Macroeconomics Study Guide

Macroeconomics Class 1 Summary In solving the economic problem of scarcity, any economy must answer the questions of: - what (and how much) should be produced? - how should it be produced? - for whom to produce it? Economic reasoning compares marginal benefits with marginal costs.! Do something if its marginal benefits > its marginal costs. •The opportunity cost of an activity is the benefit you would have gained from the next best alternative. The market, which rations scarce resources by changing prices, is efÏcient under certain conditions. The field of economics can be divided into Microeconomics – the study of individual choice Macroeconomics – the study of the economy as a whole Economic analysis can be subdivided into Positive economics – the study of what is Normative economics – the study of what should be EXERCISES 1) Suppose that you are considering going to a concert.! Tickets cost $60.! If you go to the concert, you will have to miss 4 hours of work, where you are making $10 an hour.! What is your total opportunity cost of going to the concert measured in dollars given up? - The total opportunity cost of going to the concert is $100, $60 for the ticket and $40 lost income from missing work 2) Class 2 Summary The production possibilities curve (PPC) measures or shows - the maximum combination of outputs that can be obtained from a given number of inputs. Points inside the PPC are - inefÏcient. Points along the PPC are - efÏcient. Points outside the PPC are - unattainable. According to the principle of increasing marginal opportunity cost, as the production of one good increases, - we must give up increasing quantities of something else. However, there are still gains from trade, which are gains from specializing. Specialization and trade, allows us to consume beyond our national PPC. - Given that it is a bit difÏcult to see the gains from specializing/trade with curved PPCs, we use straight line PPCs to illustrate the gains from trade. Chapter 3: Institutions A market economy - relies on prices to solve the what, how, and for whom problems. - gives private property rights to individuals. Socialism is an economic system based on - individual goodwill, rather than self-interest, to solve the what, how, and for whom problems. - government ownership of production, with economic activity governed by central planning. Who was the first macroeconomist? - Yes, in class 1, I said Keynes. The government serves as - a referee and - an actor in the economy Because there is no real-world government, governments enter voluntary organizations that (try to) regulate international markets Chapter 4 Supply & Demand Part I The law of demand states: - the quantity demanded rises as price falls, other things constant The law of supply states: - the quantity supplied rises as price rises, other things constant The law of demand holds true because - HH can substitute the good they consumed The law of supply holds true because - firms can substitute the good they produce. A A - market demand curve is the horizontal sum of all individual demand curves. market supply curve is the horizontal sum of all individual supply curves. A change in quantity demanded (quantity supplied) [caused only by a change in the good’s own price], is - a movement along the demand (supply) curve. - •A change in demand (supply) is - a shift of the entire demand (supply) curve. Factors that affect supply and demand other than the good’s own price are called - shift factors. Shift Factors of Demand Shift Factors of Supply Income [Income/Profits] Prices of Other Prices of Inputs Goods Tastes [Advertisement] Technology Expectations Expectations Taxes and Subsidies on Consumers Taxes and Subsidies on Producers Chapter 5 Supply and Demand Part 2 When quantity demanded equals quantity supplied at equilibrium, prices have no tendency to change. When quantity demanded > quantity supplied, prices tend to rise. When quantity supplied > quantity demanded, prices tend to fall. When the demand curve shifts to the right (left), equilibrium price rises (declines) and equilibrium quantity rises (falls). When the supply curve shifts to the right (left), equilibrium price declines (rises) and equilibrium quantity rises (falls). When both curves shift, we can only be definitive about either price or quantity. Almost all events can be explained in terms of shifts of and movements along demand and supply curves. Supply and demand analysis can be used to determine exchange rates (which are the prices of currencies). The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. Example: 1)a decrease in OPEC oil production due to instability in the Middle East and 2)an increase in vacation travel during the summer. The decrease in production will decrease supply from S0to S1.! The increase in demand for gasoline for vacation travel will increase demand from D0 to D1.! Price will definitely increase from P0 to P1. However, depending on which curve shifts more, the new equilibrium quantity may be higher or lower. Class 6 - Chapter 5: Using Supply and Demand Price ceilings, government imposed limits on how high a price can be charged. Effective price ceilings create - shortages [or excess demand]. - Price floors, government-imposed limits on how low a price can be charged. Effective price floors create - Surpluses [or shortage of demand]. Taxes and tariffs paid by suppliers - shift the supply curve up by the amount of the tax or tariff (or you can say shift the supply curve to the left). But what about the new eq. price? - The new equilibrium increases by less. Quantity restrictions - increase equilibrium price and reduce equilibrium quantity. In a third-party-payer market, there is a difference between - the consumer and the one who pays the cost. - When a third party pays, quantity demanded, price, and total spending are greater. Class 9- Chapter 24: Growth Cycle & Unemployment Classical economists use a laissez-faire approach while Keynesian economists use an active government approach Modern conventional economics has been a blend of the Keynesian and Classical approaches Growth is measured by the change in total output - while the secular trend growth rate has been around 3 percent for the last few decades (some expect it to fall) Business cycles are fluctuations of real output around the secular trend growth rate The long-run focus is on how to increase growth. The short-run focus is on how to get the economy operating at its potential output (long-term trend). A person is unemployed if she/he is willing & able to work, but is not working. - Structural unemployment is caused by economic restructuring (also some social restructuring). - Cyclical unemployment fluctuates with the business cycle.! - The target rate of unemployment is the lowest sustainable rate of unemployment possible under existing conditions. Class 10 – Chapter 25: Measuring Aggregate accounting is a set of rules and definitions for measuring economic activity in the aggregate economy. GDP is the total market value of all final goods and services produced in an economy in one year. GDP is the sum of four components: % GDP ≡ C + I + G + (X – M) Double counting can (theoretically) be eliminated from GDP by: - Measuring only final sales. - Measuring only value added. Difference between GDP and NDP is - depreciation. GDP measures output produced within the borders of a country; GNP measures the economic output produced by the citizens (and their businesses) of a country. The difference is: - ! Net foreign factor income Aggregate income ≡ Compensation of employees + Rent + Interest + Profit Aggregate income equals aggregate production because whenever a good is produced somebody receives income for producing it.! Profit is key to that equality. Because GDP measures only market activities, GDP can be a poor measure of relative living standards among countries. The concept of GDP has considerable problems (alternatively, you could say that wrong interpretations about “what GDP is” imply problems): - GDP does not measure economic welfare. - GDP does not include transactions in the underground economy. - Sub-categories of GDP are often interdependent (but you do not have to worry about this). Exercise 1 Suppose that GDP is $2000. Investment is $400 and government purchases are $500.! Exports are $100 and imports are $150. How much is consumption? GDP = C + I + G + (X – M).! !!!! By substitution: GDP – I – G – (X-M) = C ! 2000 – 400 – 500 – (100–150) ! = $1150 Class 11 – Chapter 26 : AD, SAS, LAS AD Curve The AD curve has a negative slope because of - the wealth effect - the interest rate effect - the international effect - the multiplier effects The AD curve shifts when there are changes in - foreign income - exchange rates - expectations - distribution of income - monetary and fiscal policy SAS The SAS curve has a positive slope because there are market imperfections (sticky wages, misconceptions) The SAS curve shifts if there are changes in: - input prices - expectation - taxes - productivity/technology The SAS curve also shifts depending on if we are in a recession or a booming economy (see slide 15). LAS The LAS curve is vertical at the point of potential output. The LAS curve shifts out if there is growth (hence, sources of growth are also the sources for outward shifts in the LAS curve): - increase available resources - Increase in capital (physical or human) - increase in labor - technology improvements - institutional improvements A lady goes into a furniture store. She picks out a lamp she likes and brings it to the counter. She finds out that the price is $69 and says, “Hey! down the street at Mitchell’s these are only $49″ The owner asks why she doesn’t buy it from Mitchell’s, and she says, “Because they just ran out of them.” The owner throws up his hands and says, “Ha! When I run out of them, they’re only $29 here!” Class 12 – Chapter 26: AD continued AS/AD Short-run equilibrium is where AD = SAS. Long-run equilibrium is at potential output! (YP) where AD = LAS. The economy may be in a short-run equilibrium (which is below or above the long-run equilibrium). - If short-run equilibrium is above YP, there is an inflationary gap and SAS eventually shifts up (to the left) to return the economy to YP at a higher price level. - If short-run equilibrium is below YP, there is a recessionary gap and SAS eventually shifts down (to the right) to return the economy to YP at a lower price level. - Class 13 – Chapter 27: Growth Economic growth is an increase in the amount of goods and services an economy produces. Per capita growth means producing more goods and services per person. Long-term impacts of per capita growth: increasing living standards! Rule of 72 Adam Smith focused on the division of labor, but saw growth as temporary. •Joseph Schumpeter focused on entrepreneurship. •The Harrod-Domar growth model focused on the role of capital accumulation in the growth process. •The Solow growth model introduced technological progress. Endogenous growth models emphasized the role of technological change due to intentional actions, due to human capital, and/or due to learning by doing. Some important sources of growth are - division of labor entrepreneurship / growth compatible institutions physical capital accumulation technological development human capital accumulation Class 14 – Chapter 28: The Financial Sector The financial sector is the market where financial assets are exchanged and, more importantly, - created. The financial sector channels flows out of the circular flow and back into the circular flow. Every financial asset has a corresponding - financial liability (possibly except cash). Money is a highly liquid financial asset that serves as - a unit of account, a medium of exchange, and a store of wealth. The 3 key measures of money are: - M0 = cash (currency in the hands of the public) - M1 = M0 plus checking account balances, plus traveler’s checks - M2 = M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares of individuals Banks create money by - loaning out deposits. - The money multiplier tells you the amount of money ultimately created per dollar injected into the banking system. The simple money multiplier is 1/r. People hold/demand money for - the transactions motive, - the precautionary motive, and - the speculative motive.! The demand for money is inversely related to the interest rate; - so is the price of bonds (to some degree also the price of stocks (even though stocks are not considered to be loanable funds). The supply of money is largely determined by the Fed (as the Fed influences how much money banks can create). Class 15: Chapter 29: Monetary Policy The Fed is the central bank of the U.S. It conducts monetary policy and regulates financial institutions. The FOMC makes the actual decisions about monetary policy. The Fed’s three main policy tools are: 1. Use open market operation 2. Change the reserve requirement 3. Change the discount rate Open market operations are the Fed’s most important policy tool. - To expand the money supply, the Fed buys bonds from the Treasury or the people (i.e., the open market) and deposits the money in the Treasury’s or people’s accounts at commercial banks, which decreases interest rates. - To decrease the money supply, the Fed sells bonds to banks and people (i.e., the open market), banks then have less money to lend out, and this increases interest rates. Contractionary monetary policy works as follows: Expansionary monetary policy works as follows: Finally, the liquidity trap refers to: a situation where interest rates are close to zero. With interest rates close to zero, most of the Fed’s conventional policy tools become ineffective. Class 16 – Chapter 30: Financial Crisis Two main ingredients of a bubble are: - herding and leveraging. •If the financial sector were to collapse: - all other sectors would crash along with it •Financial deregulations in the decades before the 2008 financial crises did what? - contributed to its emergence and depth •The Fed implemented unconventional monetary policies such as: - quantitative easing, - credit easing, - operation twist, and - precommitment policy. Class 19 – Chapter 31: Deficits and Debt A deficit is a shortfall of revenues over expenditures. A surplus is an excess of revenues over expenditures. A cyclical deficit is the part of the deficit that exists because - the economy is below its potential output/income. A structural deficit is the part of a budget deficit that - would exist even if the economy were at its potential income. Structural deficit =! Actual (total) deficit! !– Cyclical deficit Debt is - accumulated deficits minus accumulated surpluses. Deficits, surpluses, and debt should be viewed relative to GDP because -relative ratios provide a better indication on the ability to handle the deficit and to pay off the debt. The federal debt (defined as percent of GDP) can be reduced by - budget adjustments, GDP growth, inflation Class 20 – Chapter 32: Fiscal Policy The Ricardian equivalence theorem states that - it doesn’t matter whether increased government spending is financed by taxes or deficits; neither would affect the economy. Automatic stabilizers are any government program or policy that - will counteract the business cycle without any new government action. Pro-cyclical fiscal policy:!!!!!!! - changes in government spending and taxes that increase the cyclical fluctuations in the economy instead of reducing them. Counter-cyclical fiscal policy: - changes in government spending and taxes that decrease the cyclical fluctuations in the economy. Counter-cyclical policy is the way to go. Based on the overall agreement that it is beneficial to smooth growth rates, that is - to reduce the extremes of the business cycle, various automatic stabilizers have been built into the economy, mainly: owelfare payments, ounemployment insurance, and oprogressive income taxes. Given the high debt-to-GDP ratio, more and more economists tend to argue that we need a credible exit strategy (instead of further expansionary fiscal policies). Class 21 – Chapter 33: Jobs and Unemployment Inflation is a rise in the price level. Expectations play a key role in the inflationary process. Inflation has distributional implications: - The winners in inflation are people who can raise their wages or prices and still keep their jobs or sell their goods.! - The losers are people who can’t raise their wages or prices. A basic rule to predict inflation is:! Inflation equals nominal wage increases minus productivity growth. Theoretically, we can distinguish between demand pull and cost push inflation The equation of exchange is - MV = PQ.! (This is always true.) When velocity is constant and real output is independent of the money supply, money and prices are - directly linked to each other. The equation of exchange becomes the quantity theory if it states that - the price level varies in direct response to changes in the quantity of money.! That is %∆M leads to an equal % ∆P. The institutional theory of inflation sees the source of inflation in - wage- and price- setting institutions. Institutionalists see the direction of causation going from - price increases to money supply increases. - Class 22: Chapter 34: Inflation: Definition, Distributional Effects, and Sources Inflation is a rise in the price level. Expectations play a key role in the inflationary process. Inflation has distributional implications: - The winners in inflation are people who can raise their wages or prices and still keep their jobs or sell their goods.! - The losers are people who can’t raise their wages or prices. A basic rule to predict inflation is:! Inflation equals nominal wage increases minus productivity growth. Theoretically, we can distinguish between demand pull and cost push inflation The equation of exchange is - MV = PQ.! (This is always true.) When velocity is constant and real output is independent of the money supply, money and prices are - directly linked to each other. The equation of exchange becomes the quantity theory if it states that - the price level varies in direct response to changes in the quantity of money.! That is %∆M leads to an equal % ∆P. The institutional theory of inflation sees the source of inflation in - wage- and price- setting institutions. Institutionalists see the direction of causation going from - price increases to money supply increases. - Class 23 – Chapter 34: Phillips Curve •The Phillips curve refers to a supposedly inverse relationship between inflation and unemployment. •Most of the data until 1970 seemed to confirm the existence of such an inverse relationship. •When policy-makers tried to use the inverse relationship in the early 1970s to reduce high unemployment rates, the result was stagflation. Today, there is broad agreement that the long-run Phillips curve is vertical. •There is considerable disagreement on the existence of a short-run Phillips curve. Neoclassical economists believe that based on the quantity theory and rational expectations, there is never an inverse relationship between inflation and unemployment. •Instead, neoclassical economists believe that - inflation is bad for growth, hence, there is - an inverse relationship between inflation and growth, that is: - a trade-off between inflation and growth. Class 24 – Chapter 35: Comparative Advantage • According to the principle of comparative advantage, as long as the opportunity costs of producing goods differ among countries, there are - potential gains from trade. •Economists and laypeople differ in their views on trade mainly because - the gains from trade are not easily recognized, while the costs (lost jobs) are making headlines, i.e., are obvious •The U.S. has comparative advantages based on - its skilled workforce, - its institutions, - its language, etc. •The prices of currencies—foreign exchange rates—can be analyzed with the supply and demand model. •In economics, globalization refers to the overall gradual integration of economies. Class 25 – Chapter 10 : Trade Policy The nature of trade is continually changing - The U.S. is importing more and more high-tech goods and services from India and China and other East Asian countries Outsourcing is a type of trade. - Outsourcing is a larger phenomenon today compared to 30 years ago Trade restrictions include tariffs and quotas, embargoes, voluntary restraint agreements, regulatory trade restrictions, and nationalistic appeals Reasons that countries impose trade restrictions include unequal internal distribution of the gains from trade and haggling by countries over trade restrictions Economists generally oppose trade restrictions because of their understanding of the advantages of free trade The World Trade Organization is an international organization committed to reducing trade barriers Free trade unions and currency unions, such as the European Union, help trade by reducing barriers to trade among member nations Class 26 – Chapter 35: International Financial Policy 3 Main Determinants of Exchange Rate •Trade §prices and income are the major determinants of changes in the volumes of trade •Investment §interest rates influence these capital flows •Speculation close to impossible to determine Impact of Monetary Policy (e.g. Expansionary Fiscal Policy) See diagram Impact of Fiscal Policy (see diagram)