Econ 207 Final Exam Review

Exam Format

• Format similar to the midterm

  • Essays: 4 essays (do any 3, do not attempt all 4 as only the first 3 will be graded)

  • Multiple Choice: 20 questions

• Materials provided: Answer sheet for MCQs and tablet paper for essays

• Bring: Pen or pencil only

Coverage Topics

• Study the third PowerPoint deck on the expenditure model

• First 23 slides on money, the Federal Reserve, and interest rates

Expenditure Model Overview

• Definition: Short-run model based on expenditures (C, I, G, X) which make up Gross Domestic Product (GDP)

  • Expenditures includes: Consumption (C), Investment (I), Government spending (G), and Net Exports (X)

• Focus on fluctuations in spending behavior of households and firms

• Full employment: The target in the model, and the goal of fiscal policy to achieve it

Equilibrium Concept

• Equilibrium: Plans match reality, expressed as real GDP

  • Once equilibrium is reached, GDP remains stable unless planned spending changes

• Planned Spending (AEP): AEP = C + IP

  • Real GDP (Y) = C + I + G + X

  • Equilibrium occurs when AEP = Y

• Potential for unwanted or unplanned investment arises when GDP does not equal planned spending

Unwanted Investment Dynamics

• When Y > AEP: Excess production leads to decreased firm output until equilibrium is reached

• IU (Unplanned Investment): Key to returning to equilibrium; if IU > 0, firms cut back production

Consumption Function

• Consumption Spending: Breakdown of household income into consumption and saving

  • Defined by Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

• MPC greater than zero: Reflects percentage of additional income spent; always adds up to 1 with MPS

  • C = A + B * Y (where A = autonomous consumption, B = MPC)

• The gap between consumption function and 45-degree line represents saving

Investment Components

• Planned Investment (IP) is used in the model but differs from actual investment which includes unplanned investment (IU)

• Saving and Investment equivalency: S = I by definition in equilibrium

• Equilibrium Condition: S = IP only occurs in equilibrium

Government and Taxes

• Government spending increases overall planned spending

• Taxation affects disposable income and influences consumption

  • C = A + B * Y - T (where T = taxes)

Role of Exports and Imports

• Net Exports (X): Difference between exports and imports; positive X raises GDP

• Final consumption function includes effects of net exports

The Multiplier Effect

• Multiplier defined as: 1 / (1 - B) or 1 / MPC

  • Indicates total economic output change from a change in planned autonomous spending (AP)

• Understanding the multiplier: Increased AP leads to bigger changes in equilibrium GDP due to cascading spending effects

Distinction Between Spending and Tax Multipliers

• Spending Multiplier: Positive; directly influences spending stream

• Tax Multiplier: Negative; affects income before consumption adjustments are made

  • Tax multiplier typically smaller than spending multiplier by one

Stability of Equilibrium

• Equilibrium in the model is stable due to firms' production adjustments in response to unwanted/inplanned investments

• Economy returns to equilibrium unless external changes alter planned spending

Fiscal Policy Interventions

• When Y < Y_n (full employment): Use expansionary fiscal policy to increase planned spending

  • Involves increasing government spending or reducing taxes

• When Y > Y_n: Contractionary policy to decrease spending

  • Involves reducing government spending or increasing taxes

Monetary System Basics

• Functions of Money: Medium of exchange, standard of value, and store of value

• Definitions of M1 and M2: M1 as primary medium of exchange; M2 as a broader measure of store of value

The Federal Reserve's Role

• Key Functions: Carry out monetary policy, supervise banks, provide financial services, and act as lender of last resort

• Goals of Monetary Policy: Achieve stable prices (control inflation) and maximum employment

  • Interest rates influenced by Fed's monetary policy decisions

• Implementation Lags: Delays in the effect of fiscal policy due to political processes and recognition lags