GDP
Only type of good/transaction considered in GDP to avoid double-counting
What are final goods?
The Sum of Unemployed and Employed People in the Economy (definitions/what is not included)
Types of Unemployment
Natural Rate of Unemployment
What is the labor force? (Does not include retirees, miners, students, prisoners, informal workers, etc.)
What is not working in the previous week and actively have looked for the past 4 weeks? (Does not include discouraged workers)
What is frictional (workers between jobs, usually voluntary and short-term), structural (mismatch between skills of works and jobs demanded), and cyclical (business cycle recessions) unemployment?
What is having a paying job?(Not including informal work, or involuntary part-time employment. Including sick, vacation, on strike, etc.)
What is the equilibrium rate of unemployment consisting of frictional & structural unemployment?
1. Components to AE
a. Autonomous Components and Reason
b. Dependent Component and Equation
c. MPC Definition (= 0, =1) and MPS
2. Equilibrium Equation
1. What is AE= C+ IPL+G+NX?
a. What is I, G, and NX since they do not directly depend on the level of Y?
b. What is Consumption= cbar +MPC(Y-T)?
c. What is Marginal Propensity to Consume=(Change in C/Change in Y)? What is when MPC = 0 = 0% Consumption, 1= 100% consumption)? What is Marginal Propensity to Consume = 1-MPC?
2.What is Y*=[1/(1-MPC)]*cbar-MPCxT+IPL+G+NX?
Purpose
Made up of (# banks, controlled by (terms limits))
Dual Mandate (Changing Ms achieves Dual Mandate by...)
What is responsible for regulating the money supply and manage interest rates?
What are 12 banks and 7 members of the Board of Governors with 14-year terms (stagger every 2 years), with a chairperson appointed every 4 years?
What are price stability and high employment?
What is if i is high, households consume less, which makes firms borrow less, which lowers consumption and investment, and therefore lowers Y?
1. Aggregate Demand (Explain Downwards Sloping)
2. Short-Run Aggregate Supply (SRAS) (Explain Upwards Sloping)
3. Long-Run Aggregate Supply (LRAS) (Explain Vertical Slope)
1. What is total quantity of goods and services demanded at various price levels? What is the wealth effect (higher prices reduce purchasing power and consumption) and interest rate effect (higher prices increase interest rates, reducing consumption and investement?
2. What is the total quantity of goods and services producers are willing to supply at different price levels in the short run? What are firms responding to changes in price levels by adjusting their production levels?
3. What is the long-run relationship between the price level and quantity of Real GDP supplied by firms? What is in the LR prices are fully adjusted so output is only determined by factors like labor, capital and technology?
3 Measures of GDP and Caveats (Specify which we use and what goes into it)
What is the production approach (adding up all production in an economy)? What is no incentive to tell real value since it is taxable)?
What is the income approach (add up all income from final sales)? What is income distribution?
What is the expenditure approach (add up all purchases in a year)? What is what was bought in a year does NOT equal what was produced, illegal, informal, and black-market are not included, and non-market activities not counted?
What is Y= C (Consumption=spending by households/services) + I (Investment= spending by firms on new machinery, buildings, software, etc.) + G (Government Expenditure=spending by federal, state, and local gov't on goods/services) + NX (Net Exports= Exports-Imports, intermediate goods included)
3 Functions of Money
What is medium of exchange (gets around "double coincidence of wants", unit of account (standardized comparability ("price"), and store of value (grain can spoil, gold can't)?
Captures the feedback loop between C & Y and shows the total impact of a change in fiscal policy on national income (Equation)
a. Amplifies the effect of... (give equations)
b. Change in GDP=
What is The Multiplier? What is 1/1-MPC?
a.What is autonomous consumption G & T?
G Multiplier = 1/(1-MPC)
T Multiplier (-MPC/(1-MPC)
b. Initial Spending x Multiplier
Tools of Monetary Policy and Effect on Ms (+Main Tool)
1. Reserve Ratio Requirement (Simple Money Multiplier)
2a. Discount Rate
b. Federal Funds Rate
3. Open Market Operations
1. What is the amount of money banks are required to have on hand at all time to control how much money banks create through bank lending? What is 1/RR = amount of money created? What is if RR increases, banks cannot lend out as much, which decreases Ms?
2a. What is the interest rate the Fed charges commercial banks to borrow from the Fed? What is if the discount rate increases, banks are less willing to borrow from the Fed and lend out less money themselves, which decreases Ms?
b. What is the rate banks charge to each other for loans?
3. What is the buying and selling of T-bills by the FRBNY? What is buying T-bills increases Ms while selling T-bills lowers Ms?
Cause, Effects and Solutions to AD Shifts
Outwards
Inwards
Causes: Positive demand shock, expansionary policy, optimistic expectations, increased wealth
Effects: EXPANSION: YSR>Y*, price levels rise causing inflation (PSR>P*), low unemployment, higher costs for firms
Solutions: Short Run: Contractionary monetary policy Long Run:(low unemployment -> workers demand higher wages => firms face higher costs -> shifts SRAS in to YLR=Y*, PLR>P*
Causes: Negative demand shock, Contractionary monetary or fiscal policy, pessimistic expectations, decreased wealth
Effects: RECESSION: YSR<Y*, PSR<P*, high unemployment -> downwards wage pressure -> lower costs for firms
Solution: Short Run:Expansionary monetary policy Long Run:-> firms offer lower wages => decrease costs -> shifts SRAS out to YLR=Y*, PLR<P*
Consumer Price Index (purpose, equation, notes)
Inflation Rate (purpose, equation)
Real Interest Rate (purpose, equation)
What is measures the change in the price level of a basket of consumption goods over time? What is CPIt=(value of basket this year t)/(value of basket in base year)*100? What is base year CPI is always = 100 and CPI is unitless?
What is to show how inflation impacts purchasing power? What is Inflation Rate=[(CPIt-CPIt-1)/CPIt-1]*100?
What is since it adjusts the nominal interest rate for the effects of inflation to reflect the true cost of borrowing or the real return on investment? What is Real Interest Rate (r)= Nominal Interest Rate (i) - Inflation Rate (π)?
You invest $5,000 in an account that earns an annual interest rate of 6%, compounded yearly. What will the value of your investment be in 8 years?
What is $7,979.69?
FV=PV(1+r)n
FV= 5,000 (1+.06)8
1. Keynesian Cross Components
a. Meanings of Equilibrium Line, Slope of the AE curve, Y*
b. Intercept
2. Reasons of Y* Shifts (Explain logic)
1. What is a graph representing the relationship between AE and National Income (Y), with AE is on Y axis, Y is on X axis?
a. What is Y=AE is a 45° line, where all output is being purchased? What is the AE curve=MPC, showing how total spending changes as income changes? What is where AE curve crosses the 45° line?
b. What is cbar-MPC*T+G+IPL+NX?
2. a. Y* Shifts Up: What is increasing cbar, IPL, G, and NX => increases AD? What is if MPC increases, people are more likely to spend additional income => increasing AD?
b. Y* Shifts Down: What is increasing taxes (T) reduces disposable income is reduced which decreases consumption?
Expansionary Monetary Policy
Contractionary Monetary Policy
What is increasing the money supply and lowering interest rates, which boosts consumption, investment, and overall economic output (Y)?
What is decreasing the money supply and raising interest rates, which reduces consumption, investment, and overall economic output (Y) to control inflation?
Cause, Effects and Solutions to SRAS Shifts
Outwards
Inwards
Phillips Curve
Causes: Positive supply shock, Improvements in technology, increase in labor or capital stocks, lower input prices (cheaper natural resources)
Effects: EXPANSION: YSR>Y*, price levels fall (PSR<P*) deflation, increased production leads to lower unemployment in SR
Solutions: SR: No immediate intervention unless deflation occurs -> stimulate demand LR: low unemployment -> workers demand higher wages -> firms face higher costs -> shifts SRAS in to YLR=Y*, PLR=P*
Causes: Negative supply shock (higher oil prices/scarce resources), increased input prices (higher wages or material costs)
Effects: RECESSION + INFLATION=STAGFLATION: YSR<Y*, price levels rise PSR>P*, high unemployment coexists with high inflation, reduced output
Solution: high unemployment ->firms offer lower wages => decrease costs -> shifts SRAS out to YLR=Y*, PLR=P*, If inflation is severe, contractionary policy can solve inflation but worsen unemployment
What is an inverse relationship between inflation and unemployment?
Suppose that a country produces two goods: pens and notebooks. In Year 1, it produces 10 pens and 5 notebooks, with prices of $2 per pen and $4 per notebook. In Year 2, it produces 15 pens and 8 notebooks. The price of pens increases to $3 each, and the price of notebooks remains $4 each.
What is Nominal GDP in Year 2 is $69?
What is Real GDP in Year 2 is $62
What is Real GDP isolates production growth, while Nominal GDP includes both production and price changes?
These types of assets are categorized into M1, M2, M3, or M4, each representing different levels of liquidity. For the following assets, identify which category they fall into and explain why:
1. A $10,000 balance in a money market mutual fund
2. A $1,000,000 corporate bond
3. $500 in currency and coins
4. $500,000 certificate of deposit
1. What is M2 (liquid but not part of M1)?
2. What is M4 (long-term financial assets)?
3. What is M1 (most liquid form of money)?
4. What is M3 (CDs with maturity > 1 year)?
1. Economic state when Y<Y* and policy pursued to stabilize economy
2. Economic state when Y>Y* and policy pursued to stabilize economy
What is a recession and expansionary fiscal policy, which involves increasing gov't spending and/or cutting taxes to boost AD and increase Y?
What is an expansion and contractionary fiscal policy, which involves decreasing government spending and/or cutting taxes to lower AD and decrease Y?
The Federal Reserve decides to implement contractionary monetary policy to reduce inflation. As part of this policy, the Federal Reserve raises the federal funds rate.
1. Affect on borrowing costs and overall economic activity
2. Short-term effects on inflation as a result of this policy
c) Why might the Federal Reserve consider these trade-offs (e.g., higher unemployment) as part of its broader goal to stabilize the economy?
1. What makes borrowing more expensive for banks, leading to higher interest rates for consumers and businesses, which slows down overall economic activity?
2. What is an increase in inflation? Consumer and business borrowing is reduced which cools demand and pressure on prices
3. What is controlling inflation is crucial for long-term economic stability? High inflation can hurt purchasing power and disrupt economic growth, so the trade-off is necessary to maintain overall price stability.
LRAS Shifts
Outwards
Inwards
Inflation must happen because:
Outwards: increases in productivity, tech, labor, or capital
Inwards: decreases from destruction of resources or workforce reduction
What is small, sustained changes in demand or supply factors which shift LRAS?
A country experiences an increase in nominal GDP, but its real GDP remains constant. At the same time, the Consumer Price Index (CPI) rises, and the central bank increases nominal interest rates.
What is an increase in Nominal GDP but not Real GDP indicates that the change is purely due to inflation since the actual production has not changed? What is also the rise in CPI also suggests that prices are rising, due to inflation not because of economic growth?
What is real interest: either stay constant if the nominal interest rate matches inflation or decrease if inflation rises faster than nominal rate adjustment?
What is staglation or inflation without real economic growth? What is the central bank tightening monetary policy to control inflation?
Economic concept that explains why, as interest rates rise, people tend to...
What is hold less money in liquid forms like M1 and M2 in favor of earning returns on investments or savings accounts?
Suppose an economy is experiencing an economic downturn, and the government decides to implement a fiscal stimulus package. Autonomous consumption increases by $200 billion, and government spending increases by $150 billion. Assume the change in taxes is the same as government spending. The marginal propensity to consume is 0.8, and the tax rate (T) is 0.2. NX and IPL are assumed to remain constant.
1. If actual consumption exceeds the economy's potential output after the increase in government spending and consumption, what does this imply about the state of the economy? What policy would you recommend to restore equilibrium and why?
2. Calculate the government and tax multiplier and interpret the values. Why would a change in government spending impact the overall economy differently than a change in taxes? (Don't need to answer in the form of a question)
1. What is if Y<Y*, the demand is outpacing the economy's capacity to produce goods and services sustainably, which could lead to inflationary pressures? What is contractionary fiscal policy would be necessary to reduce AD?
2. G Multiplier=1/(1-MPC) x Δ G = 1/(1-.8) x 150 = 750 billion dollars
An $150 billion increase in G leads to a $750 billion increase in GDP.
T Multiplier=-MPC/(1-MPC) x Δ T = -0.8/(1-.8) x 150 = -600 billion dollars
An $150 billion tax change in T leads to a -$600 billion decrease in GDP.
Government spending has a full, direct impact on AD because it increases demand without any intermediary steps. Tax changes only affect disposable income, and only a fraction of that (determined by MPC) is consumed, leading to a smaller impact on AD compared to direct gov't spending.
Don't answer as a question!!
The Federal Reserve raises the federal funds rate from 2.5% to 3.5% to combat rising inflation. Consider the following data and economic conditions:
- The average elasticity of investment with respect to the interest rate is -0.4.
- The marginal propensity to consume (MPC) is 0.8.
- The potential GDP growth rate is 2.5% per year.
1. Calculate the impact on aggregate demand from a 1% reduction in investment. How might this impact the output level?
2. If the Fed’s increase in the federal funds rate leads to a 5% reduction in private investment due to the interest rate hike, calculate the potential change in GDP, assuming the economy operates below potential GDP.
3. How would the Federal Reserve use this information to assess the trade-off between combating inflation and risking a slowdown in economic growth? Include both short-term and long-term considerations.
4. In a dynamic model, how might the changes in the federal funds rate affect inflation expectations over time? Quantify the potential change in inflation if inflation expectations decrease by 0.5% for each 1% increase in the federal funds rate.
1. Multiplier=1/1-MPC=1−/1-0.8=5 Since the investment multiplier is 5, a 1% reduction in investment leads to a 5% reduction in aggregate demand.
2. Change in GDP=5×5%=25% Potential change in GDP is a 25% decrease in output from the level of investment. If the economy is operating below potential GDP, this could contribute to a further contraction in economic activity.
3. Short-Term Effects:Increases in the federal funds rate reduce inflationary pressure by discouraging borrowing and spending, reduced borrowing and spending lead to a decline in investment and aggregate demand, slower economic growth and a potential increase in the unemployment rate may result.
Long-Term Effects:Lower inflation contributes to a more stable and sustainable economic environment, fostering long-term growth, if demand contracts excessively, the economy may weaken, requiring the Federal Reserve to reverse its policy in the future.
4. Change in inflation expectations=0.5%×(3.5%−2.5%)=0.5% This decrease in inflation expectations would help reduce actual inflation over time, as businesses and consumers adjust their behavior in anticipation of lower future prices.
The economy of Liechtenstein is experiencing an increase in aggregate demand due to a significant rise in consumer confidence and government spending. The initial equilibrium output is Y0 at the price level P0, and the economy is operating at full employment, with output at Y*. Due to the increase in demand, the economy shifts along the aggregate demand curve, causing inflationary pressures.
1. Given that the marginal propensity to consume (MPC) in Liechtenstein is 0.75, calculate the initial increase in aggregate demand if government spending increases by $100 billion.
2. After the increase in government spending, output rises to Y1, which is greater than Y∗. Assume that the economy's potential output (Y∗) is $1,200 billion and that the new output after the increase in demand is Y1=1,350 billion. Calculate the inflationary gap and interpret the value.
3. The central Bank of Liechtenstein is concerned about rising inflation and has decided to implement a contractionary monetary policy to restore the economy to full employment. The central bank plans to reduce aggregate demand by 5%. Calculate the necessary reduction in government spending to achieve this demand reduction.
4. Explain the short-term and long-term effects on the price level and output of Liechtenstein, considering the following factors:
-The short-term effects of the contractionary monetary policy.
-The long-term adjustments to the economy as it returns to full employment.
1. Use the G multiplier: 1/(1-MPC) x ΔG = 1/(1-.75) x 100= The initial increase in AD is $400 billion.
2.
The inflationary gap is the difference between the new output and the potential output:
Inflationary Gap=Y1−Y∗=1,350 billion−1,200 billion=150 billion
3. Target reduction in AD=5%×1,350 billion=67.5 billion. We have to use the multiplier from Part 1 to calculate the necessary decrease in Gov't spending: ΔG=Target reduction in AD/Multiplier=67.5 billion/4=16.88 billion
4. Short Term: Contractionary monetary policy (e.g., raising interest rates or reducing money supply) will lead to a decrease in aggregate demand -> a reduction in output, bringing the economy closer to its potential level of output (Y*) and reducing inflationary pressures. The price level will likely fall or stabilize due to decreased demand.
Long Term: as the economy adjusts to the full employment level (Y*), the price level may increase if demand continues to rise slowly, even after the monetary tightening. The economy will return to full employment with stable output. Still, the price level may be slightly higher than initially as inflationary pressures from the initial increase in demand are addressed. If the contractionary policy is effective, the economy will stabilize around its potential output at Y*, and inflation will return to a more manageable level.