Macroeconomics Final Exam (concepts)
Microeconomics vs. Macroeconomics
Micro deals with the interactions and decisions of individual households as well as firms. Macro deals with the economy as a whole.
What is GDP?
The market value of all final goods and services produced within a country in a given period of time.
What are the factors of GDP?
Consumer spending, Investments, Government Spending and Net Exports (Imports and Exports)
How is GDP calculated?
Real GDP vs. Nominal GDP
Nominal determines value according to current prices (quantity and price) whereas Real determines value according to constant, base-year prices (quantity only)
How are real and nominal GDP calculated?
The formula for real GDP is nominal GDP divided by the deflator, or R = N/D.
The formula for nominal GDP is GDP = (quantity of A X price of A) + (quantity of B X price of B) + (quantity of C X price of C).
What are some difficulties when calculating GDP?
living standards, Pollution effect, Double Counting, Un-reported Self activities, illegal economy, statistical errors
What does real GDP measure in an economy?
An economies production of goods and services.
What is a GDP deflator?
A measure of the level of prices of all new, domestically produced, final goods and services in an economy
How is the GDP deflator calculated?
(nominal GDP/Real GDP)*100
How does the GDP deflator relate to inflation rates?
Inflation rate=(GDP deflator 1-GDP deflator 2/ GDP deflator 1)*100
What is a Consumer Price Index?
A measure of the overall cost of the goods and services bought by the typical consumer
How is CPI calculated?
CPI=(price of g&s in current year/price of g&s in base year)*100
How is inflation rate calculated from CPI?
Inflation rate in Year 2= (CPI in year 2-CPI in Year 1/CPI in year 1) * 100
Problems with CPI
Substitution Bias, Introduction of New Goods, Unmeasured Quality Change
How to calculate the cost of the same g&s in various years
Amount in Today’s Dollars= Amount in year T dollars * (price level now/price level in year T)
GDP Deflator vs. CPI
GDP Deflator reflects the price of all goods and services produced domestically while the CPI reflects the price of all goods and services bought by consumers. CPI compares the price of a fixed basket of goods and services in a base year whereas GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in a base year.
Automatic correction by law or contract of a dollar amount for the effects of inflation.
Real vs. Nominal Interest Rates
Real- interest rates corrected for the effects of inflation. Nominal- interest rate as usually reported, without a correction for the effects of inflation.
How is real interest rate calculated?
Real Interest Rate = Nominal interest rate – Inflation rate
What is productivity?
The quantity of goods and services produced from each unit of labor input.
What are the determinants of productivity?
Physical Capital: the stock of equipment and structures used to produce goods and services.
Human Capital: the knowledge and skills that workers gain through education, training and experience.
Natural Resources: Inputs into production that are provided by nature.
Technological Knowledge: the understanding of the best way to produce goods and services.
What is the production function?
L-labor, K-physical capital, H-human capital; N-natural resources
in terms of actual variables- Y = A F(L, K, H, N)
in terms output per worker- Y/L = A F(1, K/L, H/L, N/L)
What is a Constant Return to Scale?
A production function exhibits constant returns to scale if changing all inputs by a positive proportional factor has the effect of increasing outputs by that factor
How are savings (capital) and investment related?
One way to raise future productivity is to invest more in the production of capital. For people to invest more in capital, they must consume less and save more income.
What are diminishing marginal returns?
As the stock of capital rises, the extra output produced from an additional unit of capital falls.
What is the Catch-up effect?
Poor countries with the same pro-rata share of investment (or increase in the saving rate) tend to grow more rapidly than rich countries, but due to diminishing returns, that growth is temporary.
Factors that effect production
Foreign Investment: higher productivity growth
Education: higher education= higher productivity
Health and Nutrition: healthier workers are more productive
Property rights and political stability: protection of property rights and political prosperity increase productivity
Free trade: free trade policies allow for better productivity
R&D: leads to profit which provides incentive for better productivity
Population Growth: more subtle effect, more people=more workers but more people also = more consumers
What constitutes savings and investments?
Savings: total income in the economy that remains after paying for consumption and government purchases. Investment: the purchase of new capital.
What is the crowding out effect?
When government must finance its spending with taxes and/or with deficit spending, leaving businesses with less money and effectively “crowding them out.”
How does the crowding out effect affect investment?
Government financing of projects with deficit spending through the use of borrowed money. Because the government borrows such large amounts of capital, its activities can increase interest rates. Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investment activities
What are the limitations of the unemployment rate?
-Does not account for those who left the job search after turning up dry.
– it is exaggerated by those who say they are unemployed but may just simply not want to work.
Duration of unemployment
Most spells of unemployment are short, and most unemployment observed at any given time is long-term.
What is the natural rate of unemployment?
Refers to the amount of unemployment that the economy usually experiences.
What is cyclical unemployment?
Refers to the year-to-year fluctuations in unemployment around its natural rate, and it is closely associated with the short-run ups and downs in economic activity.
What is frictional unemployment?
(sectional shifts: demand or consumer preference changes) occurs because of the time it takes for a worker to search for a job that is best suited to his skills
What is structural unemployment?
(labor market specific) occurs because the number of jobs available in some labor markets are insufficient to provide a job to everyone that wants one.
What are minimum wage laws?
The body of law which prohibits employers from hiring employees or workers for less than a given hourly, daily or monthly minimum wage
What is a Union?
An organization intended to represent the collective interests of workers in negotiations with employers over wages, hours and working conditions.
What are efficiency wages?
A higher than market-clearing wage set by employers. The argument is that paying workers a higher wage may lead to increased productivity from the worker.
What is unemployment insurance?
A government program that partially protects workers incomes when it comes to unemployment.
-How it helps, how it doesn’t : reduces the hardship of unemployment, yet also causes unemployment when seen as incentive.
What is money?
The set of assets in an economy that people regularly use to buy goods and services from other people.
What are the factors of money?
Medium of exchange, unit of account and a store of value
What is liquidity?
The ease with which an asset can be converted into the economy’s medium of exchange.
What are the two kinds of money?
Commodity money: money that takes the form of a commodity with intrinsic value.
Fiat money: money without intrinsic value that is used because of government decree.
What is currency?
The paper bills and coins in the hands of the public.
What are demand deposits?
Balances in bank accounts that depositors can access on demand by writing a check.
What is the Federal Central bank?
Federal Reserve is the central bank (an institution designed to oversee the banking system and regulate the quantity of money in the economy) of the US.
What are money supply and money demand?
Supply- the quantity of money available in the economy. Demand- amount of wealth people want to hold in liquid form.
What goes into the money supply?
-M1, M2: M1 is currency and demand deposits whereas M2 is M1 plus more liquid assets like savings deposits.
-Reserves: deposits that banks have received but not loaned out.
What is a Bank’s T account?
A simplified accounting statement that shows changes in a banks assets and liabilities.
100% reserve banking vs. Fractional-reserve banking
Fractional- the widespread banking practice in which only a fraction of a bank’s demand deposits are kept in reserve and available for immediate withdrawal. The practice of fractional reserve banking expands credit and therefore also expands the money supply. 100%-banks treat deposits in a similar way to allocated gold accounts, where the money cannot be lent out for extended periods of time as the money is held in trust on behalf of the client. In this system, only those funds from depositors who voluntarily kept their money with the bank for an extended period would be available for lending to third party borrowers.
What is a reserve ratio?
The portion (expressed as a percent) of depositors’ balances banks must have on hand as cash.
How is reserve ration connected to the money multiplier?
The money multiplier is the reciprocal of the reserve ratio. (MM=1/R)
What are the Fed’s tools of monetary control?
Open Market Operations (Most Used): the purchase and sale of US government bonds by the feds. (feds loans to banks to increase reserves and money supply)
-Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits.
-The Discount Rate: The feds loans to banks to increase reserves and money supply
What are the problems with controlling the money supply?
The Fed does not control the amount of money households choose to hold as deposits in banks. The Fed does not control the amount that bankers choose to lend.
What is the value of money?
What is the Quantity theory of money?
The quantity of money available in an economy determines the value of money and growth in the quantity of money is the primary cause of inflation.
How is the quantity of money demanded related to the price level and the value of money?
Quantity of Money Demanded (Md) is positively related to price level (P) and negatively related to the value of money
Real vs. Nominal variables
– Real Variables are expressed in physical units (or in the case of Real GDP constant dollars or the real interest rate in purchasing power. The real interest rate in the loanable funds model measures the rate people exchange g&s today for g&s in the future.)
– Nominal Variables are expressed in monetary units.
What are relative prices?
the price of one thing compared to another
Real vs. nominal wages
real wages are adjusted for inflation and are not effected by a change in money supply whereas nominal wages are effected by a change in the money supply.
What is classical dichotomy?
the theoretical separation of real and nominal variables.
What is money neutrality?
irrelevance of monetary changes for real variables.
How is the velocity of money calculated?
What is the quantity equation?
MxV = PxY
What is inflation tax?
refers to the rise in price levels when the government creates money.
What is hyperinflation?
inflation that exceeds 50 percent per month.
What are the costs of inflation?
-Shoe leather costs: resources wasted when inflation encourages people to reduce their money holdings.
-menu costs: the cost of price adjustments
-relative price variability & misallocation of resources: when inflation distorts relative prices, consumer decisions are distorted which causes markets to be unable to allocate resources to their best use.
– inflation induced tax distortions: inflation tends to exaggerate capital gains which inadvertently causes a tax burden on income earned from savings.
arbitrary redistributions of wealth: unexpected redistributions of wealth among the population occur because many loans in the economy are specified in terms of the unit of account (money).
What is the Fisher effect?
the adjustment of nominal interest rate to the inflation rate. If the Fed increases the rate of money growth the long-term result is s higher inflation rate as well as a higher nominal interest rate.
Closed vs Open economy
open economies interact freely with other economies around the world whereas closed economies do not interact with them at all.
How are net exports calculated?
• NX= X- M(imports)
What variables effect net exports?
consumer tastes, prices of goods, consumer’s income, exchange rates, transportation coasts and government trade policies.
How is net capital outflow calculated?
NCO (net capital outflow)= FAPdom (foreign purchase of domestic goods) – DAPfor (domestic purchase of foreign goods)
What variables influence net capital outflow?
real interest rates on both foreign and domestic assets, perceived economical and political risks of holding assets abroad and the government policies that affect foreign ownership of domestic goods.
Foreign Direct Investment vs. Foreign Portfolio Investment
direct: investment that is actively managed
portfolio:investment that is more passively managed
What is the nominal exchange rate (e)?
The rate at which a person can trade the currency of one country for that of another.
Appreciation vs. depreciation
appreciation occurs when the exchange rate changes so a dollar buys more foreign currency whereas depreciation occurs when the exchange rate changes so a dollar buys less foreign currency.
How is real exchange rate calculated?
Real Exchange rate = (e*P)/P*
where P= domestic price (or price level), P*= foreign price (or price level)
What is the law of one price?
Goods should sell at the same price in all markets
What is purchasing power parity?
– A unit of any currency should be able to buy the same quantity of goods in all countries
– e= P*/P
– Real exchange rates should be 1 in this case
Implications and limitations of purchasing power parity
nominal exchange rates change when price levels change, not all goods are easily traded and not all tradable goods are of equal quality.
What two markets are central to the open macroeconomics model?
the market for loanable funds and the market for foreign currency exchange.
What are government budget deficits?
represents negative public saving. When the government runs a budget deficit the supply of loanable funds goes down which drives up interest rates and crowds out investment. When the interest rate goes up, net capital outflow is reduced. This causes the supply curve to shift to the left.
What is capital flight?
a large and sudden reduction in the demand for assets in a country. When this happens investors around the world sell their assets from said country which drives up net capital outflow which (by effecting the supply of their currency in the market for foreign currency exchange) increases the demand for loanable funds. On top of this, interests rates increase which causes the currency to depreciate.
What is the relationship between NCO and the Loanable Funds market and the Foreign Exchange market?
an increase in NCO causes an increase in the demand for loanable funds which causes interest rates to increase. The increase in NCO also causes and increase in supply of currency which causes the currency to depreciate driving the real exchange rate down.