Economics Final

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Three major concerns of economics

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output growth (GDP)
Full employment (unemployment)
Price Stability (inflation/ deflation)

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business cycle

Back 2

The cycle of short-term ups and downs in the economy

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aggregate output

Back 3

the total quantity of goods and services produced in an economy over a given period

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recession

Back 4

A period during which aggregate output declines.

This period consists of two quarters

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depression

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prolonged and deep recession

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between trough and peak

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expansion

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between peak and trough

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recession

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peak

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above trend line

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trough

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below trend line

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unemployment rate

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percentage of the labor force that is unemployed

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inflation

Back 11

increase in overall price level

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hyperinflation

Back 12

period of very rapid increases in the overall price level

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deflation

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decrease in overall price level

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goods and services market

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firms supply to the goods and services market

households, the government, and firms demand from the goods and services market

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labor market

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households supply labor and firms and government demands labor

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money market

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households supply funds to this market in the expectation of earning income in the form of dividends on stocks and interests in bonds

much of the borrowing and lending of households and firms, the government, and the rest of the world are coordinated by financial institutions

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fiscal policy

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government policies concerning taxes and spending

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monetary policy

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the tools used by the Federal Reserve to control the quality of money which then affects interest rates

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employed

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any person 16 years or older who who works for pay, either for someone else or in his or her own business for 1 or more hours per week, who works without pay for 15 or more hours per week in a family enterprise, or who has a job but has been temporarily absent with or without pay.

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unemployed

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A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks.

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not in the labor force

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a person who is not looking for a job or doesn't want a job, or has given up looking

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labor force

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employed + unemployed

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population

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labor force + not in labor force

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unemployment rate

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the ratio of the number of people unemployed to the total number of people in the labor force

unemployed/ (employed + unemployed)

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labor foce participation rate

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The ratio of the labor force to the total population 16 years old or older.

labor force/ population

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discouraged worker affect

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gives up hope in finding work, so stops looking

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underemployed

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employed, but not using skill set and/ or working desired hours

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structural employment

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The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

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frictional employment

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The portion of unemployment that is due to the normal turnover in the labor market; used to denote short-run job/skill matching problems.

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natural rate of unemployment

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The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment rate and structural unemployment rate

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cyclical employment

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Unemployment that is above frictional plus structural unemployment

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If the unemployment rate equals the natural rate of unemployment, then what is the cyclical rate of unemployment?

Back 32

?

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GDP

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gross domestic product

the total market value of all final goods and services produced within a given period by factors of production located within a country.

GDP is the value of output produced by factors of production located within a country.

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final goods and services

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goods and services produced for final use

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intermediate goods

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goods that are produced by one firm for use in further processing by another firm

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value added

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The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

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how to calculate gdp

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In calculating GDP, we can sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced.

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gdp concerns

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only new and current production.

old output not counted in current gdp because it was already counted previously

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gap doesn't count

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GDP does not count transactions in which money or goods changes hands but in which no new goods and services are produced.

illegal,

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gnp

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gross national product

The total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizens, regardless of where the output is produced.

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when we save...

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there is less income, and there is a greater decrease in output and wages become lower

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expenditure approach

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A method of computing GDP that measures the total amount spent on all final goods and services during a given period.

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income approach

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A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services.

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Four main categories of expenditure

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Personal consumption expenditures (C): household spending on consumer goods

Gross private domestic investment (I): spending by firms and households on new capital, that is, plant, equipment, inventory, and new residential structures

Government consumption and gross investment (G)

Net exports (EX  IM): net spending by the rest of the world, or exports (EX) minus imports (IM)

GDP = C + I + G + (EX - IM)

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current dollars

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the current prices that we pay for goods and services

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nominal gdp

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gross domestic product measured in current dollars

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weight

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the importance attached to an item within group of items

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real gdp

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fluctuating prices are removed from analysis

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gdp limitations

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If CRIME went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP.

does not subtract for ENVIRONMENTAL disasters

An increase in LEISURE is also an increase in social welfare, sometimes associated with a decrease in GDP.

Most NONMARKET AND DOMESTIC ACTIVITIES, such as housework and child care, are not counted in GDP even though they amount to real production.

GDP also has nothing to say about the DISTRIBUTION of output among individuals in a society.

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we know AE=C + I
At full employment, Y=AE (equilibrium at intersection)
Y=C + I
C=200 + .8Y (.8 = MPC)
I=50

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Y=(200 + .8Y) + 50
Y=.8Y + 250
-.8Y + Y=250
.2Y=250
Y=1250

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inequality

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top 5% makes most of the money
racial discrimination
bottom is making less and less every year

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cpi

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consumer price index

A price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer.

split between food, housing, recreation, education, other goods and services, medical care, health, apparel

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t or f

Inflation May Change the Distribution of Income

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true

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real interest rate

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The difference between the interest rate on a loan and the inflation rate.

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administrative costs and inefficiencies

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shoe leather costs
menu costs

There is more uncertainty and risk when inflation is unanticipated. This uncertainty may prevent people from signing long-run contracts that would otherwise be beneficial for both parties.
More frequent bank transactions (shoe-leather costs

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calculating inflation

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CPI = (cost of market basket in current year)/ (cost of market basket in base year) *100

Inflation Rate = (CPI in year 2 – CPI in year 1)/(CPI in year 1) * 100

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aggregate output

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The total quantity of goods and services produced (or supplied) in an economy in a given period.

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aggregate income

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The total income received by all factors of production in a given period.

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aggregate output and income

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In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income) (Y)

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consumption function

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for a household

A consumption function for an individual household shows the level of consumption at each level of household income.

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aggregate consumption function

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With a straight line consumption curve, we can use the following equation to describe the curve:
C = a + bY

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mpc

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marginal propensity to consume

That fraction of a change in income that is consumed, or spent.

mpc= slope of consumption function = change in c/ change in y

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aggregate savings

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(S)

The part of aggregate income that is not consumed.

S ≡ Y – C

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mps

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marginal propensity to save

That fraction of a change in income that is saved

MPC + MPS ≡ 1

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base equation for consumption function

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The Aggregate Consumption Function Derived from the Equation C = 100 + .75Y

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what other factors may impact the decisions of households to consume

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their wealth, the interest rate, and their expectations of the future.

Households with higher wealth are likely to spend more, other things being equal, than households with less wealth.

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planned investment

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Those additions to capital stock and inventory that are planned by firms.

flat lined

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actual investment

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The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

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equilibrium

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Occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when AE = Y.

At equilibrium, investors were able to accurately predict consumption and thus, inventory is what is expected. If consumption is different than expected, inventories (and therefore investment) will change accordingly.

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planned aggregate expenditure

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(AE)

The total amount the economy plans to spend in a given period. AE ≡ C + I.

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aggregate output vs planned aggregate expenditure

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Y > C + I
aggregate output > planned aggregate expenditure

C + I > Yplanned aggregate expenditure > aggregate output

Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I).
Saving and planned investment are equal at Y = 500.

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equilibrium aggregate output

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Equilibrium occurs when planned aggregate expenditure and aggregate output are equal.


Planned aggregate expenditure is the sum of consumption spending and planned investment spending.

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the savings investment approach to equilibrium

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Y ≡ C + S, which is an identity.

The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium.

By substituting C + S for Y in the equilibrium condition, we can write:

C + S = C + I

Because we can subtract C from both sides of this equation, we are left with:

S = I

Thus, only when planned investment equals saving will there be equilibrium.

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adjustment to equilibrium

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The adjustment process will continue as long as output (income) is below planned aggregate expenditure.

If unplanned inventories (UP) firms will (DOWN) output (i.e., planned spending < output). As output (DOWN) , income (DOWN) , consumption (DOWN) , and so on until equilibrium is restored with Y lower than before.

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How is this story different if planned spending is > output?

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If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to equilibrium, with Y higher than before.

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multiplier

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The ratio of the change in the equilibrium level of output to a change in some exogenous variable.

1/ 1-mpc

1/mps

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exogenous variable

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A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes.

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the multiplier equation

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Recall that the marginal propensity to save (MPS) is the fraction of a change in income that is saved. It is defined as the change in S (∆S) over the change in income (∆Y):

mps= change in s/ change in y

Because (change) S must be equal to (change) I for equilibrium to be restored, we can substitute (change) I for (change) S and solve:

mps= change in i/ change in y
change in y= change in i * 1/mps

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The Paradox of Thrift

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household attempt to increase their savings
An increase in planned saving from S0 to S1 causes equilibrium output to decrease from 500 to 300.
The decreased consumption that accompanies increased saving leads to a contraction of the economy and to a reduction of income.
But at the new equilibrium, saving is the same as it was at the initial equilibrium.
Increased efforts to save have caused a drop in income but no overall change in saving.

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costs of inflation

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During inflations, most prices—including input prices like wages—tend to rise together, and input prices determine both the incomes of workers and the incomes of owners of capital and land.

So inflation by itself does not necessarily reduce ones purchasing power.

Examples:
Declining value of minimum wage
Contract workers

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Inflation May Change the Distribution of Income

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One way of thinking about the effects of inflation on the distribution of income is to distinguish between anticipated and unanticipated inflation.

The effects of anticipated inflation on the distribution of income are likely to be fairly small, since people and institutions will adjust to the anticipated inflation.

Unanticipated inflation, on the other hand, may have large effects, depending, among other things, on how much indexing to inflation there is.

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real interest rate

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(r)

The difference between the nominal interest rate (i) on a loan and the inflation rate (r =- I).

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variables and equations:

Y
C
I
AE (C + I)
Y - (C + I)
Y=AE

Back 83

Y= aggregate output (income)
C= aggregate consumption
I= planned investment
AE= planned aggregate expenditure
Y- (C + I)= unplanned inventory change
Y=AE= equilibrium (At equilibrium, investors were able to accurately predict consumption and thus, inventory is what is expected. If consumption is different than expected, inventories (and therefore investment) will change accordingly.)

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discretionary fiscal policy

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changes in taxes or spending that are the result of deliberate changes in government policy

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net taxes

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(T)

Taxes paid by firms and households to the government minus transfer payments made to households by the government.

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disposable, or after-tax, income (Yd)

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Total income minus net taxes: Y − T.

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disposable income

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disposable income ≡ total income − net taxes

Yd ≡ Y − T

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disposable income must end up as _________ or _____________.

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consumption (C) or savings (S)

Yd=C + S

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Because disposable income is aggregate income (Y) minus net taxes (T), we can write another identity:

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Y - T = C + S
OR
Y=C + S + T

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AE=C + I + G

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Planned aggregate expenditure (AE) is the sum of consumption spending by households (C), planned investment by business firms (I), and government purchases of goods and services (G).

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budget deficit

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The difference between what a government spends and what it collects in taxes in a given period.

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debt

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The accumulation of deficits

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debt ceiling (or debt limit)

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The legislative mechanism to limit the amount of national debt that can be issued by the Treasury.

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balanced budget

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Government Spending = Taxes

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deficit

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Government Spending > Taxes

4 causes of deficit: less tax revenue, unemployment insurance and food stamps, military, Bush’s TARP and Obama’s stimulus (small part and temporary)

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surplus

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Government Spending < Taxes

Deficit and surplus are flows, while debt is a stock. Bathtub analogy: debt is the amount of water in the tub, deficit flows in adding to the stock, while surplus drains the tub

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during economic downturns

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Falling incomes => decline in income tax revenue => Increases deficit

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adding taxes to the consumption function

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C = a + bYd
OR
C = a + b(Y − T)

Our consumption function now has consumption depending on disposable income instead of before-tax income.

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saving/investment approach to equilibrium

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S + T = I + G

To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE). By definition, AE equals C + I + G, and by definition, Y equals C + S + T.

Therefore, at equilibrium:

C + S + T = C + I + G

Subtracting C from both sides leaves:

S + T = I + G

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government spending multiplier

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1/ mps

The ratio of the change in the equilibrium level of output to a change in government spending.

increase or decrease in the level of government purchases ((change)G)

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tax multiplier

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The ratio of change in the equilibrium level of output to a change in taxes.

change in y = (initial increase in aggregate expenditure) * (1/mps)

Because the initial change in aggregate expenditure caused by a tax change of ∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution:

tax multiplier= -(mpc/mps)

increase or decrease in the level of net taxes ((change)T)

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balanced budget multiplier

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simultaneous balanced-budge increase or decrease in the level of government purchases and net taxes: ((change)G = (change)T)

multiplier= 1

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federal surplus (+) or deficit (−)

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Federal government receipts minus expenditures.