production costs such as wages

Equation of exchange — Money supply times velocity equals price level times real output

Money supply — Total amount of money in the economy

Velocity of money — How often money is used in transactions

Nominal GDP — Price level times real output

Quantity theory of money — Money supply growth causes inflation in the long run

Key assumption quantity theory — Velocity is constant and output does not depend on money supply

Institutionalist theory — Inflation starts with rising costs and money supply increases afterward

Phillips curve — Relationship between inflation and unemployment

Short run Phillips curve — Shows a trade off between inflation and unemployment

Long run Phillips curve — Vertical meaning no trade off

Non accelerating inflation rate of unemployment — The unemployment rate that keeps inflation stable

Natural rate equals this — Yes

Stagflation — High inflation and high unemployment

Lesson from nineteen seventies — Inflation did not reduce unemployment

Key modern agreement — No long run trade off between inflation and unemployment

Key disagreement — Whether short run trade off exists

Keynesian view — Trade off may exist in the short run during recessions

Neoclassical view — No trade off even in the short run

Scarcity, Resources are limited while wants are unlimited
Opportunity Cost, Value of the next best alternative forgone
Marginal Cost, Additional cost of one more unit
Marginal Benefit, Additional benefit of one more unit
Decision Rule, Choose option where MB ≥ MC
Sunk Cost, A past cost that cannot be recovered and should be ignored
Rational Behavior, Making decisions by comparing marginal benefit and marginal cost
Fallacy of Composition, Assuming what is true for one is true for all

🔹 POSITIVE VS NORMATIVE (TESTED MULTIPLE TIMES)

Positive Statement, Objective statement about what is
Normative Statement, Opinion about what should be
Subjective Statement, Based on personal opinion (same as normative in exams)
Objective Statement, Based on facts and evidence

🔹 MARKET SYSTEMS & SOCIETIES

Market Economy, Decisions made through markets and prices
Command Economy, Decisions made by government planning
Mixed Economy, Combination of markets and government
Private Property Rights, Right to own and control resources (essential for markets)
How Economists Classify Societies, By degree to which they rely on markets
Self-Interest, Individuals act in their own best interest

🔹 CIRCULAR FLOW (VERY TESTED)

Circular Flow Model, Shows movement of goods, services, and money
Goods Market, Firms sell goods to households
Factor Market, Households sell labor to firms
Households, Supply labor and demand goods
Firms, Demand labor and supply goods
Government Role (Actor), Government spends and participates in markets
Government Role (Referee), Government sets rules and regulations

🔹 SUPPLY & DEMAND BASICS

Law of Demand, Price ↑ → Quantity demanded ↓ (ceteris paribus)
Law of Supply, Price ↑ → Quantity supplied ↑ (ceteris paribus)
Demand, Relationship between price and quantity demanded
Supply, Relationship between price and quantity supplied
Quantity Demanded, Movement along demand curve due to price change
Quantity Supplied, Movement along supply curve due to price change

🔹 DEMAND SHIFTERS (VERY IMPORTANT)

Demand Increase, Shift right → price ↑ quantity ↑
Demand Decrease, Shift left → price ↓ quantity ↓
Substitutes, Price of one ↑ → demand for other ↑
Complements, Price of one ↑ → demand for other ↓
Income Effect, Income ↑ → demand ↑ for normal goods
Expectations, Future price expectations shift demand

🔹 SUPPLY SHIFTERS

Supply Increase, Shift right → price ↓ quantity ↑
Supply Decrease, Shift left → price ↑ quantity ↓
Input Costs, Higher costs → supply decreases
Technology, Improvements → supply increases
Expectations, Expected higher prices → supply decreases today

🔹 EQUILIBRIUM (HIGH FREQUENCY)

Equilibrium, Quantity demanded = quantity supplied
Surplus, Quantity supplied > quantity demanded
Shortage, Quantity demanded > quantity supplied
Shortage Adjustment, Price rises
Surplus Adjustment, Price falls

🔹 SHIFT LOGIC (CRITICAL FOR EXAM)

Price ↑ + Quantity ↓, Supply decreases
Price ↓ + Quantity ↑, Supply increases
Price ↑ + Quantity ↑, Demand increases
Price ↓ + Quantity ↓, Demand decreases
Two Shifts Same Direction, Quantity predictable, price ambiguous
Two Shifts Opposite Direction, Price predictable, quantity ambiguous

🔹 PRICE CONTROLS

Price Ceiling, Legal maximum price
Binding Ceiling, Below equilibrium → shortage
Nonbinding Ceiling, Above equilibrium → no effect
Price Floor, Legal minimum price
Binding Floor, Above equilibrium → surplus
Nonbinding Floor, Below equilibrium → no effect

🔹 GOVERNMENT & POLICY

Tariff, Tax on imports
Quota, Limit on imports
Third-Party Payer System, Buyer ≠ payer
Effect of Third-Party System, Higher spending/consumption

🔹 PPC & PRODUCTION (HEAVILY TESTED)

PPC, Maximum combinations of goods
Efficient Point, On PPC
Inefficient Point, Inside PPC
Unattainable Point, Outside PPC
Constant Opportunity Cost, Straight-line PPC
Increasing Opportunity Cost, Bowed-out PPC
Reason for Bowed PPC, Resources are specialized

🔹 COMPARATIVE ADVANTAGE (BIG EXAM AREA)

Comparative Advantage, Lower opportunity cost
Absolute Advantage, More output with same resources
Gains from Trade, Specialization based on comparative advantage
Equal Opportunity Cost Case, No gains from trade

Opportunity Cost Formula, What you give up ÷ what you gain

Flatter PPC, Lower opportunity cost of x-axis good
Steeper PPC, Higher opportunity cost of x-axis good

🔹 SPECIAL TESTED CONCEPTS FROM YOUR MIDTERM

Law of Demand Explanation, Consumers substitute away from higher-priced goods
Expectations Effect, Waiting for lower prices shifts demand left
Labor Supply, Upward sloping due to higher wages increasing quantity supplied
Market Demand, Sum of individual demand curves horizontally
Taxi Medallions, Example of supply restriction creating higher prices

🧠 Growth and Business Cycle

Economic growth :: Increase in real GDP over time
Real GDP growth :: Percent change in inflation adjusted output
GDP per capita :: GDP divided by population
Per capita growth :: GDP growth minus population growth
Business cycle :: Fluctuations in output around long run trend
Expansion :: Period of increasing output
Recession :: Period of decreasing output
Peak :: Highest point before downturn
Trough :: Lowest point before recovery
Secular growth trend :: Long run path of potential output

Cyclical unemployment :: Unemployment caused by recessions
Structural unemployment :: Unemployment due to skill mismatch or technology
Frictional unemployment :: Short term unemployment between jobs
Seasonal unemployment :: Unemployment due to seasonal patterns
Natural rate of unemployment :: Frictional plus structural unemployment

🏛 Macroeconomic Foundations

Keynesian economics :: Government intervention is needed to stabilize economy
Classical economics :: Markets self correct in the long run
Macroeconomics origin :: Developed due to the Great Depression

Short run :: Focus on demand and stabilizing output
Long run :: Focus on growth and supply

Laissez faire :: Minimal government intervention
Say Law :: Supply creates its own demand

📊 GDP and National Accounting

GDP :: Market value of final goods and services produced domestically in a given time period
Final goods :: Goods used by end consumers
Intermediate goods :: Goods used to produce other goods
Double counting :: Counting same value multiple times
Value added :: Output minus cost of inputs

Consumption :: Household spending
Investment :: Spending on capital goods
Government spending :: Government purchases
Net exports :: Exports minus imports

GDP formula :: Consumption plus investment plus government spending plus net exports

Flow :: Measured over a period of time
Stock :: Measured at a point in time

NDP :: GDP minus depreciation
Depreciation :: Capital used up in production
GNP :: GDP plus net foreign factor income

Nominal GDP :: Measured using current prices
Real GDP :: Adjusted for inflation
Inflation :: Increase in price level

Real GDP measures :: Change in market production not welfare

📉 Aggregate Demand

Aggregate demand :: Total demand for goods and services in an economy

Wealth effect :: Lower prices increase purchasing power and spending
International effect :: Lower prices increase exports and reduce imports
Multiplier effect :: Initial spending change leads to larger output change

AD shifts right when ::
Foreign income increases
Currency weakens
Consumers expect higher future income
Income shifts to poorer households
Government increases spending or cuts taxes
Money supply increases

AD shifts left when ::
Imports increase
Government spending decreases
Taxes increase
Money supply decreases

📊 Aggregate Supply

Short run aggregate supply :: Output supplied when wages are sticky

SAS shifts left when ::
Input costs increase
Taxes increase
Productivity decreases
Firms expect worse conditions

SAS shifts right when ::
Input costs decrease
Taxes decrease
Productivity increases
Firms expect better conditions

Long run aggregate supply :: Output at full employment
Potential output :: Maximum sustainable output

LAS shifts when ::
Technology changes
Capital changes
Labor changes
Education changes

⚖ AD AS Model

Short run equilibrium :: AD equals short run supply
Long run equilibrium :: AD equals short run supply equals long run supply

Recessionary gap :: Output below potential
Inflationary gap :: Output above potential

Adjustment below potential :: Wages fall and supply increases
Adjustment above potential :: Wages rise and supply decreases

🏛 Fiscal Policy

Expansionary fiscal policy :: Increase spending or decrease taxes
Contractionary fiscal policy :: Decrease spending or increase taxes

Countercyclical policy :: Government acts opposite the business cycle

Recession policy :: Increase demand
Inflation policy :: Decrease demand

📈 Growth Theory

Rule of seventy two :: Divide seventy two by growth rate to find doubling time
Compounding :: Growth builds on previous growth

Classical growth model :: Growth driven by saving and investment
Schumpeter theory :: Growth driven by entrepreneurship and innovation

Sources of growth ::
Technology
Human capital
Physical capital
Trade

Financial markets role :: Move funds from savers to investors

Small growth differences matter :: Due to compounding

Paradox of thrift :: More saving reduces output in the short run

💰 Money and Financial Sector

Money :: Liquid asset used in transactions

Functions of money ::
Medium of exchange
Unit of account
Store of wealth

Bond price relationship :: Bond prices move opposite to interest rates

🏦 Banking and Money Creation

Reserves :: Money held by banks
Required reserves :: Minimum reserves required
Excess reserves :: Reserves above required

Reserve ratio :: Required reserves divided by deposits

Money multiplier :: One divided by reserve ratio

Money creation :: Banks create money by making loans

When banks lend :: Money supply increases

📉 Money Market

Money demand :: Demand for holding money
Money supply :: Controlled by central bank

Interest rate :: Cost of holding money

Motives for holding money ::
Transactions
Precautionary
Speculative

Opportunity cost of holding money :: Lost interest

🏛 Monetary Policy

Federal Reserve :: Central bank of the United States

Open market operations :: Buying and selling bonds
Reserve requirement :: Required reserves ratio
Discount rate :: Interest rate charged to banks

Buying bonds :: Increases money supply
Selling bonds :: Decreases money supply

📊 Monetary Policy Effects

Expansionary policy ::
Money supply increases
Interest rates fall
Investment increases
Demand increases
Output increases

Contractionary policy ::
Money supply decreases
Interest rates rise
Investment decreases
Demand decreases
Output decreases

Transmission mechanism ::
Money supply affects interest rates
Interest rates affect investment
Investment affects demand
Demand affects output

Monetary policy affects :: Both output and inflation

⚠ Financial Crisis

Financial crisis :: Breakdown of financial system
Asset bubble :: Prices exceed true value
Herding :: People follow others
Leverage :: Borrowing to invest

Financial crisis danger :: Can collapse entire economy

Quantitative easing :: Buying assets to increase money supply
Credit easing :: Lending to financial institutions
Operation Twist :: Changing short and long term interest rates
Precommitment policy :: Promise to maintain policy

⚠ High Yield Concepts and Traps

GDP does not measure welfare

Income redistribution :: More income to poor increases demand

Increase in imports :: Reduces aggregate demand

Decrease in foreign income :: Reduces aggregate demand

Above potential output :: Supply decreases over time

Below potential output :: Supply increases over time

Increase in reserve requirement :: Reduces money supply

Expansionary policy does not always increase real output if already at potential