Honors Econ – Final Exam Study GuideUnit I – Introduction to Economics (chapters 1-5): Economics is concerned with the efficient use of limited productive resources to achieve maximum

satisfaction of human wants. Economic perspective has three interrelated features:

o Scarcity requires choice and that all choices entail a cost;o People are rational decision makers who make choices based on self-interest;o Marginal analysis is used to assess how marginal costs of decisions compare with

marginal benefits. “Other things equal” (ceteris paribus) assumptions are used to limit the influence of other factors

when making a generalization. Economic analysis is conducted at two levels:

o Macroeconomic – looks at the entire economy or its major aggregates or sectors, such as households, businesses or government;

o Microeconomic – studies economic behavior of individuals, particular markets, firms or industries.

Pitfalls to objective thinking include:o Bias of preconceived beliefs;o Loaded terminology;o Fallacy of composition – assumption that what is true of the part is necessarily true of

the whole;o Post hoc, ergo propter hoc – mistaken belief (causation fallacy) that when one event

precedes another, the first event is the cause of the second;o Confusion of correlation with causation – mistaken belief (causation fallacy) that while

two factors may be related, one factor may not necessarily have caused the other. Economics is based on scarcity – the fact that material wants are unlimited, but resources to

satisfy those wants are not:o Economic resources are classified as natural (land), capital, labor (human) and

entrepreneurial ability;o Payments for resources are rental income, interest income, wages and profits,

respectively. The opportunity cost of producing one product is the amount of other products that are

sacrificed; opportunity costs increase as more product is produced because resources aren’t completely adaptable to alternative uses.

Different economic systems differ as to how they respond to the economizing problem—e.g., economic scarcity:

o At one extreme is pure capitalism, which relies on private ownership of economic resources and the market system;

o At the other extreme, the command economy uses the public ownership of resources and central planning;

o Economies in the real world lie between these two extremes and are hybrid systems;o Some less-developed nations have traditional economies which are shaped by

society’s customs and traditions. The circular flow model helps clarify relationships between households and business firms in a

capitalist economy:o In resource markets, households supply and firms demand resources; in product

markets, the firms supply and households demand products. Households use incomes

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they obtain from supplying resources to purchase goods and services produced by firms.

A market is any institution or mechanism that brings together buyers and sellers. Demand is a schedule of prices and the quantities which buyers would (are willing and able to)

purchase at each of these prices during a selected period of time. o Demand depends on the tastes, incomes and expectations of buyers; the number of

buyers in the market; and prices of related goods. A change in demand is caused by a change in any of these factors (determinants of demand) and means that the demand schedule and demand curve have changed.

o A change in demand and a change in the quantity demanded are not the same thing. Supply is a schedule of prices and the quantities which sellers will sell at each of these prices

during some period of time.o The supply of a good depends on the techniques used to produce it, the prices of

resources used in its production, the extent to which it is taxed or subsidized, the prices of other goods which might be produced, the prices expectations of sellers and the number of sellers of the product. A change in supply is caused by a change in any of these “determinants of supply.”

o A change in supply and a change in the quantity supplied are not the same thing. The market or equilibrium price of a product is that price at which quantity demanded and

quantity supplied are equal; the quantity exchanged in the market (equilibrium quantity) is equal to the quantity demanded and supplied at the equilibrium price.

o A change in demand, supply or both changes both equilibrium price and equilibrium quantity.

Pure capitalism has the following features:o Private individuals and organizations own and control their property resources by

means of institution of private property;o These individuals and organizations possess both freedom of enterprise and freedom

of choice;o Each is motivated largely by self-interest;o Competition prevents them, as buyers and sellers, from exploiting others;o Markets and prices (the market system) are used to communicate and coordinate

decisions of buyers and sellers;o Role of gov’t limited in a competitive and capitalist economy.

Five Fundamental Economic Questions must be answered by the market system:o What is to be produced;o How much output is to be produced;o How is output to be produced;o Who is to receive the output?o Can economic system adapt to change?

Competition in the economy compels firms seeking to promote their own interests to promote—as though led by an “invisible hand”—the best interests of society as a whole: an allocation of resources appropriate to consumer wants, production by most efficient means, and lowest possible price.

The three principal legal forms of business firms are:o A proprietorship (or sole proprietorship) is easy to form, lets owner be boss, allows

great freedom. Disadvantages include lack of access to large amounts of financial capital, difficulty of managerial specialization and owner’s unlimited liability;

o A partnership is easy to form, allows for more access to financial capital and permits more managerial specialization. Potential disadvantages include conflict between partners, some limits to financial capital and/or managerial specialization, continuity over time and unlimited liability;

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o A corporation can raise financial capital through sale of stocks and bonds, has limited liability for owners, can become large in size and have independent life. Chief disadvantages are double taxation of some corporate income and legal or regulatory expenses.

Our government performs five economic functions:o Provides legal and social framework that makes effective operation of market system

possible;o Maintains competition and regulation of monopoly;o Redistributes income to reduce income inequality;o Reallocates resources to deal with spillover costs and benefits; to provide society with

public goods and services; to purchase or produce public goods;o Stabilizes price levels and maintains full employment.

A circular flow diagram that includes the public sector shows that government purchases public goods from private businesses, collects taxes from and makes transfer payments to firms, purchases labor services from households, collects taxes from and makes transfer payments to households.

At the federal level of government, most spending goes for pensions and income security, national defense, health care, or interest on public (national) debt; major sources of revenue are personal income taxes, payroll taxes, and corporate income taxes.

At other government levels:o State governments depend on sales, excise and personal income taxes; they spend

revenues on public welfare, education, health care and highways;o Local governments rely heavily on property taxes and spend much of revenue on

education;o State and local gov’ts often receive transfers and grants from the Federal gov’t.

Unit I Terms:

Economic perspective Marginal analysis Ceteris paribus

Tradeoffs Macroeconomics Microeconomics

Aggregate Fallacy of composition Post hoc, ergo propter hoc

Utility Factors of production Full production/full employment

Allocative efficiency Productive efficiency Consumer goods

Capital goods Production possibilities curve (frontier)

Opportunity cost

Pure capitalism Market systems Command economies

Resource market Product market Circular flow model

Market Demand Demand schedule/curve

Law of demand Diminishing marginal utility Quantity demanded

Income effect Substitution effect Individual demand

Total or market demand Determinant of demand Substitute good

Complementary good Supply Quantity supplied

Supply schedule/curve Determinant of supply Equilibrium price

Equilibrium quantity Other things equal assumption Private property

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Self-interest Competition Specialization

Division of labor Medium of exchange Barter

Economic cost Normal profit Economic profit

Invisible hand Functional distribution of income Personal consumption expenditures

Durable good Nondurable good Horizontal combination

Vertical combination Conglomerate combination Sole proprietorship

Partnership Corporation Stocks

Bonds Limited liability Monopoly

Spillover effect (externality) Exclusion principle Public goods

Free-rider problem Government transfer payment Marginal tax rate

Corporate income tax Sales tax Excise tax

Unit II – Microeconomics (chapters 20, 22, 23 [p. 467-469], 24-26, 28 [p. 581-587, p. 595-597]): Price elasticity of demand is a measure of the responsiveness or sensitivity of quantity

demanded to changes in the price of a product—e.g., the degree to which a change in price affects quantity demanded... When quantity demanded is relatively responsive to a price change, demand is said to be elastic; when it is relatively unresponsive, demand is said to be inelastic:

o Demand is elastic when the percentage change in quantity is greater than the percentage change in price;

o Demand is inelastic when the percentage change in quantity is less than the percentage change in price;

o Demand elasticity is not the same at all prices;o One way to test the demand elasticity of a product is the total revenue test:

When demand is elastic, a decrease in price will increase total revenue and an increase in price will decrease total revenue;

When demand is inelastic, a decrease in price will decrease total revenue and an increase in price will increase total revenue;

o The price elasticity of demand for a product depends on the number of good substitutes for the product, its relative importance in the consumer’s budget, whether it is a necessity or a luxury and the period of time under consideration.

Price elasticity of supply is a measure of the sensitivity of quantity supplied to changes in the price of a product:

o Supply will tend to be more price inelastic in the short run than in the long run. Price ceilings and price floors set by gov’t prevent price from performing its rationing function—

that is, reach equilibrium:o A price ceiling results in a shortage of the product, may bring about formal rationing

by gov’t and a black market, and causes a misallocation of resources;o A price floor creates a surplus of the product, and may induce gov’t to take measures

either to increase the demand for or to decrease the supply of the product. In money terms, the costs of using resources are an opportunity cost: the payments a firm must

make to the owners of resources to attract these resources away from their best alternative opportunities for earning incomes.

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In the short run the firm cannot change the size of its plant and can vary its output only by changing the quantities of the variable resources it employs.

In the long run, all the resources employed by the firm are variable resources, and therefore all its costs are variable costs.

As the firm expands its output by increasing the size of its plant, average total cost tends to fall at first because of the economies of large-scale production, but total cost begins to rise because of the diseconomies of large-scale production.

The price a firm charges and its output of that product depend only on the demand for and the cost of producing it, but on the character of the market.

The models of the markets are pure competition, pure monopoly, monopolistic competition and oligopoly.

A firm selling its product in a purely competitive industry cannot influence the price and is a price taker.

A firm will maximize profits when marginal revenue (MR) equals marginal costs (MC) at an output level where price is greater than average total cost.

Pure monopoly: a market structure in which a single firm sells a product for which there are no close substitutes:

o Monopoly firms are price makers;o In monopolies, the following barriers to entry exist:

Economies of scale; Legal restrictions through patents and licenses; Ownership or control of essential resources; Pricing and other practices, such as price cuts, ad campaigns, producing

excess capacity.o Pure monopoly has the following effects on the economy:

They charge a higher price and produce less output than in a more competitive industry;

It contributes to income inequality in the economy; The legal fees, lobbying and public-relations expenses to obtain and /or

maintain monopoly status add nothing to output, but increase costs; It’s not likely to be technologically progressive, since there’s no incentive to do

so;o Policy options to deal with monopoly include use of antitrust laws and breakup of firms,

and the regulation of price, output and profits. Monopolistic competition, found in many industries, has the following characteristics:

o The relatively large number of sellers means that each has a small market share, there is no collusion, and firms take actions that are independent of each other;

o They exhibit product [nonprice] differentiation: different attributes, services to customers, brand names, packaging, etc.

o Entry into or exit from the industry is relatively easy;o In addition to price competition, monopolistically competitive firms also use nonprice

competition in the form of product differentiation, new-product development and advertising.

o Product differentiation means consumers will be offered a wide range of types, styles, brands, and quality variants of a product;

Oligopolies are composed of a few firms that dominate an industry and sell a standardized or differentiated product:

o They control price, though there is also mutual interdependence, because firms must consider the reactions of rivals to any changes;

o Barriers to entry, plus mergers, help explain the existence of oligopoly;

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o Concentration of the industry can be measured by either concentration ratios or the Herfindahl index.

o Oligopoly often leads to overt or covert collusion among firms to fix prices or coordinate pricing; overt collusion can include cartels.

o These firms often avoid price competition, but since they have greater financial resources, they do engage in nonprice competition through product development and advertising.

Technological advance involves the development of new and improved products and new and improved ways of producing and distributing products.

Technological advance involves a three-step process:o Invention – the discovery of product or process, which is encouraged by the granting

of patents;o Innovation – the first successful commercial use of a new product or method or the

creation of a new form of business; this can involve innovation of products (product innovation) or methodologies (process innovation);

o Diffusion – the spread of an innovation through imitation or copying. The optimal amount of R&D (research and development) depends on the marginal benefit and

marginal cost of R&D activity; the greatest profit from R&D will be reached when the marginal benefit equals the marginal costs:

o Sources for financing firms’ R&D activities are banks, bond issues, retained earnings, venture capital, etc. A firm’s marginal cost of these funds is the interest rate;

o A firm’s marginal benefit of R&D is its expected profit (or return) from the last dollar spent on R&D;

o The optimal amount of R&D in a marginal-cost and marginal-benefit analysis is the point where the interest-rate cost-of-funds (marginal-cost) curve and the expected-rate-of-return (marginal-benefit) curve intersect. R&D expenditures can be justified only if the expected return equals or exceeds the cost of financing it;

o Firms may use a fast-second strategy by imitating the innovator, rather than spending R&D money on invention, resulting in the imitation problem;

o Taking the lead in innovation could offer firms several protections and potential advantages:

Patents limitation imitation and protect profits; Copyrights and trademarks reduce direct copying; The time lags between innovation and diffusion give innovators time to make

substantial economic profits; There is potential purchase of innovating firm by larger firm at high price; Brand names may provide major marketing asset.

o Technological advances, however, do enhance economic efficiency. The wage rate received by a specific type of labor depends on the demand for the supply of that

labor and the competitiveness of the market in which that type of labor is hired. Differences in wages exist for three reasons:

o Workers are not homogeneous and have different skills, abilities and training;o Jobs vary in difficulty and attractiveness, meaning that higher wages may be necessary

either to attract skilled labor or to compensate for less desirable aspects of some jobs;o Workers are not perfectly mobile, and some areas may simply pay more.

Unit II Terms:

Price elasticity of demand Elastic demand Inelastic demand

Total-revenue test Price elasticity of supply Elastic supply

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Inelastic supply Price floor/price ceiling Economic cost

Implicit cost Explicit cost Law of diminishing returns

Normal profit Economic profit Average product

Fixed/variable resources Marginal product Total cost

Average fixed cost Fixed/variable costs Marginal cost

Average total cost Total product Diseconomies of scale

Natural monopoly Economies of scale Pure competition

Pure monopoly Monopolistic competition Oligopoly

Price taker Barrier to entry Product differentiation

Nonprice competition Excess capacity Herfindahl index

Collusion Price war Cartel

Price leadership Invention Innovation (product/process)

Patents Venture capital Interest-rate cost-of-funds curve

Expected-rate-of-return curve Optimal amount of R&D Fast-second strategy

Creative destruction Wage rate

Unit III – Microeconomic Issues and Policies (selections from chapters 32-36) A case can be made for and against industrial concentration, a situation in which a small

number of firms control all or a substantial percentage of the total output of a major industry. Gov’t policy has tended to restrict concentration and to promote competition. Government has, however, undertaken to regulate natural monopolies:

o A natural monopoly exists if a single producer can provide a good or service at a lower average cost (because of economies of scale) than several producers;

o Government either produces the good or service or, more commonly, regulates private producers of the product for the benefit of the public.

Social regulation began in the 1960s and resulted in the rise of new regulatory agencies: o Social regulation differs from general regulation of specific industries in that it aims to

improve the quality of life:o Critics claim that social regulation has high administration and compliance costs, tend

to attract “overzealous” workers who believe in regulation, and may increase product prices and slow the rate of innovation;

o Others, however, claim that social benefits will, over time, exceed the costs; The farm problem is both a short-run and a long-run problem: In the short-run, farm incomes often change radically from year to year:

o Demand for farm products is inelastic;o Farm output fluctuates wildly year-over-year;o Foreign demand is unstable

In the long-run, farm prices and incomes lag behind the upward trend of prices and incomes in the rest of the economy:

o Technological advances have led to an oversupply of agricultural products;o Demand, being inelastic, has failed to keep up with supply, leading to surpluses.

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Federal subsidies are based on the concept of parity, which gives farmers year-after-year the same real income per unit of output:

Government tries to reduce the resulting surpluses by:o Reducing output of farm products by acreage allotment ando Expanding demand for farm products by finding new uses (ethanol), expanding

domestic demand, and increasing foreign demand. Although income inequality is a natural result of the “impersonal market system,” there is

considerable income inequality in the U.S. economy, resulting from:o Increased demand for highly skilled workers, compared with less-skilled;o Changing demographics from less-skilled baby boomers;o Increase in dual incomes among high-wage households;o More single-parent households earning less income.

Income inequality can be shown with a Lorenz curve. Income inequality naturally results from:

o The distribution of abilities and skills of people;o Differences in education and training;o Discrimination in labor markets;o Preferences of certain types of jobs and willingness to accept risk on the job;o Other factors, such as luck, personal connections and misfortunes.

Aside from inequality in the distribution of income, there is a great concern with the problem of poverty:

o Over 13% of people in the U.S. economy lived in poverty in 1996;o The poor tend to be concentrated among certain groups, such as African Americans,

Hispanics, female-headed families and children;o Poverty tends to be invisible, because the pool of poor people changes, the poor are

isolated in large cities, and the poor do not have a political voice. There are two problems with the health care industry in the U.S.:

o Costs are high and growing; and even though the medical care in the U.S. is the best in the world, the U.S. ranks low internationally on many health indicators;

o A large percentage of the population (16% in 1996) has no medical coverage. Health care costs have increased because:

o Health care is price inelastic;o Health insurance causes people to over-consume health care, since the insured don’t

pay full costs;o Unhealthy lifestyles (alcohol, tobacco, drug abuse) increase the demand for and

spending on health care. Health care reforms include:

o Play-or-pay would require all employers to fund basic health insurance (play) or pay through special payroll tax (pay);

o Tax credits and vouchers;o National health insurance program financed from tax revenues.

Unit III Terms:

Antitrust regulation Social regulation Industrial concentration

Sherman Act Clayton Act Income inequality

Lorenz curve Poverty rate Deductibles

Co-payments National health insurance Health maintenance

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organization (HMO)

Collective bargaining Closed shop Union shop

National Labor Relations Act Nat’l Labor Relations Board Affirmative action

Reverse discrimination Acreage allotment Farm parity

Unit IV – Macroeconomics: National Income, Employment and Fiscal Policy (chapters 7-8, 9 [p. 172-179, 181-188], 10 [p. 199-202], 11, 12 [p. 243-252, 255-258])

National income accounting enables us to measure the economy’s output, compare it with past outputs, explain its size and the reasons for changes in its size and formulate policies to increase it.

GDP measures the market value of all final goods and services produced in the economy during the year.

Non-production transactions (purely financial transactions and second-hand sales) are not included in GDP;

Measurement of GDP is done by either:o Expenditures approach – requires the addition of total spending for final goods and

services: Personal consumption expenditures (C) Gross private domestic investment (Ig) – sum of spending by business firms

for machinery, equipment, tools; spending by firms and households for new buildings; changes in inventories of business firms;

Government purchases (G) Net exports (Xn) – exports minus imports In equation form, C + (Ig) + G + (Xn) = GDP

o Income approach: Compensation of employees Interest payments by business firms Proprietors’ income Corporate profits: corporate income taxes, dividends, undistributed corporate

profits Other: indirect business taxes, depreciation, net foreign factor income

o Each produces the same result. Because price levels change from year to year, nominal GDP must be converted into real GDP

(adjusted for inflation). GDP is not a measure of economic well-being:

o It excludes value of final goods and services not bought and sold;o It excludes the amount of leisureo It does not record the improvements in quality of productso It doesn’t take into account the size of the populationo It does not record the pollution costs to the environmento It does not include goods and services produced in the underground economy.

The business cycle describes a history of alternating periods of prosperity and recession. Changes in the levels of output and employment are largely the result of changes in the level of

total spending in the economy. The production of capital and durable consumer goods fluctuates more than the production of

consumer nondurable goods because the former can be postponed.

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Full employment does not mean all workers in the labor force are employed; some unemployment is normal:

o Frictional unemployment is generally desirable; structural unemployment is inevitable in a dynamic economy; cyclical unemployment arises during the recession phase of the business cycle and is caused by insufficient total spending.

o Full-employment unemployment (the natural rate of unemployment) is the sum of frictional and structural unemployment and is achieved when cyclical unemployment is zero…and is about 5.5% of the labor rate.

o The economic cost of unemployment is the unproduced output, or the GDP gap. Inflation if an increase in the general level of prices in the economy and is caused by:

o Demand-pull inflation – the result of excess total spending in the economy; o Cost-push or supply-side inflation – the result of factors that raise per-unit

production costs. Inflation injures those whose real incomes fall and benefits those whose real incomes rise, avers

because it decreases the real value of any savings and creditors because it lowers the real value of debts; it benefits debtors for the same reason.

Classical economics, based on Say’s law (supply creates its own demand) claimed the economy would automatically tend to full employment.

The Great Depression and the ideas of John Maynard Keynes debunked classical economics by showing the economy was not self-regulating—that government policies are necessary to counteract economic instability.

Consumption is the largest component of aggregate expenditures; savings is disposable income not spent for consumer goods.

o Disposable income is the most important determinant of both consumption and saving.o The marginal propensity to consume (MPC) and the marginal propensity to save (MPS)

are, respectively, the percentages of additional income spent for consumption and saved, and their sum is equal to 1.

Two important determinants of the level of investment spending in the economy are the expected rate of return from the purchase of additional capital goods and the real rate of interest:

o The expected rate of return is directly related to the net profits that are expected to result from an investment;

o The rate of interest is the price paid for the use of money. Changes in investment (or in the consumption and saving schedules) will cause real GDP to

change in the same direction by an amount greater than the initial change in investment (or consumption); this is called the multiplier effect:

o The value of the simple multiplier is equal to the reciprocal of the MPS (1/MPS);o The multiplier is significant because relatively small changes in the spending plans of

business firms or households bring about large changes in GDP. Changes in government spending and tax rates can offset cyclical fluctuations and increase

economic growth; this is called fiscal policy: Aggregate demand (AD) is a curve which shows total quantity of goods and services that will be

purchased at different price levels:o AD curves are downward sloping;o Changes in spending by consumers (changes in wealth, expectations, taxes), business

(changes interest rates, expected returns on investment, taxes, technology), government and foreign buyers will change the AD curve:

Aggregate supply (AS) is a curve that shows the total quantity of goods and services produced (supplied) at different price levels; the AS curve has three ranges:

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o In the horizontal range (when economy is in severe recession, with unemployed labor and capital), the AS curve is horizontal; producers are induced to supply larger quantities of goods and services even without rise in price levels;

o In the vertical range (when economy is at full employment), the AS curve is vertical; a rise in price level cannot result in increases in quantity of goods & services;

o In the intermediate range, the AS curve is upward sloping; the price level must rise to induce producers to supply larger quantities of goods and services.

Factors that shift AS curve include changes in prices of inputs for production, changes in productivity, changes in legal and institutional environment in economy.

Equilibrium real domestic output and equilibrium price level are at intersection of AD and AS curves.

Equilibrium changes with shifts in either AS or AD curves, An increase in AD in the…

o Horizontal range results in increase in real output (GDP), with no change in price level—full multiplier effect will occur;

o Vertical range results in increase in price level, with real domestic output (GDP) remaining unchanged;

o Intermediate range results in increases in both output (GDP) and price levels—multiplier effect will be less.

A decrease in AD may not have the opposite effect on price level because prices tend to be inflexible (sticky) downward.

An increase in AS has salutary effect on both output (increases) and price levels (decreases). Fiscal policy is the manipulation by the Federal government of its expenditures and tax receipts

in order to expand or contract the economy…to increase real output (and employment) or decrease its rate of inflation.

Discretionary fiscal policy involves changes in government spending or taxation by Congress:o Expansionary fiscal policy is used to counteract recession or cyclical downturn in

economy by increasing AD;o Contractionary fiscal policy is a restrictive form of fiscal policy used to control

demand-pull inflation by reducing AD; Contractionary fiscal policy results in a budget deficit; to finance the deficit, the gov’t can either borrow money or issue new money to creditors.

Unit IV Terms:

National income accounting Price level Gross domestic product (GDP)

Final goods Intermediate goods Multiple counting

Expenditures approach Income approach Government Purchases

Personal consumption expenditures (“C”)

Gross private domestic investment

Net private domestic investment

Net exports National income Personal income

Disposable income Nominal GDP Real GDP

Price index Consumer price index Business cycle

Peak Recession Trough

Recovery Frictional unemployment Structural unemployment

Cyclical unemployment Full-employment unemployment rate

Natural rate of unemployment

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Potential output Unemployment rate Labor force

GDP gap Okun’s law Inflation

Deflation Demand-pull inflation Rule of 70

Cost-push inflation Per unit production cost Cost-of-living adjustment (COLA)

Say’s law Keynesian economics Consumption schedule

Saving schedule Marginal propensity to save Marginal propensity to consume

Expected rate of return Real rate of interest Investment demand curve

Investment schedule Multiplier Recessionary gap

Inflationary gap Aggregate demand curve Aggregate supply curve

Determinants of AD Determinants of AS Productivity

Horizontal range Vertical range Intermediate range

Fiscal policy Discretionary fiscal policy Expansionary fiscal policy

Budget deficit Contractionary fiscal policy Budget surplus

Progressive tax Proportional tax Regressive tax

Crowding-out effect Supply-side fiscal policy

Unit V – Macroeconomics: Money, Banking and Monetary Policy (chapters 13, 15)

Money is whatever performs the three basic functions of money: a medium of exchange, a unit of account (standard of value) and a store of value.

In the U.S.,o Money has value only because people can exchange it for desirable goods and

services;o The value of money is inversely related to the price level;o Money is backed by the confidence which the public has that the value of money will

remain stable. In the money market, the demand for money and the supply of money determine the interest rate;

graphically, the demand for money is a downsloping line and the supply of money is a vertical line. The Board of Governors of the Fed exercises control over the money supply and the banking

system; the U.S. president appoints the 7 members of the Board of Governors.o The U.S. banking system contains thousands of commercial banks and thrift

institutions (savings and loans) that are directly affected by the Fed’s decisions.o The Fed performs seven functions: issuing currency, setting reserve requirements and

holding reserves, lending money to banks and thrifts, collecting and processing checks, serving as fiscal agent for the Federal government, supervising banks, and controlling the money supply—the last function is the most important.

o The character (and some say the supply) of money has changed with the shift to use of electronic money and other forms of payment.

The fundamental objective of monetary policy is full employment without inflation. The Fed accomplishes this by exercising control over the amount of excess reserves held by commercial banks and thereby influencing the size of the money supply and the level of aggregate expenditures (AD).

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The principal assets of the Federal Reserve Banks (in order of size) are U.S. government securities and loans to commercial banks.

Their principal liabilities are Federal Reserve Notes, the reserve deposits of commercial banks and U.S. Treasury deposits.

Tools to control bank reserves and the size of the money supply:o The Fed buys and sells gov’t securities in the open market:

Buying from either banks or the public increases the reserves of banks; Selling decreases the reserves of banks;

o The Fed raises or lowers the reserve ratio: Raising the reserve ratio decreases the excess reserves of banks and the size

of the monetary multiplier; Lowering the reserve ratio increases the excess reserves of banks and the size

of the monetary multiplier;o The Fed can also lower the discount rate to encourage banks to borrow reserves from

the Fed and raises it to discourage them from borrowing reserves;o Monetary policy can be easy or tight:

With an easy money policy, the Fed buys gov’t bonds, decreases the discount rate or decreases the reserve requirement;

With tight money policy, the Fed essentially does the opposite.o Open-market operations are the most important of the monetary policy tools.

Monetary policy affects the equilibrium GDP:o The interest rate affects investment spending which affects AD and the equilibrium

level of output and prices;o If unemployment and deflation are the problems the Fed increases the money supply,

causing the interest rate to fall and investment spending to increase, thus increasing AD and real GDP by a multiple of the increase in investment;

o If inflation is the problem, the Fed decreases the money supply, causing the interest rate to rise….

o The AS curve will influence how the change in investment spending and AD is divided between change in real output and changes in the price level.

There are international linkages to monetary policy:o An easy money policy will tend to lower domestic interest rates and cause the dollar to

depreciate; in this situation, net exports will increase, thus increasing AD and reinforcing the effect of the easy money policy;

o A tight ;money policy will tend to raise domestic interest rates and cause the dollar to appreciate, decreasing net exports and reducing AD, thereby strengthening the tight money policy.

Unit V Terms:

Medium of exchange Unit of account Store of value

Money supply M1, M2, and M3 Intrinsic value

Federal Reserve Note Near-monies Legal tender

Fiat money Money market bonds Federal Reserve System (Fed)

Federal open Market Committee (FOMC)

Monetary policy Open-market operations

Reserve ratio Discount rate Easy-money policy

Tight-money policy Velocity of money Federal funds rate

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Prime interest rate (prime rate)

Unit VI – Macroeconomics: Money, Banking and Monetary Policy (chapters 6, 37, 38, & 39)

The U.S. is the largest trading nation in the world. Most U.S. trade is with IACs, with Canada being the largest trade partner; overall imports exceed

exports significantly, with deficits the greatest with Japan, China and OPEC countries. International trade must be financed, and large trade deficits in the U.S. have required the selling

of business ownership (securities) to companies in other nations. Factors facilitating trade since WWII include improvements in transportation and communications

technology, along with a general decline in tariffs and worldwide peace. Specialization and trade are based on the principle of comparative advantage: specialization

and trade increase productivity and the output of goods and services.o The terms of trade between nations—the ratio at which one product is traded for

another—lies between the cost ratios for the two nations;o Each nation gains from this trade; it has the effect of easing the fixed constraints of the

production possibilities curve for each nation. National currencies are traded in a foreign exchange market; the price of a domestic currency,

or its exchange rate, is the price paid in the domestic currency to buy 1 unit of another currency ($0.01 U.S. = 1 Japanese yen):

o The exchange rate is determined by the supply of and demand for that currency;o The exchange value of a currency can depreciate or appreciate.

Governments develop trade policies that can reduce trade between nations:o Trade restrictions include protective tariffs, import quotas, nontariff barriers and

export subsidies;o Arguments for protectionism include military self-sufficiency, increasing domestic

employment, permitting diversification to stabilize the economy, protecting infant industries, protecting against dumping and protecting against cheap foreign labor.

o Special-interest groups benefit from protection and persuade their nations to erect trade barriers, although generally, the costs of trade restrictions outweigh the benefits;

o As a consequence, consumers pay higher prices and the nation makes less efficient use of its resources.

International trade policies have changed over the years with the development of multilateral agreements and free-trade zones:

o U.S. trade policy has been significantly affected by the Reciprocal Trade Agreements Act of 1937, by the General Agreements on Tariffs and Trade (GATT) and by GATT’s successor, the World Trade Organization (WTO);

o The European Union and the North American Free Trade Agreement (NAFTA) are examples of regional free-trade zones.

Increased international trade has resulted in more competitive pressure on U.S. businesses:o Some businesses have been able to compete by lowering production costs, improving

products or using new technology; other firms have had difficulty remaining competitive;

o U.S. consumers have been the winners, regardless of firms being able to meet foreign competition.

The U.S. has a trade deficit in goods, a trade surplus in services, and a trade deficit in goods and services.

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Trade between nations uses different currencies, the difficulties of which are resolved by foreign exchange markets:

o U.S. exports create a foreign demand for dollars;o U.S. imports create a domestic demand for foreign currencies.

The international balance of payments for a nation is an annual record of all its transactions with the other nations in the world; it records all the payments received from and made to the rest of the world.

There are flexible (floating) and fixed exchange-rate systems that nations use to correct imbalances in the balance of payments:

o A change in the demand for or the supply of a foreign currency will cause a change in the exchange rate for that currency;

o When there is an increase in the price paid in dollars for a foreign currency, the dollar has depreciated and the foreign currency has appreciated in value;

o Conversely, when there is a decrease in the price paid in dollars for a foreign currency, the dollar has appreciated and foreign currency has depreciated…;

o Changes in the demand for or supply of a foreign currency are largely the result of changes in tastes, relative incomes, relative price levels, relative interest rates and speculation.

In recent history, the world has used three different exchange-rate systems:o Under the gold standard, each nation defined its currency in terms of a quantity of gold,

maintained a fixed relationship between its gold and its money supply and allowed gold to be imported or exported without restrictions;

o From the end of WWII until 1971 the Bretton Woods system, committed to the adjustable-peg system of exchange rates, kept foreign exchange rates relatively stable;

o Exchange rates today—managed floating exchange rates—are managed by individual nations to avoid short-term fluctuations.

Over the last decade, the U.S. has had large and persistent trade deficits, caused by:o More rapid growth in the domestic economy than in the economies of our trading

partners, causing imports to rise more than exports;o Large deficits in the Federal budget which drove up real interest rates, increased the

international value of the dollar, increasing imports;o A decline in the rate of saving and a capital account surplus, which allowed U.S.

citizens to consume more imported goods. The effects of U.S. trade deficits include:

o Increasing U.S. consumption and allowing the nation to operate outside its production possibilities frontier;

o Increasing the indebtedness of U.S. citizens to foreigners; Implications of these persistent trade deficits are they will lead to permanent debt and foreign

ownership of domestic assets, or large sacrifices of future domestic consumption. There is considerable income inequality among countries: Industrially advanced countries (IACs)

account for 83% of the world’s income; developing countries (DVCs) have average per capita incomes ranging from $400 to $2,500.

The human implications of extreme poverty include lower life expectancies, higher infant mortality, lower literacy rates, more of the labor force in agriculture, and fewer non-human sources of energy.

Economic growth requires that DVCs use their existing resources more efficiently and that they expand their available supplies of resources:

o They possess inadequate natural resources, or use them inefficiently;o They tend to be overpopulated, experience unemployment and underemployment and

have low levels of labor productivity because of insufficient physical capital and lack of investment in human resources;

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o They have an inadequate amount of capital goods, resulting from being too poor to save, capital flight to more stable IACs, investment obstacles and inadequate infrastructure;

o Technological advance is slow;o It is difficult for DVCs to alter the social, cultural and institutional factors to create a

good environment for achieving economic growth. IACs can help by directing foreign aid to poorest of DVCs, reducing tariffs and import quotas,

providing debt relief, allowing more low-skilled immigration and discouraging brain drains, and limiting arms sales

DVCs can promote growth by establishing the rule of law (reducing corruption), opening economies to international trade, controlling population growth, encouraging direct foreign investment, building human capital, making peace with neighbors, privatizing state industries and reducing socio-cultural barriers.

Unit VI Terms:

Multinational corporations Asian tigers Terms of trade

Foreign exchange market Exchange rates Depreciation

Appreciation Protective tariff Import quota

Nontariff barriers Export subsidy Smoot-Hawley Tariff Act

Reciprocal Trade Agreement Free-trade zone Most-favored-nation status

General Agreements on Tariffs and Trade (GATT)

World Trade Organization (WTO)

North American Free Trade Agreement (NAFTA)

Trade bloc European Union (EU) Labor-intensive goods

Capital-intensive goods Comparative advantage Tariff

Voluntary export restriction Dumping Int’l balance of payments

Current account Trade balance Balance on goods and services

Balance on current account Capital account Balance on capital account

Official reserves Balance of payments deficit Balance of payments surplus

Devaluation Fixed exchange-rate system Gold standard

Flexible exchange-rate system Managed floating exchange rate Bretton Woods system

International Monetary Fund (IMF)

Industrially advanced countries (IACs)

Developing countries (DVCs)

Underemployment Brain drain Capital flight

Infrastructure Capital-saving technology Capital-using technology

Land reform Vicious circle of poverty World Bank

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Essay Questions: You will answer one question from each group. Use charts and graphs where appropriate to illustrate your answers:

Group 1 : x

Group 2 : x

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