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314 Cards in this Set
- Front
- Back
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A change in market price is represented by a ______________ (movement along line/shift of curve)
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movement along line
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What causes a shift in demand (i.e. increase in demand)?
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- increase in price of substitute - increase in income - decrease in price of complement - increase in consumer preferences |
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What causes a shift in supply?
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- change in price of substitutes - supply shock |
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If price is above equilibrium level, we see...
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excess supply |
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If price is below equilibrium level, we see..
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excess demand
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Stable equilibrium vs. unstable equilibrium
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supply curve must cut through demand curve when sloping upward
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Common value auction
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- value of item to be auctioned will be same to any bidder, but bidders do not know the value - auction participants estimate value and bidder who most overestimates he value will be the highest (winning bidder)--> winners curse |
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Private value auction
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value that each bidder places on item is value it has to him
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Ascending price auction (English auction)
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bidders can bid an amount higher than previous bid
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Sealed bid auction
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each bidder provides one bid, unknown to other bidders
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Reservation price
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highest price bidder is willing to pay
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Second price sealed bid auction (Vickrey auction)
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bidder submitting the highest bid wins the item but pays the amount bid by the second highest bidder
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Descending price auction (Dutch auction)
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Begins with price greater than what any bidder will pay and offer price reduced until bidder agrees to pay it
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Noncompetitive bid for U.S. Treasuries
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Bidders will accept the quantity of treasuries they want at the price determined by auction
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Consumer surplus
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price willing to pay - actual price top part of demand/supply curve |
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Producer surplus
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Total revenue - total variable cost
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Deadweight loss
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loss of consumer or producer surplus by over or underproduction
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Price ceilings and price floors
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minimum price a buyer can offer (floors) and maximum price a buyer can offer (ceilings)
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Obstacles to Efficient Allocation of Productive Resources
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- Price controls (price ceilings/price floors) - Taxes and trade restrictions (subsidies and quotas) - External costs (costs not taken into account in production decision) - External benefits (benefits enjoyed by others who didn't buy good) - Public goods and common resources ( don't pay for public goods but enjoy benefits so competitive markets produce less than what is needed) |
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If a price ceiling is above the equilibrium price..
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it will have no effect
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If a price ceiling is below the equilibrium price..
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it will result in a shortage
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If a price floor is below equilibrium price..
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it will have no effect on equilibrium price and quantity
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If a price floor is above the equilibrium price..
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it will cause a surplus
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Tax on producers vs. tax on buyers
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tax on producers decreases supply/demand curve depending on who it is on
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Incidence of tax
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allocation of tax between buyers and sellers
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Statutory incidence
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who is legally responsible for paying the tax
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actual incidence of a tax
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who actually bears the cost of the tax through an increase
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If demand is less elastic (demand curve is steeper), ___________ will bear a higher burden.
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consumers
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If supply is less elastic (supply curve steeper), ____________ will bear a higher burden.
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producers
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As the elasticity decreases, the deadweight loss ___________ (increases/decreases)
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decreases
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Elastic vs. Inelastic supply curve
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.
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Subsidies
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- payments made by governments to producers (often farmers) - leads to a deadweight loss from overproduction |
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Production quotas
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- used to regulate markets by imposing an upper limit on quantity of a good that may be produced over a specified time period - can produce deadweight loss if amount below equilibrium amount |
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Price elasticity
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measure of responsiveness of quantity demanded to price change
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Perfectly inelastic demand curve vs. Perfectly elastic demand curve |
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Price elasticity along a linear demand curve
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total revenue is maximized when price elasticity is equal to ________
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-1
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What affects demand elasticity
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- quality and availability of substitutes - portion of income spent on goods (larger portion of income spent= more elastic) - time (longer the time period since the last price change= more elastic) |
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Income elasticity
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sensitivity of quantity demanded to change in income
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Increase in income leads to __________ (increase/decrease) in quantity demanded of normal goods and ___________ (increase/decrease) in quantity demanded of inferior goods.
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increase decrease |
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Cross price elasticity of demand
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ratio of percentage change in quantity demanded of a good/percentage change in the price of a related good
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When the cross price elasticity of two goods is ____________ we say the goods are substitutes. When the cross price elasticity of two goods is _____________ we say the gods are complements.
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positive (price of one up, quantity demanded of other up) negative (price of one up, quantity demanded of other down) |
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Price elasticity of demand
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Income elasticity of demand
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Arc elasticity of demand
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Percent change in quantity/Percent change in price
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In a market with an unstable equilibrium price and quantity: A. the demand curve must slope upward B. prices do not move toward their equilibrium values C. both price and output are highly variable around the equilibrium |
B.
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The imposition of a price floor above the current equilibrium price is most likely to result in a: A. change in supply B. welfare loss to the economy C. decrease in quantity supplied |
B.
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A demand function for air conditioners is given by: QDac = 10,000 - 2Pac + 0.0004income + 30Pfan - 4Pelectricity At current average prices, an air conditioner costs 5,000 yen, a fan costs 200 yen, and electricity costs 1,000 yen. Average income is 4,000,000 yen. The income elasticity of demand for air conditioners is closest to: A. 0.0004 B. 0.444 C. 40,000 |
B. QD= 3,600 Income elasticity = I/Q x change in Q/change in I = 4000000/3600 x 0.0004 = 0.444 |
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Condition of non-satiation
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More is always preferred to less. If less is preferred, we have a bad (i.e. garbage)
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Utility is a ______________ (ordinal/cardinal) measure
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ordinal
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The utility of bundle 1 equals 100, and the utility of Bundle 2 equals 200. What can we infer from this
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Bundle 2 is preferred. We cannot infer that Bundle 2 gives twice the satisfaction of Bundle 1
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Indifference curves
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plot the combinations of two goods that provide equal utility to a consumer - indifference curves for two goods slope downward - indifference curves are convex towards the origin - indifference curves cannot cross |
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The slope of an indifference curve is referred to as ____________________________
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marginal rate of substitution (rate at which you exchange units of good X for good Y)
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Equilibrium bundle of goods
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most preferred affordable combination of Good X and Good Y
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Substitution Effect
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always acts to increase consumption of a good that has fallen in price
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Income effect
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can either increase or decrease consumption of a good that has fallen in price
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Graphically show a positive income effect and positive substitution effect
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Graphically show a negative income effect smaller than a positive substitution effect
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Graphically show a negative income effect larger than a positive substitution effect
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Normal good vs. inferior good
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normal= income effect is positive inferior= income effect is negative |
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Giffen good
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- inferior good for which negative income effect outweighs positive substitution effect - theoretical and would have upward sloping demand curve |
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Veblen good
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higher price makes the good more desirable (i.e. Gucci bag/Ferrari) - would have positively sloped demand curve for SOME individuals over SOME range of prices - not theoretical |
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A consumer has a budget of 120 euros. The price of melons increases from 4 euros to 5 euros, and the price of fish increases from 6 euros to 10 euros. These changes represent an increase in the: A. relative price of fish B. relative price of melons C. opportunity set of melons and fish |
A.
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If widgets are a Giffen good, which of the following describes the effect of a price decrease in widgets? Quantity demanded will most likely A. increase in accordance with the law of demand B. decrease because a lower price makes a Giffen good less desirable C. decrease because the income effect will more than offset the substitution effect |
C.
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Accounting profit vs. Economic profit
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Accounting= total revenue - total explicit costs Economic= total revenue - implicit opportunity costs |
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Normal profit
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accounting profit that firm must earn to cover implicit opportunity costs Economic profit= (accounting profit-normal profit)= 0 |
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What economic profit do we expect in equilibrium?
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0
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Economic rent
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payment to a resource in excess of the minimum payment to retain resources in their current use
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Economic rent in perfectly elastic supply curve vs. Economic rent in perfectly inelastic supply curve
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In the short run, the normal profit for a firm is ____________ (fixed/variable), but in the long run it is _______________ (fixed/variable)
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fixed variable with required rate of return on equity investments |
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Total revenue, Average revenue, and Marginal revenue
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Total= P x Q Average = Total/Q Marginal= increase in total revenue from selling one more unit |
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True or False. In perfectly competitive market, D= market price=MR=AR
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True
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When is total revenue maximized?
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when marginal revenue = 0
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Factors of production
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land, labor, capital (plant and equipment), and materials (inputs)
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Quasi fixed costs
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costs will remain constant over some range of output but will increase if output is increased beyond some quantity
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Marginal costs
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Change in total costs/Change in quantity
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Graphically show the Average and Marginal costs
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Show the breakeven and shutdown points in a graph with average and marginal costs
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MC= ATC (breakeven) MC > AVC (operate in SR MC = AVC (shutdown in LR) MC < AVC (shutdown in SR) |
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When are economic profits maximized?
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MR=MC
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Minimum efficient scale
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Lowest point on the long run average cost curve
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Economies of scale
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- downward sloping segment of the long run average total cost curve - may result from factors such as labor specialization, mass production, and investment in more efficient equipment and technology |
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Diseconomies of scale
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- upward sloping segment of long run average total cost curve - may result from increasing bureaucracy, problems motivating large workforce |
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Graphically represent economies and diseconomies of scale using a long run average cost curve
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Increasing cost industry
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- as firms enter the industry in pursuit of profits, the demand for productive inputs specific to the industry increases, and their market price increases as well - i.e. oil industry |
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Decreasing cost industry
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resource prices fall as industry expands
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Display the long run supply curves of increasing cost industry, decreasing cost industry, and constant cost industry
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Total product of labor, average product of labor, marginal product of labor
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Total= output for a specific amount of labor Average= Product of labor/number of workers Marginal= addition to total product of labor from employing one more unit of labor |
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True or False. A necessary condition for cost minimization is MPL/PL= MPK/PK
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True. Using more labor = decrease MPL Using less capital = increase MPK |
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Marginal revenue product (MRP)
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- monetary value of the marginal product of an input - profit maximizing when MRP = P |
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Which of the following statements most accurately describes the shape of the average fixed cost curve? A. It becomes relatively flat at large output levels B. It is always below the average variable cost curve C. It intersects the marginal cost curve at its minimum |
A.
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If a firms long run average total cost increases by 6% if output is increased by 6%, the firm is experiencing A. economies of scale B. diseconomies of scale C. constant returns to scale |
B. Increasing log run average total cost as a result of increasing output demonstrates diseconomies of scale
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A firm is considering whether to determine its profit maximizing quantity of output by maximizing the difference between total revenue and total cost or by producing up to the point where marginal revenue equals marginal cost. Which method is most likely to generate the greatest profit? A. Profit will be the same using either method B. Profit will be greater with the total revenue/total cost approach C. Profit will be greater with the marginal revenue/marginal cost approach |
A.
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Which of the following statements most accurately describes the relationship between marginal product and average product of labor in the short run? As the quantity of output increases A. AP is always less than MP B. initially, AP < MP, then AP=MP, then AP>MP C. initially, AP> MP, then AP=MP, then AP |
B.
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In a given firm, the marginal product per hour worked for a skilled worker is twice as much as it is for an unskilled worker. Skilled workers earn $20 per hour and unskilled workers earn $8 per hour. Based on this information, the firm should increase the: A. salary of skilled workers to attract more of them B. use of skilled workers or decrease the use of unskilled workers C. use of unskilled workers or decrease the use of skilled workers |
C.
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A firm is using the profit-maximizing combination of labor and capital if the ratio of each input's marginal revenue product to its cost per unit is A. maximized B. equal to one C. minimized |
B. At the optimal combination of labor and capital, the ratio of each inputs marginal revenue product to its cost per unit is equal to one.
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Perfect competition
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- Many firms - Very low barriers to entry - Very good substitutes - Nature of competition: price only - no pricing power |
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Monopolistic competition
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- Many firms - Low barriers to entry - good substitutes but differentiated - Nature of competition: price, marketing, features - some pricing power |
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Oligopoly
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- few firms - high barriers to entry - very good substitutes or differentiated - Nature of competition: price, marketing, features - some to significant pricing power |
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Monopoly
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- single firm - very high barriers to entry - no good substitutes - nature of competition: advertising - significant |
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Describe profit maximization under the marginal approach and total approach for perfect competition
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Marginal approach--> marginal revenue=marginal cost Total approach --> total revenue > total cost by maximum amount |
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Equilibrium in a perfectly competitive market for the market vs. the firm
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Short run adjustment to an increase in demand under perfect competition for market vs. firm
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Where does monopolistic competition maximize profits?
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- Where MR=MC and charging price for that quantity from the demand curve - P > MC (producers realize a markup and average total cost not a minimum suggesting excess capacity) |
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Short run and long run output under monopolistic competition
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Kinked demand curve model
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based on assumption that an increase in a firms product price will not be followed by its competitors, but a decrease in price will
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Which firm model uses the kinked demand curve model? Draw this graph
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Oligopoly
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Cournot Model
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industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other at the same time
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Nash equilibrium
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reached when there is no other choice that could make any firm better off
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Dominant firm model
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- single firm that has a significantly large market share because of its greater scale and lower cost structure - dominant firm believes that quantity supplied by other firms decreases at lower price - firms decisions are interdependent |
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Profit Maximization for monopoly
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where MR=MC Economic profit= (P-ATC) x Q - monopolists do NOT charge the highest possible price |
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Price discrimination
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charging different consumers different prices for same product or service
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What conditions must be met by the seller in order for price discrimination to work?
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- Must face downward sloping demand curve - Have at least two identifiable groups of customers with different price elasticities of demand - Prevent the customers paying lower price from reselling |
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Perfect price discrimination
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- charge each customer maximum they are willing to pay for each unit - would be no deadweight loss - no consumer surplus- would all be captured by monopolist |
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True or False: Compared to a perfectly competitive industry, the monopoly firm will produce less total output and charge a higher price
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True
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True or False: Monopolies create a deadweight loss relative to perfect competition because monopolies produce a quantity that does not maximize the sum of consumer surplus and producer surplus
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True
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Natural monopoly
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occurs when cost of producing a product is lower due to economies of scale if there is just a single producer than if there are several competing producers
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Average cost pricing
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forces monopolists to reduce price to where the firms ATC intersects the market demand curve - will increase output and decrease price - increase social welfare - ensure monopolist a normal profit because price= ATC |
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Marginal cost pricing
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- reduces price to point where the firms MC curve intersects the market demand curve - this type of pricing requires a government subsidy in order to provide firm with normal profit and prevent it from leaving the market entirely |
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Describe a firms supply function under each market structure
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Quantity supplied is determined by the intersection of marginal cost and marginal revenue and the price charged is then determined by the demand curve the firm faces
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Describe the pricing strategy under each market structure
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Perfect competition: P=MR=MC Monopoly: MR=MC Monopolistic competition: MR=MC Oligopoly: - kinked demand curve: MR=MC - Collusion, Dominant firm model: Quantity where MR=MC and price from the industry demand curve - Game theory: price between monopoly price and perfect competition price |
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What is used as an indicator of market power?
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Concentration measures
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N-firm concentration ratio
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- sum or percentage market shares of the largest N firms in a market - limitation is that it may be relatively insensitive to mergers of two firms with large market shares |
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Herfindahl-Hirschman Index
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sum of the squares of the market shares of the largest firms
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When a regulatory agency requires a monopolist to use average cost pricing, the A. ATC curve intersects the MR curve B. MR curve intersects the demand curve C. ATC curve intersects the demand curve |
C.
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When a firm operates under conditions of pure competition, marginal revenue always equals A. price B. average cost C. marginal cost |
A.
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In which market structure(s) can a firm's supply function be described as its marginal cost curve above its average variable cost curve? A. Oligopoly or monopoly B. Perfect competition only C. Perfect competition or monopolistic competition |
B. The supply function is not well-defined in markets other than those that can be characterized as perfect competition
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A purely competitive firm will tend to expand its output so long as: A. marginal revenue is positive B. marginal revenue is greater than price C. market price is greater than marginal cost |
C.
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What values are used in calculating GDP?
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market value of final goods and services
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Expenditure approach
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GDP calculated by summing amount spent on good and services
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Income approach
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GDP calculated by summing amounts earned by holds and companies during the period, including wage income, interest income, and business profits
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Value of final output method vs. Sum of value added method
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- Value of final output method = expenditure approach - sum of value added method= summing additions to value created at each stage of production and distribution |
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Nominal GDP
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Price in year N x quantity in year N
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Real GDP
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Price in base year x quantity in current year
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GDP deflator
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(Nominal GDP/Real GDP) x 100
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GDP under expenditure approach
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GDP= C + I + G + (X-M)
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GDP under income approach
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GDP= national income + capital consumption allowance + statistical discrepancy
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Capital consumption allowance
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measures depreciation of physical capital from production of goods and services
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Statistical discrepancy
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adjustment for difference between GDP measured under income approach and expenditure approach
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National income
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= wages + corporate/gov profits + interest income + business owners income + rent + taxes - subsidies
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Personal income
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= national income + transfer payments to households - business taxes - corporate income taxes - undistributed corporate profits
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Personal disposable income
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= personal income - personal taxes
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Fiscal balance
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= G - T
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Trade Balance
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= X-M
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Government budget deficit vs. budget surplus
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budget deficit = G-T = positive budget surplus= G-T= negative |
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Savings curve
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S= I + (G-T) + (X-M)
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Marginal propensity to consume
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proportion of additional income spent on consumption
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Marginal propensity to save
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proportion of additional income saved
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IS curve (income-savings curve)
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negative relationship between real interest rates and real income
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LM curve (liquidity- money curve)
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positive relationship between real interest rates and income consistent with equilibrium in the money market
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What causes a shift in the aggregate demand curve?
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- Increase in consumer wealth (C increases) - Business expectations (I increases) - Consumer expectations of future income (C increases) - High capacity utilization (I increases) - Expansionary monetary policy (C and I increase) - Expansionary fiscal policy (C increases for tax cut, G increases for spending increase) - Decrease in exchange rate ( NX increases) - Global economic growth (NX increases) |
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What causes a shift in aggregate supply curve
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1. Labor productivity 2. Input prices 3. Expectations of future output prices 4. Taxes and government subsidies 5. Exchange rates (appreciation of country currency makes imports cheaper) |
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What causes a shift in long run aggregate supply curve
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1. Increase in supply and quality of labor 2. Increase in the supply of natural resources 3. Increase in the stock of physical capital 4. Technology |
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When real GDP is less than full employment GDP, we say there is a ________________________
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recessionary gap
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When real GDP is greater than full employment GDP, we say there is a ________________________
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inflationary gap
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Stagflation
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declining economic output and higher prices
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What happens to real GDP, unemployment, and price level when there is an increase in AD?
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Real GDP: increase Unemployment: decrease Price level: increase |
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What happens to real GDP, unemployment, and price level when there is a decrease in AD?
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Real GDP: decrease Unemployment: Increase Price level: decrease |
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What happens to real GDP, unemployment, and price level when there is an increase in AS?
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Real GDP: Increase Unemployment: Decrease Price level: Decrease |
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What happens to real GDP, unemployment, and price level when there is a decrease in AS?
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Real GDP: Decrease Unemployment: Increase Price Level: Increase |
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Sources of economic growth
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1. Labor supply 2. Human capital 3. Physical capital stock 4. Technology 5. Natural resources |
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Sustainable rate of economic growth
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growth in potential GDP= growth in labor force + growth in labor productivity
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Production Function
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Y= A x f(L,K) Y= aggregate economic output A= total factor productivity L= size of labor force K= amount of capital available |
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Capital deepening investment
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increasing physical capital per worker over time
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Solow model
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growth in potential GDP= growth in technology + WL (growth in labor) + WC(growth in capital) WL: labors percentage of national income WC: capitals percentage of national income |
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The least appropriate approach to calculating a country's gross domestic product (GDP) is summing for a given time period the: A. value of all purchases and sales that took place within the country B. amount spent on final goods and services produced within the country. C. income generated in producing all final goods and services produced within the country |
A.
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When GDP is calculated by the sum-of-value-added method, what is the value of a manufactured product in GDP? A. The sum of the product's value at each stage of production and distribution B. The sum of the increases in the products value at each stage of production and distribution C. The products retail price less the value added at each stage of production and distribution |
B.
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Which of the following statements most accurately describes personal income? Personal income: A. includes unearned income from governments, such as transfer payments B. measures the amount of after-tax income that households can spend or save C. includes indirect business taxes, corporate income taxes, and retained earnings |
A.
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Long-term sustainable growth of an economy is least likely to result from growth in: A. the supply of labor B. capital per unit of labor C. output per unit of labor |
B.
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A common rule of thumb is to consider _____ consecutive quarters of growth in real GDP as the beginning of an expansion and ______ consecutive quarters of declining real GDP as indicating the beginning of a contraction
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2 2 |
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What ratio should be increasing as expansion is approaching its peak
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inventory sales ratio (sales growth begins to slow and unsold inventories accumulate)
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Business cycle characteristics of a trough
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- GDP growth rate changes from negative to positive - High unemployment rate, increasing use of overtime and temporary workers - spending on consumer durable goods and housing may increase - moderate or decreasing inflation rate |
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Business cycle characteristics of an expansion
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- GDP growth rate increases - Unemployment rate decreases as hiring accelerates - Investment increases in producers' equipment and home construction - Inflation rate may increase - imports increase as domestic income growth accelerates |
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Business cycle characteristics of a peak
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- GDP growth rate decreases - Unemployment rate decreases but hiring slows - Consumer spending and business investment grow at slower rate - Inflation rate increases |
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Business cycle characteristics of a contraction/recession
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- GDP growth rate is negative - hours worked decrease, unemployment rate increases - Consumer spending, home construction, and business investment decreases - inflation rate decreases with a lag - imports decrease as domestic income growth slows |
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Neoclassical school
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- economists believe shifts in both aggregate demand and aggregate supply are driven by changes in technology over time - business cycles result from temporary deviations from long run equilibrium |
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Keynesian school
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- shifts in aggregate demand due to changes in expectations - wages are downward sticky - believe you should increase AD directly through monetary policy or fiscal policy |
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New Keynesian school
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added the assertion that prices of productive inputs other than labor are also downward sticky
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Monetarist school
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variations in AD are likely from inappropriate decisions by monetary authorities
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Austrian school
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business cycles are cause by government intervention in the economy
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New classical school
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- introduced real business cycle theory - emphasizes changes in technology and external shocks as opposed to monetary variables - policymakers should not try to counteract business cycles because expansions and contractions are efficient market responses to real external shocks |
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Frictional unemployment
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time lag between matching employees to employers who need their skills
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Structural unemployment
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eliminate some jobs while creating others which unemployed workers are not qualified
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Cyclical unemployment
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caused by changes in general level of economic activity
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Participation ratio
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percentage of working age population who are either employed or actively seeking employment
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Inflation favors _______________ (borrowers/lenders)
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borrowers
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Disinflation |
inflation rate that is decreasing over time but still above 0
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Deflation
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persistently decreasing price level
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CPI
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= (cost of basket at current prices/cost of basket at base period prices) x 100
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Headline inflation
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inflation for price indexes for all goods
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Core infaltion
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- inflation for price indexes that exclude food and energy - food and energy are more volatile than those of most other goods |
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Laspeyres index vs. Paasche index
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Laspeyres uses base year quantities Paasche uses period N quantities |
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Factors that cause Laspeyres index to be biased upward
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- new goods - quality changes - substitution |
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Hedonic pricing
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adjusts price index for product quality
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Cost push inflation
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results from a decease in aggregate supply - wage pressure can be a source of cost push inflation |
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Demand-pull inflation
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results from an increase in aggregate demand
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NAIRU
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non accelerating inflation rate
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NARU
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Natural rate of unemployment
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Leading indicators
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change direction BEFORE peaks or troughs
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Coincident indicators
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change direction at roughly the same time as peaks or troughs
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Lagging indicators
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change direction AFTER expansions or contractions
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According to which business cycle theory should expansionary monetary policy be used to fight a recession? A. Keynesian school B. Monetarist school C. New classical school |
A. Keynesian recommends monetary or fiscal policy, monetarists believe money supply growth should be kept stable, New classical school recommends against monetary or fiscal policy
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Which of the following is least likely to reduce substitution bias in a consumer price index? A. Use a chained index B. Use a Paasche index C. Adjust for the bias directly using hedonic pricing |
C. Chained price index and Paasche address substitution bias
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In which of the following inflation scenarios does short run aggregate supply decrease due to increasing wage demands? A. Cost-push inflation B. Demand-pull inflation C. Both cost-push and demand-pull inflation |
C.
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Budget surplus
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Taxes > Government spending
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Budget deficit
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Taxes < Government spending
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Monetary has three functions
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1. medium of exchange (accepted form of payment) 2. Unit of account (prices expressed in money) 3. Store of value (be saved to purchase goods later) |
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Narrow money
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amount of notes (currency) and coins in circulation plus checkable bank deposits
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Broad money
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narrow money plus available liquid assets
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Fractional reserve banking
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bank holds proportion of deposits in reserve
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Money multiplier
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1/reserve requirement
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Relationship between money and price level
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MV= PY M: money supply V: velocity: average number of times money used to buy goods and services PY: nominal GDP |
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Money neutrality
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belief that real variables (real GDP and velocity) are not affected by monetary variables (money supply and prices)
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Demand for money
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amount of wealth that households/firms choose to hold in the form of money
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What are the reasons for holding money?
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1. Transaction demand 2. Precautionary demand 3. Speculative demand |
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An increase in money supply will put _____________(downward/upward) pressure on interest rates
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downward
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Fisher effect
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Nominal interest rate= Real + Inflation + RP RP: risk premium for uncertainty |
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Roles of central banks
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1. sole supplier of currency 2. banker to the government and other banks 3. regulator and supervisor of payments system 4. lender of last resort 5. holder of gold and foreign exchange reserves 6. Conductor of monetary policy |
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What is the primary objective of central banks
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control inflation and promote price stability
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Menu costs
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costs of having to constantly change prices
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Shoe leather costs
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costs of making frequent trips to bank to minimize holdings of cash that are depreciating due to inflation
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Pegging
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choose a target level for exchange rate of their currency with that of another country
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Monetary policy tools
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1. Policy rate (fed funds rate) 2. Reserve requirement (increase reserve requirement=less funds for lending= lower money supply= interest rate increases) 3. Open market operations (Central bank buys securities= more cash= more lending= money supply increases= interest rates decrease) |
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Discount rate |
rate at which banks can borrow reserves from Fed
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Refinancing rate
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rate at which banks borrow from ECB
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Repurchase agreement
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Bank purchases securities from banks, and agree to repurchase that security at a higher price in the future
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Federal funds rate
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rate that banks charge each other on overnight loans of reserves
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Central banks have three essential qualities. What are they?
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1. Independence - operational independence: independently determine policy rate - target independence: defines how inflation is computed, set target inflation, determine horizon over which target is to be achieved 2. Credibility 3. Transparency |
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Transmission mechanism for decrease in interbank lending rate
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1. market rates decrease-> asset prices increase-> firms and individuals raise expectations -> domestic currency depreciates
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Interest rate targeting
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increasing the money supply when specific interest rates rise above the target band
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Real trend rate
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economy's long term sustainable growth rate |
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Neutral interest rate
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= real trend rate + inflation target
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Bond market vigilante
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- prices and yields have inverse relationship - If inflationary environment ensues, bond market vigilantes protest this by selling bonds (increasing yields) even though price level is going up (cause situation where price level and yield both up) |
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Liquidity trap
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people hoard cash and so central bank injecting money into economy do not cause interest rates to decrease
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Discretionary fiscal policy
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spending and taxing decisions of a national gov that are intended to stabilize economy
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Transfer payments
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entitlement programs that redistribute wealth (social security/unemployment insurance)
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Current spending vs. Capital spending
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- current= gov spending on goods and servicse - capital= gov spending on infrastructure |
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Direct taxes vs. indirect taxes
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- direct= levied on income/wealth -indirect= levied on good and services |
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Fiscal multiplier
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= 1/[1-MPC(1-t)] - determines potential increase in AD resulting from an increase in gov spending |
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Ricardian equivalence
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when gov increases spending to stimulate economy, demand remains unchanged because public saves money for expected future tax increase
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Crowding out effect
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Government spending drives down public spending
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Recognition lag
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May take policymakers time to recognize the nature and extent of the economic problems
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Action lag
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time it takes government to discuss, vote on, and enact fiscal policy
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Impact lag
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time between enactment of fiscal policy and impact of changes
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Structural (or cyclically adjusted) budget deficit
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deficit that would occur based on current policies if the economy were at full employment
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Contractionary monetary policy + Contractionary fiscal policy
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- interest rates higher - output lower - private sector spending lower - public sector spending lower |
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Expansionary monetary policy + Contractionary fiscal policy
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- interest rates lower - output higher - private sector spending higher - public sector spending higher |
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Contractionary monetary policy + expansionary fiscal policy
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- interest rates higher - output higher - private sector spending lower - public sector spending higher |
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Expansionary monetary policy + contractionary fiscal policy
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- interest rates lower - output varies - private sector spending higher - public sector spending lower |
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If money neutrality holds, the effect of an increase in money supply is A. higher prices B. higher output C. lower unemployment |
A. According to money neutrality an increase in money supply should only increase price level
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A central banks policy goals least likely include A. price stability B. minimizing long term interest rates C. maximizing the sustainable growth rate of the economy |
B.
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An increase in the policy rate will most likely lead to an increase in A. business investment in fixed assets B. consumer spending on durable goods C. foreign exchange value of the domestic currency |
C. increase in rates makes investment in domestic economy more attractive to foreign investors which causes currency to appreciate
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A government enacts a program to subsidize farmers with an expansive spending program of $10 billion. At the same time, the government enacts a $10 billion tax increase over the same period. Which of the following statements best describes the impact on aggregate demand? A. Lower growth because the tax increase will have a greater effect B. No effect because tax and spending offset each other C. Higher growth because spending increase will have greater effect |
C. the multiplier for gov spending is greater than the multiplier for tax increase
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In the presence of tight monetary policy and loose fiscal policy, the most likely effect on interest rates and the private sector share in GDP are: A. low interest rates, lower private sector B. higher interest rates, higher private sector C. higher interest rates, lower private sector |
C. loose fiscal policy expands public sector reducing overall share of private sector in GDP
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Autarky or closed economy
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country that does not trade with other countries
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Trade protection
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government places restrictions, limits, or charges on exports or imports
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World price
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Price of a good or service in world markets for those to whom trade is not restricted
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Terms of trade
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- ratio of index of exports/index of imports - base value is 100 |
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Foreign direct investment
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ownership of productive resources in a foreign country
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Multinational corporation
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firm that has made foreign direct investments in one or more foreign countries
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Gross national product
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measures value of goods/services produced by countries citizens (including those who work in other countries)
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Absolute advantage vs. Comparative advantage
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absolute= can produce good at lower cost Tcomparative= opportunity cost in terms of other good is lower |
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True or False: If one country has a lower opportunity cost of producing one good, the other country must have a comparative advantage in production of the other good
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True
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Can a country produce outside its PPF curve?
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yes through specialization and trade
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Ricardian model of trade
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- only one factor of production (labor) - source of differences in production costs is differences in labor productivity |
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Heckscher-Ohlin model of trade
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- two factors of production- capital and labor -country that has more capital will specialize in the capital intensive good and trade for the less capital intensive good |
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What are reasons why trade restrictions are good?
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- Infant industry- gives them opportunity to grow to an internationally competitive scale - national security Arguments that have little support - protecting domestic jobs and protecting domestic industries |
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Tariffs
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taxes on imported good collected by government
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Quotas
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limit on amount of imports allowed
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Minimum domestic content
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requirement that some percentage of product content must be from domestic country
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Voluntary export restraint
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country voluntarily restricts the amount of a good that can be exported (in hopes of avoiding tariffs/quotas)
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Free Trade Areas
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-barriers to import and export among member countries are removed
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Custom Union
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- barriers to import/export among member countries removed - common trade restrictions with non members |
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Common Market
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- all barriers to import/export among countries removed - common trade restrictions with non members - barrier to movement of labor and capital goods removed among member countries |
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Economic union
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- all barriers to import/export among member countries removed - common trade restrictions with non members - barrier to movement of labor/capital removed - common institutions and economic policy for union |
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Monetary union
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- all barriers to import/export among member countries removed - common trade restrictions with non members - barrier to movement of labor/capital removed - common institutions and economic policy for union - members adopt single currency |
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The North American Free Trade Agreement (NAFTA) is an example of a ______________________ and the European Union is an example of a ____________________ and the Eurozone is an example of a _______________________
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free trade area economic union monetary union |
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What are the objectives of capital flow restricitons? |
- reduce the volatility of domestic asset prices - maintain fixed exchange rates - keep domestic interest rate low - protect strategic industries |
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Balance of payments
|
- current account - capital account - financial account |
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Current account
|
- merchandise and services - income receipts - unilateral transfers |
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Capital account
|
- capital transfers - sales and purchases of non financial assets |
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Financial account
|
- government owned assets abroad - foreign owned assets in the country |
|
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Current account deficit vs. Current account surplus
|
deficit= imports > exports surplus= exports> imports |
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International Monetary Fund
|
facilitates trade by promoting international monetary cooperation and exchange rate stability
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World Bank
|
provides low interest loans, interest free credits, and grants to developing countries
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World Trade Organization
|
has goal of ensuring trade flows freely and works smoothly
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The least likely result of import quotas and voluntary export restraints is: A. increased revenue for the government B. decrease in the quantity of imports of the product C. shift in production toward higher cost suppliers |
A. Import quotas and voluntary export restraints do not necessarily generate tax revenue
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Which of the following is least likely a component of the current account? A. unilateral transfers B. payments for fixed assets C. payments for goods and services |
B.
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A current account deficit is most likely to decrease as a result of an increase in: A. domestic savings B. private investment C. fiscal budget deficit |
A. Increase in domestic savings decreases current account deficit, while an increase in a private investment or an increase in the fiscal budget deficit would tend to increase the current account deficit
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Real Exchange Rate
|
= nominal exchange rate x (CPI foreign/CPI domestic)
|
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|
How does inflation in the UK affect the price of goods and services in the UK with relation to USD?
|
inflation in UK causes real goods and services in UK to cost relatively more in USD
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How does inflation in US affect the prices of goods and services in UK with relation to USD?
|
Inflation in US causes real goods and services in UK to cost relatively less in USD
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Spot exchange rate
|
currency exchange rate for immediate delivery
|
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forward exchange rate
|
currency exchange rate for exchange to be done in the future
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|
The USD/EUR has changed from 1.42 to 1.39 USD/EUR. The change is -2.11%. Describe this change
|
The Euro has depreciated 2.11%
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|
What if you wanted to describe that change in terms of USD.
|
convert to EUR/USD by doing 1/1.42 and 1/1.39
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Cross exchange rate
|
exchange rate between two currencies implied by their exchange rate with common third currency - MXN/AUD= USD/AUD x MXN/USD |
|
|
When currencies are freely traded and forward currency contracts exist, the percentage difference between forward and spot exchange rates is approximately equal to the difference between the two countries' ____________________
|
interest rates
|
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Interest rate parity |
Forward/spot = (1 + domestic rate)/(1 + foreign rate)
|
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Formal dollarization
|
country can use currency of another country (cannot create money or have its own monetary policy)
|
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Currency board arrangement
|
explicit commitment to exchange domestic currency for specified foreign currency at a fixed exchange
|
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Conventional fixed peg arrangement
|
country pegs its currency within margins of +/- 1 versus another currency
|
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Pegged exchange rates within horizontal bands or target zone
|
permitted fluctuations are wider
|
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Crawling peg
|
exchange rate is adjusted periodically, typically to adjust for higher inflation
|
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Management of exchange rates within crawling bands
|
width of bands increased over time to transition from fixed peg to floating rate
|
|
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Managed floating exchange rates
|
Monetary authority attempts to influence exchange rate in response to specific indicators
|
|
|
Independently floating
|
exchange rate is market determined
|
|
|
Elasticities approach
|
focuses on impact of exchange rate changes on the total value of imports/exports
|
|
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Absorption approach
|
focuses on impact of exchange rates on capital flows - BT=Y-E Bt: balance of trade Y: domestic production of goods and services E: domestic absorption of goods and services |
|
|
What condition demonstrates that depreciation of the domestic currency will decrease a trade deficit?
|
Marshall-Lerner condition Wx Ex + WM (EM-1) > 0 Wx: weight of exports Ex: price elasticity demand for exports Wm: weight of imports Em: price elasticity demand for imports |
|
|
J-curve
|
short term increase in deficit followed by decrease when Marshall-Lerner condition is met
|
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|
One year ago, the nominal exchange rate for USD/EUR was 1.300. Since then, the real exchange rate has increased by 3%. This most likely implies that: A. the nominal exchange rate is less than USD/EUR 1.235 B. purchasing power of the euro has increased approximately 3% in terms of US goods C. inflation in Eurozone was approximately 3% higher than inflation in the US |
B.
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The current spot rate for the British pound in terms of US dollars is $1.5333 and the 180 day forward rate is $1.508. Relative to the pound, the dollar is trading closest to a 180 day forward A. discount of 1.63% B. premium of 1.66% C. discount of 1.66% |
B. forward price is greater than spot price, the dollar is at a forward premium of 1.66%
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A devaluation of a country's currency to improve its trade deficit would most likely benefit a producer of: A. luxury goods for export B. export goods that have no close substitutes C. an export good that represents a relatively small proportion of consumer expenditures |
A. greatest benefit would be to producers of goods with more elastic demand
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Other things equal, which of the following is most likely to decrease a country's trade deficit? A. Increase its capital account surplus B. Decrease expenditures relative to income C. Decrease domestic saving relative to domestic investment |
B.
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