Econ exam 2

Chapter 10: Basic Macroeconomic Relationships

45° (Degree) Line:

• In macroeconomics, the 45° line often appears in graphical representations, especially in Keynesian economics. It represents a line where the value on the horizontal axis is equal to the value on the vertical axis. In the context of consumption and income, the 45° line signifies equilibrium, where consumption equals income. This concept is pivotal in understanding the Keynesian cross model and the determination of aggregate expenditure.

• Consumption Schedule:

  • A consumption schedule is a table or graph that outlines the relationship between disposable income and consumption levels. Disposable income is the income households have available after paying taxes. The consumption schedule demonstrates how changes in income affect consumption spending, assuming other factors remain constant. It's essential in analyzing consumer behavior and understanding the consumption function in macroeconomic models.

• Saving Schedule:

  • A saving schedule is a table or graph showing the relationship between disposable income and saving levels. It illustrates how changes in income influence the amount households save, holding all other factors constant. This schedule aids in understanding the saving function and is crucial in analyzing the determinants of saving behavior in an economy.

• Break-even Income:

  • Break-even income, also known as the level of income at which consumption equals income, occurs where the consumption schedule intersects the 45° line. At this point, households spend all their income on consumption, leaving no saving or dissaving. It's a significant concept in understanding the equilibrium level of income and consumption in macroeconomic analysis.

• Average Propensity to Consume (APC):

  • The average propensity to consume (APC) is the ratio of total consumption expenditure to total disposable income. Mathematically, it is expressed as APC = Consumption / Disposable Income. It measures the proportion of disposable income that households spend on consumption. APC provides insights into the consumption behavior of households and how it changes with income levels.

• Average Propensity to Save (APS):

  • The average propensity to save (APS) is the ratio of total saving to total disposable income. Mathematically, it is expressed as APS = Saving / Disposable Income. APS indicates the proportion of disposable income that households save rather than spend on consumption. It complements APC and provides valuable information about saving patterns in an economy.

• Marginal Propensity to Consume (MPC):

  • The marginal propensity to consume (MPC) measures the change in consumption resulting from a change in disposable income. It is defined as the ratio of the change in consumption to the change in disposable income. Mathematically, it is expressed as MPC = ΔConsumption / ΔDisposable Income. MPC helps economists understand how changes in income affect consumption behavior and the multiplier effect on aggregate demand.

• Marginal Propensity to Save (MPS):

  • The marginal propensity to save (MPS) measures the change in saving resulting from a change in disposable income. It is defined as the ratio of the change in saving to the change in disposable income. Mathematically, it is expressed as MPS = ΔSaving / ΔDisposable Income. MPS provides insights into how households adjust their saving behavior in response to changes in income levels.

• Wealth Effect:

  • The wealth effect refers to the impact of changes in asset prices, such as stocks, bonds, or real estate, on consumer spending. When the value of household wealth increases, consumers tend to feel wealthier and may increase their spending, even if their income remains unchanged. Conversely, a decrease in wealth may lead to reduced spending. The wealth effect plays a significant role in consumption decisions and aggregate demand.

• Expected Rate of Return on Investment:

  • The expected rate of return on investment is the anticipated profit or yield that investors expect to earn from a particular investment. It considers factors such as the initial cost of investment, expected future cash flows, and the risk associated with the investment. The expected rate of return influences investment decisions by firms and individuals and affects the level of investment in the economy.

• Investment Demand Curve:

  • The investment demand curve represents the relationship between the expected rate of return on investment and the level of investment spending in an economy. It illustrates how changes in the expected rate of return influence investment decisions by firms. A higher expected rate of return leads to increased investment spending, while a lower expected rate of return reduces investment demand.

• Multiplier:

  • The multiplier is a concept in macroeconomics that illustrates how changes in autonomous spending (such as investment or government spending) lead to larger changes in aggregate demand and national income. The multiplier effect occurs because an initial change in spending sets off a chain reaction of additional spending throughout the economy. The multiplier measures the ratio of the change in equilibrium output to the initial change in spending.

• Paradox of Thrift:

  • The paradox of thrift is an economic concept that suggests an increase in saving by households, while beneficial at the individual level, can lead to a decrease in aggregate demand and economic output when everyone saves more simultaneously. This is because increased saving reduces consumption, which in turn reduces aggregate demand, potentially leading to lower income levels and unemployment. Thus, what may be rational behavior for individuals can have adverse effects on the economy as a whole.

Chapter 11: The Aggregate Expenditures Model

Planned Investment:

• Planned investment refers to the amount of investment spending that firms intend to undertake during a specific period. It is based on their expectations regarding future profitability, interest rates, technological advancements, and overall economic conditions. Planned investment plays a crucial role in determining the level of aggregate demand in the economy and influences economic growth.

Investment Schedule:

• An investment schedule is a tabular or graphical representation that shows the relationship between the expected rate of return on investment and the level of planned investment spending by firms. It illustrates how changes in the expected rate of return influence investment decisions. The investment schedule is essential in understanding the determinants of investment and its impact on aggregate demand and economic activity.

Aggregate Expenditures Schedule:

• An aggregate expenditures schedule is a tabular or graphical representation that shows the total planned spending (aggregate expenditures) at various levels of real GDP in an economy. It includes consumption spending, planned investment, government spending, and net exports. The aggregate expenditures schedule helps analyze the relationship between total spending and output and identifies equilibrium GDP.

Equilibrium GDP:

• Equilibrium GDP is the level of real GDP at which aggregate demand equals aggregate supply in an economy, resulting in stable prices and full employment of resources. It represents the point of intersection between the aggregate expenditures schedule and the 45-degree line in the Keynesian cross model. Equilibrium GDP reflects the level of output where there are no unplanned changes in inventories.

Leakage:

• Leakage refers to the diversion of income from the circular flow of income and spending in an economy. Common forms of leakage include saving, taxes, and imports, which withdraw income from the domestic economy. Leakage reduces the multiplier effect and can lead to a decrease in aggregate demand and economic output.

Injection:

• Injection refers to the addition of income to the circular flow of income and spending in an economy. Common forms of injection include investment, government spending, and exports, which inject income into the domestic economy. Injections stimulate economic activity and contribute to the multiplier effect, leading to an increase in aggregate demand and economic output.

Unplanned Changes in Inventories:

• Unplanned changes in inventories occur when actual sales differ from expected sales, leading to unintended changes in firms' inventory levels. If actual sales exceed expected sales, firms will experience unplanned inventory reductions, prompting them to increase production to restock their inventories. Conversely, if actual sales fall short of expected sales, firms will accumulate unplanned inventory surpluses, leading to decreased production to reduce inventories.

Net Exports:

• Net exports represent the difference between a country's exports (goods and services sold to foreign countries) and imports (goods and services purchased from foreign countries). Net exports reflect the contribution of international trade to the economy's overall level of output and aggregate demand. Positive net exports contribute to economic growth, while negative net exports detract from growth.

Lump-Sum Tax:

• A lump-sum tax is a fixed amount of tax levied on individuals or firms regardless of their income or economic activity. Unlike proportional or progressive taxes, which are based on income levels, a lump-sum tax remains constant regardless of changes in income. Lump-sum taxes are often used for simplicity and to generate government revenue without distorting incentives or behaviors.

Recessionary Expenditure Gap:

• A recessionary expenditure gap occurs when equilibrium GDP is below potential GDP, indicating an underutilization of resources and high levels of unemployment. It results from insufficient aggregate demand relative to the economy's productive capacity. A recessionary expenditure gap is typically associated with a contractionary phase of the business cycle and may require fiscal or monetary policy interventions to stimulate demand and promote economic recovery.

Inflationary Expenditure Gap:

• An inflationary expenditure gap occurs when equilibrium GDP exceeds potential GDP, indicating an overheating economy and upward pressure on prices. It results from excessive aggregate demand relative to the economy's productive capacity. An inflationary expenditure gap is typically associated with an expansionary phase of the business cycle and may require contractionary fiscal or monetary policies to reduce demand and control inflation.

Chapter 12: Aggregate Demand and Aggregate Supply

Aggregate Demand–Aggregate Supply (AD-AS) Model:

• The aggregate demand-aggregate supply (AD-AS) model is a macroeconomic framework used to analyze the equilibrium level of output and the price level in an economy. It illustrates the relationship between aggregate demand, representing total spending in the economy, and aggregate supply, representing total production in the economy. The model incorporates various factors influencing aggregate demand and aggregate supply to determine equilibrium output and the equilibrium price level.

• Aggregate Demand:

  • Aggregate demand (AD) represents the total demand for goods and services in an economy at a given price level and within a specific time frame. It is composed of consumption spending, investment spending, government spending, and net exports. Aggregate demand is influenced by factors such as consumer confidence, interest rates, government policies, and international economic conditions.

• Real-Balances Effect:

  • The real-balances effect refers to the impact of changes in the price level on the real value of wealth and purchasing power. When the price level falls (deflation), the real value of money holdings increases, leading to an increase in consumers' purchasing power. This, in turn, stimulates consumer spending and aggregate demand. Conversely, when the price level rises (inflation), the real value of money holdings decreases, reducing consumers' purchasing power and dampening aggregate demand.

• Interest-Rate Effect:

  • The interest-rate effect refers to the impact of changes in the price level on interest rates and investment spending. When the price level falls (deflation), nominal interest rates decline, leading to lower borrowing costs and increased investment spending. This stimulates aggregate demand and economic activity. Conversely, when the price level rises (inflation), nominal interest rates increase, raising borrowing costs and reducing investment spending, thereby dampening aggregate demand.

• Foreign Purchases Effect:

  • The foreign purchases effect refers to the impact of changes in the price level on a country's exports and imports. When the domestic price level falls relative to foreign prices (deflation), domestic goods become more competitive in international markets, leading to an increase in exports and a decrease in imports. This boosts net exports and stimulates aggregate demand. Conversely, when the domestic price level rises relative to foreign prices (inflation), domestic goods become less competitive, leading to a decrease in exports and an increase in imports, thereby reducing net exports and dampening aggregate demand.

• Determinants of Aggregate Demand:

  • The determinants of aggregate demand are factors that influence the total spending on goods and services in an economy. They include changes in consumer confidence, disposable income, wealth, interest rates, government spending, and foreign economic conditions. Shifts in any of these determinants can lead to changes in aggregate demand and impact the equilibrium level of output and the price level in the economy.

• Aggregate Supply:

  • Aggregate supply (AS) represents the total quantity of goods and services that producers are willing and able to supply at different price levels in an economy. It is divided into short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS). Aggregate supply is influenced by factors such as resource availability, technology, labor market conditions, and government regulations.

• Immediate-Short-Run Aggregate Supply Curve:

  • The immediate-short-run aggregate supply (SRAS) curve represents the relationship between the price level and the quantity of output supplied by firms in the very short term, assuming that input prices remain fixed. In the immediate-short run, firms are unable to adjust their production levels or input prices quickly. As a result, the SRAS curve is typically horizontal or nearly horizontal at the existing level of potential output.

• Short-Run Aggregate Supply Curve:

  • The short-run aggregate supply (SRAS) curve represents the relationship between the price level and the quantity of output supplied by firms in the short term, considering adjustments in input prices but not in technology or productivity. In the short run, firms can adjust their production levels in response to changes in demand or input prices, leading to a positively sloped SRAS curve.

• Long-Run Aggregate Supply Curve:

  • The long-run aggregate supply (LRAS) curve represents the relationship between the price level and the quantity of output supplied by firms in the long term, assuming full adjustment of input prices, technology, and productivity. In the long run, firms can adjust all factors of production, leading to a vertical LRAS curve at the economy's potential output level, independent of the price level.

• Determinants of Aggregate Supply:

  • The determinants of aggregate supply are factors that influence the total quantity of goods and services that firms are willing and able to supply at different price levels. They include changes in resource prices, technology, labor market conditions, government regulations, and productivity growth. Shifts in any of these determinants can lead to changes in aggregate supply and affect the equilibrium level of output and the price level in the economy.

• Productivity:

  • Productivity refers to the efficiency with which inputs (such as labor, capital, and technology) are utilized to produce goods and services. Higher productivity allows firms to produce more output with the same level of inputs or produce the same output with fewer inputs. Productivity growth is a key driver of long-term economic growth and influences the economy's potential output and aggregate supply.

• Equilibrium Price Level:

  • The equilibrium price level is the price level at which aggregate demand equals aggregate supply in an economy, resulting in macroeconomic equilibrium. It represents the level at which the quantity of goods and services demanded equals the quantity supplied, ensuring that all markets in the economy clear. The equilibrium price level determines the overall price level in the economy and affects inflationary pressures.

• Equilibrium Real Output:

  • Equilibrium real output is the level of real GDP at which aggregate demand equals aggregate supply in an economy, resulting in macroeconomic equilibrium. It represents the level of output produced by firms when all resources are fully utilized and the economy operates at its potential output level. Equilibrium real output determines the economy's overall level of economic activity and employment.

• Menu Costs:

  • Menu costs refer to the costs incurred by firms when they adjust prices in response to changes in market conditions, such as changes in demand or input prices. These costs include expenses related to updating price lists, printing new menus, and implementing pricing changes. Menu costs can create price rigidities and hinder the adjustment of prices to changes in supply and demand conditions, leading to inefficiencies in resource allocation.

• Efficiency Wages:

  • Efficiency wages are wages paid by firms that exceed the equilibrium market wage rate in order to motivate workers to increase their productivity and reduce turnover, absenteeism, and shirking. By offering higher wages, firms aim to attract and retain skilled workers, improve worker morale and effort, and enhance overall productivity. Efficiency wages can lead to higher labor costs for firms but may result in long-term benefits such as higher quality output and lower production costs.

Chapter 13: Fiscal Policy, Deficits, and Debt

• Fiscal Policy:

  • Fiscal policy refers to the use of government spending and taxation to influence the economy's performance. It aims to stabilize economic fluctuations, achieve full employment, and control inflation. Expansionary fiscal policy involves increasing government spending and/or reducing taxes to stimulate economic activity during recessions. Contractionary fiscal policy involves decreasing government spending and/or increasing taxes to cool down an overheated economy and combat inflation.

• Council of Economic Advisers (CEA):

  • The Council of Economic Advisers (CEA) is a group of economists appointed by the President of the United States to provide economic analysis and advice on domestic and international economic policy issues. The CEA assists the President in formulating economic policies, preparing the annual Economic Report of the President, and assessing the state of the economy.

• Expansionary Fiscal Policy:

  • Expansionary fiscal policy is a macroeconomic policy aimed at stimulating aggregate demand and economic growth during periods of economic downturns or recessions. It involves increasing government spending on goods and services and/or reducing taxes to boost disposable income and consumer spending. Expansionary fiscal policy is used to counteract unemployment and stimulate economic activity.

• Budget Deficit:

  • A budget deficit occurs when government expenditures exceed government revenues in a given fiscal period, typically a year. It represents the amount by which government spending exceeds its income from taxes and other sources. Budget deficits are financed by borrowing through the issuance of government securities, which increases public debt.

• Contractionary Fiscal Policy:

  • Contractionary fiscal policy is a macroeconomic policy aimed at reducing aggregate demand and controlling inflation during periods of economic overheating or high inflationary pressures. It involves decreasing government spending on goods and services and/or increasing taxes to reduce disposable income and consumer spending. Contractionary fiscal policy is used to combat inflation and prevent excessive economic growth.

• Budget Surplus:

  • A budget surplus occurs when government revenues exceed government expenditures in a given fiscal period, typically a year. It represents the amount by which government income from taxes and other sources exceeds its spending on goods, services, and interest payments. Budget surpluses can be used to pay down public debt or fund future expenditures.

• Built-In Stabilizer:

  • Built-in stabilizers are automatic features of the fiscal system that help stabilize economic fluctuations without explicit government intervention. Examples include the progressive tax system and unemployment benefits. During economic downturns, tax revenues tend to decrease, and spending on unemployment benefits tends to increase automatically, providing a stabilizing effect on aggregate demand.

• Progressive Tax System:

  • A progressive tax system is one in which the average tax rate increases as income rises. Higher-income individuals pay a larger proportion of their income in taxes compared to lower-income individuals. Progressive taxation aims to redistribute income and reduce income inequality by taxing the wealthy more heavily.

• Proportional Tax System:

  • A proportional tax system, also known as a flat tax system, is one in which the average tax rate remains constant regardless of income level. All individuals, regardless of their income, pay the same proportion of their income in taxes. Proportional taxation is often considered simpler and fairer but may exacerbate income inequality.

• Regressive Tax System:

  • A regressive tax system is one in which the average tax rate decreases as income rises. Lower-income individuals pay a larger proportion of their income in taxes compared to higher-income individuals. Regressive taxation tends to place a heavier burden on low-income households and may exacerbate income inequality.

• Cyclically Adjusted Budget:

  • The cyclically adjusted budget is an estimate of the federal government's budget balance adjusted for the effects of the business cycle. It removes the impact of cyclical fluctuations in tax revenues and government expenditures to provide a clearer picture of the underlying fiscal position. The cyclically adjusted budget helps policymakers assess the structural health of the government's finances independent of temporary economic fluctuations.

• Cyclical Deficit:

  • A cyclical deficit is the portion of a government's budget deficit that is attributable to changes in economic conditions and the business cycle. It reflects the decline in tax revenues and increase in government expenditures that occur during economic downturns. Cyclical deficits automatically increase during recessions and decrease during expansions as the economy moves through the business cycle.

• Political Business Cycle:

  • The political business cycle refers to the phenomenon where politicians manipulate economic policy variables, such as fiscal and monetary policy, to influence the timing of economic fluctuations for political gain. Politicians may pursue expansionary policies before elections to stimulate economic growth and boost their chances of reelection, even if such policies are not optimal for the economy's long-term health.

• Crowding-Out Effect:

  • The crowding-out effect occurs when increased government borrowing to finance budget deficits leads to higher interest rates and reduces private investment spending. As the government competes with the private sector for funds in the financial markets, it drives up interest rates, making borrowing more expensive for businesses and households. This, in turn, reduces private investment and offsets some of the stimulative effects of fiscal policy.

• Public Debt:

  • Public debt, also known as government debt or national debt, refers to the accumulated borrowing of a government over time to finance budget deficits. It represents the total amount of money owed by the government to creditors, including individuals, businesses, and foreign governments. Public debt is typically issued in the form of government securities, such as bonds and Treasury bills.

• U.S. Securities:

  • U.S. securities are debt instruments issued by the U.S. Treasury to finance government spending and budget deficits. They include Treasury bonds, Treasury notes, Treasury bills, and savings bonds. U.S. securities are considered safe investments because they are backed by the full faith and credit of the U.S. government and are widely traded in financial markets.

• External Public Debt:

  • External public debt refers to the portion of a country's public debt owed to foreign creditors, including foreign governments, international organizations, and private investors. External public debt represents borrowing from abroad to finance domestic expenditures and budget deficits. It is subject to exchange rate fluctuations and international financial market conditions.

• Public Investments:

  • Public investments refer to government expenditures on infrastructure, education, healthcare, research and development, and other capital projects aimed at promoting long-term economic growth and development. Public investments contribute to improving the economy's productive capacity, enhancing human capital, and fostering innovation and technological progress.