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Macroeconomics Test Review II:  Understanding Total Economic Activity
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I. Measuring Total Economic Activity (Chapter8) 
    A. Gross domestic product (GDP)
    
  1. The sum of all the goods and services produced within an economic unit (country, state)
             within a period of time (normally a year)
         2. Excludes non-productive transfers
             a. Stock market sales
             b. Working at home
             c. The "Underground Economy" (unreported taxable income)
         3. Two approaches to calculating GDP
             a. Expenditure approach
                 1. GDP equals Personal Consumption plus Business Investment plus Government
                     Spending plus Net Exports (exports minus imports)
                 2. GDP = C + I + G + XN
             
   3. I is gross investment which is new capital and  replacement capital (depreciation)
                 4
. Q1 2010 GDP 3rd revision - 2.7% from the economicpopulist.org blog give some
                     current information
on the national income accounting calculation process.
             b. Income approach
                 1. GDP equals Rent plus Wages plus Interest plus Profits plus Depreciation plus
                     Indirect Business Taxes plus miscellaneous
                 2. GDP = R + W + I + P + Acc. Dep. + Ind. Bus. Taxes + Misc. 

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   B. Interpreting national income account data
        1. Comparing data over time requires adjusting for inflation, population increases, and number of people working.
        2. National income accounts do not consider leisure time.
        3. Positive and negative effects of economic activity upon the environment are not measured by national income accounts.
   C.  Money vs. real GDP (taking inflation out of financial data)
        1. A Price Index measures price changes for a basket of commonly used goods over a period of years. 
            a. One year is chosen as a base year, set equal to 100 and years before and after are expressed as a percent
 of the base year. 
            b. For convenience all index calculations are multiplied by 100 allowing the percent sign to be dropped. 
            c. Two
important indexes are the Consumer Price Index (CPI) and the Producer Price Index (PPI) which respectively 
                measure the inflation associated with consumer and producer goods.
 
      2. An index can be used to determine whether someone's salary, a consumer good, and other items of interest have changed
            more or less than inflation.
            a. Nominal salary is salary measured in current dollars.
            b. Real salary is salary adjusted for inflation.
        3. This example uses actual consumer price changes and 1982 as the base year (PB). The item of interest could be 
            someone's salary,
the price of a new car, etc. (PC is price in current year).
Year Cost of a basket of goods Calculation of CPI
(PC/PB)x100
CPI Price of Item of Interest (x) Average Weekly Earnings1  x in 1982 dollars
(x/CPI)100
1981 $557 (557/592)100 94 $255.20 271.49
1982 Pb = $592 (592/592)100 100 $267.26 267.26
1983 $611 (611/592)100 103 $280.70 272.52
 
II. The Business Cycle (chapter 9) describe the business activity over time.
    A. Recession:
commonly accepted definition is two consecutive quarters of negative
        growth in Real GDP.

    B. Why business activity fluctuates
         1. Inventory Recession:
Excessive optimism causes inventories to over expand and
             eventually they must be worked down causing a recession. 
         2. Rolling Recessions:
Economic downturn is limited to areas or sectors of the economy. 
         3. Innovation Cycle:
railroads, computers, bio-technology
         4. Political Events:
wars, international trade
         5. Misuse of Monetary and Fiscal Policy:
government creates and/or borrows an incorrect
              amount of money
         6. Non-cyclical Fluctuations
              a. Seasonal variation:
Christmas buying rush, spring construction 
              b. Long-Term Secular Trends:
the expansion or contraction in the level of economic
               activity over a long period of years (the dark ages, the industrial revolution) 
         7. Durable Goods
have a long useful life (houses, equipment, etc.) Sale of durable goods
            
contract substantially during a recession as their purchase may be easily postponed.
   
C.  Leading, coincidental, and lagging indicators are measures such as the unemployment
          rate, which respectively change before, with or after general economic activity. Economists
          use to predict future economic activity.
    D. Unemployment Types and special topics
         1. Frictional is caused by time lags in the operation of labor markets.
              a. Workers are between employment because they have been fired, are changing
                  careers, are seasonal workers, have been temporarily laid off, etc.
              b. Short-term, inevitable, temporary, and is eliminated with time.
         2. Structural is caused by changes in consumer demand and technology.
             a. Result is an oversupply of workers with a particular skill. 
             b. This unemployment is often concentrated in a particular area, associated with a
                 particular industry, and is often permanent. 
             c. Increased economic activity will not decrease this type of unemployment as training
                 and/or relocation are required.
             d. Happened in the 1970's and early 1980's as consumers decided to buy small foreign
                  built cars and other products produced in the Rust Belt. Now it is happening because
                  NAFTA and foreign  competition  are causing industries 
                 to  restructuring is needed because of  foreign competition.
           3. Cyclical
                a. Caused by a lack of total demand at the end of an economic expansion 
                b. Temporary
                c. Recession of the early 1990's was due to a drop in demand caused by a debt
                    buildup in the 1980's by individuals, businesses, and the federal government.
                    Apprehension caused by high structural unemployment of both blue and white collar
                    workers slowed the recovery.
                d. Recession of 2001 was caused by debt build up of individuals resulting from the long
                    period of prosperity and the stock market  bubble, excess capital investment caused by
                    Y2K and internet optimism, and September 11.  
                e. Great Recession of 2008-09 was caused by the end of an excessive building boom
                    compounded by a banking and stock market crisis. 
            4. Special topics 
                    a. Natural unemployment (frictional + structural unemployment) is usually 4% to 6%
                        of the labor force 
                b. Full employment is when cyclical unemployment equals zero 
                c  Okun's Law: a 1% increase in cyclical unemployment will cause a 1% increase in
                     cyclical unemployment will cause given a 2.5% annual drop in GNP 
                    1) GNP change = 2.5 (unemployment rate change)
                    2) If unemployment goes up 2% as it did in the 1990-91 recession then the drop in 
                       GNP would be 2.5 X 2% or 5%.
                    3). Cost to a 6 trillion dollar economy of 250 million people
                         (5% X $6,000,000,000,000) /  250,000,000 = $1,200/person/year.

 

 

 

 

 

 

 

 

E. Inflation is an increase in prices as measured by a price index such as the consumer producer index, CPI and the Producer Price Index, PPI.
     1. The PPI measures the
          change in  wholesale prices.
     2 The PPI is a leading indicator for CPI as wholesalers can usually pass price
         changes on to retailers who pass them to consumer.
        a. Recent increases in foreign competition made passing price increases on difficult.
        b. The internet had the same kind of affect in the late 1990's. 
     3. The inflation rate for a year when a basket of consumer goods increase from
         $400 to $420 would be calculated as follows.

     4. Causes of inflation
         a. Demand-pull inflation
             1. Increases in C + I + G + XN will cause GDP to increase.
             2. As the economy nears full employment, the prosperity caused by high
                  employment increases demand and put upward pressure on prices.
             3. When this happens, the economy is said to be overheated.
         b. Cost-push inflation
             1. As the economy approaches full employment factor resources become scarce
                 allowing their owners to increase prices.
             2. Supply-side shocks can cause high resource prices even if demand for
                 resources is low, i.e., OPEC's two oil  embargoes of the 1970's
     5. Economic effect of inflation
          a. Both income and resource allocations are affected by inflation as the market tries
              to adjust to the loss in value caused by inflation.
              1. High gas prices in the 1970's caused a switch to small cars and many people
                  bought wood stoves.
              2. Low gas prices in the 1990's made RV's less expensive to run.
         b. Debtors (homeowners, businesses, government) are helped by high inflation
              because they pay back with dollars worth less than those borrowed.
         c. Creditors are hurt by inflation as they are paid back in less valuable dollars. 
                  d.Those on a fixed income are also hurt by the cheaper dollars. 
         d. Cost-of-Living Increases (COLA's) were instituted in the 1970's to negate
             the severe effects of that period's high inflation. 
         e. Deflating GDP
            1. Inflation can be taken out of growth in GDP by expressing later year production
                at earlier year prices. 
            2. In the following chart, letters Q, P and T are quantity, price per unit 
                and total respectively.

III. Macro Equilibrium (chapter 10) exists when the demand and supply variables affecting total economic
       activity are in balance and under no pressure to change.

 
     
A. Macro equilibrium exists even though the more slowly changing variables affecting long-term activity are still
             in flux. Said
long-term activity is called a long-term secular trend.
       B. Aggregate demand, AD, is a schedule matching the Real Gross Domestic Product a country purchases at
            various price levels.
           1. As prices drop, the amount of real gross domestic
product purchased (AD) increases.  AD = C + I + G + XN  
          
2. Like all demand curves, AD increases to the right  and decreases to the left  
           3. Price level is the key determinate of aggregate demand. Holding non-price level determinants constant
                yields the following analysis of why price levels and aggregate demand are inversely related. 
               a. Interest rate effect
                   1. If the price (inflation) is low, interest rates will be low causeing consumption and investment to be high
                       increasing AD.
                   2. This is especially true now that home mortgages are easily refinanced at lower interest rates. 
               b. Real asset balance effect as low inflationary expectations cause people think their past accumulations
                  (savings) will maintain their value. causing people to spend more which increases AD.
               c. Low domestic inflation relative to foreign inflation results in low-priced exports selling better which
                   increases AD
               d. High price levels will bring opposite results
           4. Non-price level determinants of aggregate demand and
their determining characteristics
               a. Consumption (C). Increased expectation of wealth caused by more overtime, debt decreasing by
                    refinancing a home at lower interest and taxes going down all  increase consumption. 
               b. Investment (I) Increased profit expectations,  decreased business taxes, low excess capacity, and
                   positive technology outlook all increase investment. .
               c. Government Spending (G)
               d. Net Exports (XN) (exports minus imports) are determined by economic activity abroad and exchange rates
           5. Price level and non-price level factors together determine aggregate demand which interacts with aggregate
                supply to determine total economic activity.

      
C. Aggregate Supply is a schedule of the amounts of Real Gross Domestic Product companies are willing to
             produce at various
price levels. 
            1. Holding non-price determinants constant yields
the following analysis of how different price levels affect AS.
            2. Keynesian Range: increases in AD increase real GDP and prices do not change
            3. Intermediate Range: both prices and real GDP change
            4. Classical Range: increases in AD increases prices and real GDP does not change because full
                 employment exists
            5. Non-price factors affecting aggregate supply factor price decrease, productivity increases and 
                 increased domestic and foreign tranquility all will increase AS

D. Static equilibrium is where AD and AS intersect     
   

E. Dynamic equilibrium depicts changes in
     AD and AS over time
   
  1. GDP grows to Q'. 
     2. Prices increase to P'
   .
 
Editors Note: This section belongs at the end of the next section but I can't make the spacing work! Sorry, No Front Page training, I just wing it!

     F. Supply-side economics described three key problems causing slow economic growth.
         1. High taxes are the fundamental problem, especially high marginal rates.
             a. decrease incentive to work and save a
             b. cause cost-push inflation.
         2. High transfer payments lower worker incentives.
         3. Government regulation is expensive and counterproductive.
   
     4. Solving these problems would stimulate high noninflationary
             economic growth by increasing AS.  
     G. Many predicted high deficits, economist Arthur Laffer disagreed.
     

1. Laffer Curve
2. Lowering the tax rate from X to X' would increase
     tax receipts.
    a. Lower tax rate would lessen avoidance of taxes.
    b. Fewer transfer payments due to tougher welfare
         policies
        would result in more people working and paying taxes. 
    c. Overall effect of the program would be higher
        productivity. This would increase AS causing GDP
        and tax revenue to increase.
IV. Competing Macro Theories and Issues (chapter 11

    A. Classical economics
         1. Dominated philosophically during the late 18th, 19th and early 20th centuries.
         2. First defined by Adam Smith its primary beliefs were full employment was a norm of capitalism and 
             Laissez-faire
(hands-off) government policy was best.     
         3. Say's Law
            a. Supply created enough factor income to clear the market so inventories will not accumulate and 
                a slow down to use excess inventory, which causes unemployment, was not necessary.
            b. Savings is not a leakage because interest rates adjust to insure saving is borrowed and invested  (spent).
                1) Leakage describes the loss of a variable required to maintain a state of equilibrium (stable level 
                    of economic activity).
                2) Interest rates drop when savings increase to insure savings is invested and there isn't leakage.
        2. Price-Wage flexibility
            a. During periods of slow economic activity wage rates would fall and everyone wanting to work could find work.
            b. All factor prices, not just wages, would adjust downward and all factors would be fully employed. 
                "Real" factor prices would therefore remain constant.
  

 

 

 

 

 

 

 

 

 

 

B. Keynesian economics
        1. Macro equilibrium could settle at an unacceptable level of unemployed resources and government intervention 
            was needed to fully employ resources.
        2. To some, The Great Depression discredited classical economics.
        3. John Maynard Keynes wrote The General Theory of Employment, Interest, and Money (1936). 
            a. Disagreed with Say's Law: savings may not be invested.
                1. Interest rates are not the sole determinate of savings and investing.
                2. Saving and investment are done by different people with different motives, may not be equal causing
                    goods to go unsold and inventories to increase.
                3. Saving is based upon "liquidity preference," the need to hold money
                    a) Transactionary Motives: for every day use.
                    b) Speculative Motives: save because prices may drop (Japan in late 1990's).
                    c) Precautionary Motives: save due to uncertainty (when a recession is expected).
                4. Investment decisions are based upon profit expectations and interest rates
                5. Money balances (savings) are also important in determining aggregate demand.

             b. Disagreed with price-wage flexibility: prices would adjust downward insuring all resources are fully employed.
                 1. Resource prices are inflexible downward meaning resource prices may not adjust and unemployment may persist.
                 2. Wages are sticky downward because of unions, monopoly power of corporations, and government policies.
             c. As a result, government involvement may be required to keep AD high enough to maintain full employment.
       
4. Manipulating equilibrium
            a. Classical economists didn't see a need as Real GDP was fixed..
            b. Keynesian economists want to manipulate AD by changing C + I + G + XN to maintain noninflationary full employment.

 

 

    The quantity theory of money  
        
1. Represents the basic theory behind macroeconomics prior to theKeynesian Revolution
         2. Believed that changes in the money supply would only affect price
and not economic activity.
         3. The equation of exchange
                                                                                         MV = PT
           
Money Supply X Velocity of Money  = Average Price Level X Number of Transactions

            a. Velocity of money is how often the money supply is spent.
             b. Number of transactions is real economic activity
            c. The equation is an identity
                1. Dollars spent = dollars received
                2. MV = Aggregate Demand and PT = Nominal GDP = C + I + G + XN = GDP 
            d. Classical theory stated that V was basically stable and that there existed some  natural level of
                 growth for T. 
                1. This natural level was a function of individual and business interaction. 
                2. V and T were essentially unalterable which meant changes in M would change P and not the natural
                     level of T. 
                3. Government should
therefore refrain from interfering with market activity by  adjusting the money
                    supply.
 
               4. Came into disfavor in the 1930's with the popularity of Keynesian economics which stated that real
                     output could be
                    changed by
affecting aggregate demand.   
    D. Monetarism
         1. Monetarists believe that changes in the money supply are both a
             necessary and sufficient condition to cause inflation.
          2. If AD was low, increasing the money supply would only increase
             short-run  economic activity. 
             a Eventually short-term expansion stops and increasing M only 
                adds to inflation. 
             b. Public anticipation stops the process from being repeated. 
             c. Monetarists believe that government involvement in the economy, 
                especially monetary intervention, increases the magnitude of the
                business cycle.

         3. Keynes believed changing the money supply would affect interest
             rates affecting investment affecting Real GDP
         4. To some degree monetarism is an extension of classical economics.  
              Advocates believe that a competitive market, free of government inter-
             ference, causing economic stability and a
reasonable growth rate
     E. New Classical economics states market forces and not government. 
         manipulation of aggregate demand and the money supply control 
         economic activity.
V. Money, Banking, and the Creation of Money (chapter13)
    A
. Functions of money
        1. Medium of exchange: facilitate exchange eliminating barter 
        2. Standard of value: allows for the pricing of heterogeneous goods.
        3. Store of value: maintains value and provides liquidity so extra spending power
             is available as needed.
        4. Standard of deferred payment: makes credit contracts possible so credit 
            transactions are possible.
    B. The supply and demand for money
         1. Three categories of the supply of money
             a. M1 = Currency, coins, and demand deposits (checking accounts). 
             b M2 = M1 plus near monies such as small time deposits (savings accounts) and
                short-term government securities. 
             c. M3 = M2 plus large time deposits (over $100,000)
         2. What backs the dollar?
             a. It is a debt of the federal government.
             b. Backed by faith in the government's ability to control inflation.
             c. Value is determined by acceptability (it is legal tender and scarce).
             d.  It's fiat (by decree of the government) money.
             e. Coins have little intrinsic value (a small % of face value), it's called token money.
             f.  Commodity money such as tobacco used as money in the Virginia colony has 
                 intrinsic value of its own.
  C. The Demand for Money 
         
1. Transaction D, Dt
, results because people hold money, 
              often in a money market account,
              to use as a medium of exchange.
          2. Asset Demand, Da, results because people accumulate money, 
             often held in an investment account, to buy assets.
          3. The demand for money Dm= D t + Da
          4. Interest rates are set in the money market.

   D. Maintaining money's value requires
       1. A sound fiscal policy (a reasonable federal debt)
      
2. A sound monetary policy (not using inflation to pay the federal debt)

    E. United States private banking system
         1. Two kinds of banks
             a. Commercial banks offer demand deposits (checking accounts)
             b. Savings and loan associations used to specialize in time deposits
                 (saving accounts) and home mortgages. Now, because of dereg-
                 ulation during the early 1980's, they are similar to commercial banks. 
         2. Federal deregulation contributed to banking difficulties in the 1980's.
   
   F. The Federal Reserve
        
1. Organization  
            
A Board of Governors oversee the Federal Reserve System
                1. Seven governors
                2. Governors are appointed by the President and confirmed by the Senate.
                3. The chair
is appointed by the President for a four-year term.
                    a)  To foster independence, the term does not coincide with the President's term. 
                    b) Other board members are appointed to 14-year terms on a staggered basis
                        to insure an experienced board.
           B. Federal Open Market Committee
               1. Membership consists of the Board of Governors and 5 of the 12 Federal Reserve
                   bank
presidents with the N.Y. president always a member because N.Y. City is the
                   financial center for U.S. international trade.
               2. The Committee tries to affect interest rates by affecting the supply of money by
                   buying and selling U.S. government bonds (See Chapter 15).
   
       C. Federal Advisory Council 12 prominent commercial bankers, one from each district,
                who advise the Board of Governors
           D. Twelve Federal Reserve Banks 
                
a. The United States is divided into 12 homogenous districts and each has its own bank

          

 
   
              b. Bank for the federal government
                 c. Bank for member banks
                 d. Graphic is complements of the Board of Governors of the 
                     Federal Reserve System.
                 e. Member commercial banks
                  f.  Nonmember commercial banks and thrifts are regulated by 
                     other government agencies
      
  2. Functions of the Federal Reserve
            a. Regulate the money supply
            b. Oversea the financial system
            c. Check collection and clearing
            d. Fiscal agent for the government
            e. Supervise (audit) member banks 
            f. Hold reserves (deposits) for member banks
            g. Compile economic statistics such as the 2010
BeigeBook, 
                which is a quarterly summary of  each districts' recent 
                economic activity.

VI. Keynesian Economics: An Expanded View  C + I + G + EN  
      A. Consumption and Saving
           1. Average Propensity to Consume (APC) is consumption (C)
              divided by income (Y). 
              a. APC = C/Y
              b. APC decreases as income increases as people can afford
                 to save.
           2. Marginal Propensity to Consume (MPC) is the change in 
               consumption divided by the change in income. 
              a. MPC decreases as income increases.
              b. This makes sense because when an average is falling, what is 
                  happening on the margin must be less.
                  1) Suppose your test average after one test is 90 and after
                      2 tests its 80.
                  2) Your second test had to be below 80 to pull the average
                      down. Test 2 was a 70 and (90 + 70) / 2 = 80. 
                                                   
         

Note: Points on a 45-degree line equate values on the x and y axes

    3. Saving (S) is income minus consumption. S = Y - C 
    4. Average Propensity to Save (APS) 
        a. APS = S/Y 
        b. If APC drops as income increases, then APS increases
            as income increases because APC + APS = 1
    
5. Marginal Propensity to Save is change in saving
        divided by change in income. 
        a. MPS increases as income increases because
            wealthy
            people can afford to save a higher percentage of
            income.
        b. This makes sense because when an average is rising, 
            what is happening on the margin must be higher.

                                                  

    6.
    7. Other factors affecting consumption and therefore saving
         include wealth (savings), expectations about personal 
         needs and future economic activity, and concerns about
         consumer, business, and government debt.


     B. Investment is business spending on capital
          goods,
inventory, and research &
          development.
          1. The level of investment is a function of
              expected profit,
interest rates, and the level
              of technology required
to maintain a desired
              competitive position.
          2. Investment spending tends to be somewhat
              volatile.
     C. Government Spending is assumed to be
          constant. 
     D. Net Exports, exports minus imports, are also
          assumed to be constant for this simplified
          model.

 

 

II. Aggregate Demand and Equilibrium
     A. Equilibrium (E) is where planned and actual AD and AS are equal.
          1. Equilibrium is where all goods produced for sale are sold. 
          2. At points below equilibrium, AD < AS, inventories are 
              building and business activity is contracting. This level of 
              economic activity was depicted by the horizontal (Keynesian)
              range of AS explained in the previous model.
          3. At points above equilibrium AD > AS, inventories are 
              decreasing and business activity is expanding as depicted
               by the intermediate range and eventually the classical range
               of AS.
          4. Economic activity (Real GDP) will be wherever AD
              intersects AS. Equilibrium seldom exists as economic
              activity is usually in one stage or another of the business
              cycle.   

    

B. If economic activity is not in balance, a dynamic situation
     exists and will continue until equilibrium is reached.
C. Keynes believed that E could settle at a level of
     economic activity with large amounts of unemployment.
     1. If potential Real GDP is greater than what actual AD
         yields, a recessionary gap exists and may persist
          indefinitely. The solution is to increase AD. 

      2. If potential Real GDP is less than what actual AD
          yields, an inflationary gap exists and the inflation
          may persist indefinitely.  The solution to this
          unacceptable level of economic activity is to
          decrease AD.

 

D. Multiplier Affect (K) is important to
         determining the change in AD needed to
         reach equilibrium E.
         1. Changes in AD will result in larger changes in
             NNP as increases are not spent and respent.
         2. Decreases in AD have a similar but opposite
            affect.
         3. K = 1/MPS = 1?(1-MPC) Note: As MPS
             increases, K decreases.
         4. A MPS is 20%, Multiplier is 5 as 1/20% =  
            1/(1/5) = 1X 5 = 5