ECON102 Study Guide

Site: Saylor Academy
Course: ECON102: Principles of Macroeconomics
Book: ECON102 Study Guide
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Date: Tuesday, February 20, 2024, 5:10 PM

Navigating the Study Guide


Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

  • questions for you to answer independently;
  • a brief summary of the learning outcome topic;
  • and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

 

How to Use the Study Guide

  1. Review the entire course by reading the learning outcome summaries and suggested resources.
  2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Overview of Economics

You may also refer to this Macroeconomics Study Guide to review definitions, calculations, and succinct explanations throughout this course.

 

1a. Identify the determinants of demand and supply

Demand

Markets consist of buyers and sellers. Demand is a term that describes the behavior of buyers in the market.

The Law of Demand – What is the relationship between quantity demanded and the price of a good? Do we consume more or less of a good when prices increase or decrease? How does the law of demand help us answer these questions?

Demand Determinants – Many factors affect demand, including income, prices of related goods, population, preferences, etc. Factors other than price are "shifters" of demand – changes in these variables cause the demand curve to shift up or down.

As you study this material, pay attention to the differences between substitutes and complements and their effect on demand. Furthermore, distinguish between normal and inferior goods, and the effects of income on demand for each of these types of goods. Study the effect of these variables on demand by reviewing the graphical analysis presented in the course materials.

The most important determinants of demand include:

  • Preferences;
  • Prices of related goods and services;
  • Income;
  • Demographic characteristics;
  • Buyer expectations.

IMPORTANT: Pay particular attention to the difference in effects caused by the price of the good and the shifters of demand. A change in the price of a good will not shift the demand curve but cause a movement along the demand curve.

Students may confuse demand and quantity demanded. Consider that quantity demanded is illustrated on a specific point on the demand curve. When the price of the good changes, there is a movement along the demand curve which represents a change in quantity demanded, but demand itself remains in the same position ... it does not change. Subsequently, if an exam question asks you whether demand for a good changes when its price changes, the answer is "no". Demand itself does not shift, only quantity demanded changes.

The Difference Between Change in Quantity Demanded and Change in Demand

The Difference between Change in Quantity Demanded and Change in Demand

It is critical to distinguish between a change in quantity demanded, which is a movement along the demand curve caused by a change in price, and a change in demand, which implies a shift of the demand curve itself. A change in demand is caused by a change in a demand shifter. An increase in demand is a shift of the demand curve to the right. A decrease in demand is a shift in the demand curve to the left. The above drawing of a demand curve highlights the difference.

Supply

Supply describes the behavior of sellers in the market. The analysis of supply follows a similar path as the analysis of demand in the previous section.

The Law of Supply – What is the relationship between quantity supplied and the price of a good? Do producers have an incentive to produce and sell more or less of a good when its price increases or decreases? The Law of Supply can help us answer these questions.

Supply Determinants – Many factors affect supply. Factors other than price are "shifters" of supply: changes in these variables cause the supply curve to shift up or down. Study the effect of these variables on supply by reviewing the graphical analysis presented in the course materials.

The most important determinants of supply include:

  • Prices of factors of production;
  • Returns from alternative activities;
  • Technology;
  • Seller expectations;
  • Natural events;
  • The number of sellers.

IMPORTANT: Pay particular attention to the difference in effects caused by the price of the good and the shifters of supply. A change in the price of a good will not shift the supply curve, but cause a movement along it. Why is the price of the good not a shifter of supply?

It is easy to confuse supply and quantity supplied. Consider that quantity supplied is illustrated at a specific point on the supply curve. When the price of the good changes, there is a movement along the supply curve which represents a change in quantity supplied but supply itself remains in the same position … it does not change. Subsequently, if an exam question asks you whether supply for a good changes when its price changes, the answer is "no". Supply itself does not shift, only quantity supplied changes.

The Difference Between Change in Quantity Supplied and Change in Supply

The Difference between Change in Quantity Supplied and Change in Supply

It is critical to distinguish between a change in quantity supplied, which is a movement along the supply curve caused by a change in price, and a change in supply, which implies a shift of the supply curve itself.

A change in supply is caused by a change in a supply shifter. An increase in supply is a shift of the supply curve to the right. A decrease in supply is a shift in the supply curve to the left. The above drawing of a supply curve highlights the difference.

1b. Describe how changes in demand and supply lead to changes in a market's equilibrium price and quantity

  • What will happen in a free market when a sudden change in demand or supply causes a shortage to occur at the original price? Think about the effect of a shortage on the price of the good.
  • What will happen in a free market after a sudden surplus?
  • Will sellers have an incentive to raise or lower their prices to eliminate the surplus?
  • What happens to the equilibrium point if the government imposes a price control (such as a price ceiling or a price floor)?

Now, let's review two more central concepts to the study of economics which we also explored in ECON101 Microeconomics: equilibrium price and quantity.

In a free market, capitalist, economic system, economists say that buyers and sellers will eventually achieve an equilibrium: the point where demand and supply intersect to create an equilibrium price and quantity in the market. Note that a completely free market economy will always reach equilibrium.

Note that government intervention means the market is no longer free and unable to respond freely. Remember to distinguish among price controls that are binding or effective, and those that are not. As you review this material, it is helpful to draw graphs of demand and supply to analyze the changes in the equilibrium point that result from shifts in demand or supply.

To review market equilibrium, see Demand, Supply, and Equilibrium, Market Equilibrium, Changes in Market Equilibrium, and Putting Demand and Supply to Work. Be sure to practice this section thoroughly by completing any accompanying exercises and practice problems.

 

1c. Distinguish microeconomics from macroeconomics

  • Define and explain the difference between microeconomics and macroeconomics.
  • Name the major economic aggregates macroeconomics analyzes.
  • What are the values for these variables in the United States?
  • What are the main goals of U.S. economic institutions (including government) with regards to the macroeconomy?

Microeconomics is the field of economics that focuses on individuals, businesses, and their decisions in the marketplace. Macroeconomists, on the other hand, study the entire aggregate economy in a given country and use the statistics they derive to make comparisons about similar economic trends in other countries.

To review microeconomics and macroeconomics, see The Field of EconomicsMacroeconomics, Introduction to Macroeconomic Data, and Economic Growth.

 

1d. Describe the circular flow model, identifying linkages between the markets for goods and resources as well as the exchanges between businesses and households

  • Define the business sector, the household sector, the government sector, the financial sector, and the global marketplace.
  • Describe the flow of payments and resources among these economic entities.

A circular flow diagram is one of the most important models in economics because it identifies the economic components and players and their interdependencies.

Spending = Production

Production = Payments to Inputs

Payments to Inputs = Income

Income = Spending

The Circular Flow Diagram

The circular flow of income describes how money flows among different sectors of the economy. This representation includes the five main sectors: households, firms, the government, the financial sector, and the global marketplace.

The Circular Flow Diagram

Unit 1 Vocabulary

  • Business sector
  • Change in demand
  • Change in quantity demanded
  • Change in quantity supplied
  • Change in supply
  • Circular flow diagram
  • Complements
  • Demand
  • Demand shifter
  • Equilibrium
  • Financial sector
  • Global marketplace
  • Government sector
  • Household sector
  • Inferior goods
  • Inventory
  • Law of demand
  • Law of supply
  • Normal goods
  • Quantity demanded
  • Quantity supplied
  • Shortage
  • Substitutes
  • Supply
  • Supply shifter
  • Surplus

Unit 2: Macroeconomics: Goals, Measures, and Challenges

2a. Define nominal gross domestic product and real gross domestic product

  • Define servicesdurable goodsnondurable goodsstructures, and change in inventories.
  • Define gross domestic product (GDP).
  • Define market value.
  • Define final and intermediate goods and services.
  • How does including intermediate goods and services or inputs to production when calculating GDP reflect double counting?
  • Does the calculation for GDP include the value of goods and services that foreign nationals (residents who are not citizens) produce?
  • Does the calculation for GDP include the value of goods and services that all nationals (citizens who live in foreign countries) produce?

Definition and Components of Gross Domestic Product

The concept of gross domestic product (GDP) is central to macroeconomics. The media and government officials and the media use it to document the health of a country's economy. The size of a nation's overall economy is typically measured by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year.

Remember four central elements economists use to calculate gross domestic product (GDP) from this definition:

  1. market value;
  2. final goods and services;
  3. within one country; and
  4. during one given year.

Gross domestic product (GDP) tallies up the services, durable goods, nondurable goods, structures, and change in inventories a country produces. GDP measures domestic economic activity.

When we calculate gross domestic product (GDP) or economic activity from this supply-side or output-driven perspective, we tend to focus on the physical objects an economy produces, such as cars, machines, or computers. However, the services comprise the largest part of today's gross domestic product (GDP) by far.

In today's economy, most jobs involve working behind a computer screen, coordinating activities, creating plans, and meeting with our co-workers, customers, and suppliers to cater to the needs of our individual customers and clients. Today's leading service industries include healthcare, education, and legal and financial services. Do not forget to include these major producers when you think of GDP.

Economists assign five categories to the goods and services they include in GDP: services, durable goods, nondurable goods, structures, and the change in inventories.

  1. We just explored services.
  2. Durable goods include long-lasting items, such as cars and refrigerators.
  3. Nondurable goods include short-lived items that last less than a year, such as food and clothing (this category includes clothing even though many clothes last longer than a year!).
  4. Structures include homes, office buildings, shopping malls, and factories.
  5. Inventories refer to the goods a business has already produced, but not yet sold to consumers. They are sitting in warehouses and on shelves.
To review GDP, see:

 

2b. Compare and contrast as well as discuss various measures of output and income

  • Define consumptioninvestmentgovernmentexports, and imports.
  • Does investment refer to financial capital or physical capital?
  • Which component reflects new home purchases?
  • What common unit of measurement do economists use to measure GDP?

In national income accounting, we calculate the GDP to identify economic activity in a given country. Economists use two primary methods to calculate GDP: the income and expenditure methods. These calculations of GDP should produce the same result: every transaction has a seller who receives income from the sale proceeds and a buyer who spends money to purchase goods and services. The nationally-reported numbers for income and expenditures frequently differ slightly due to errors or omissions in measurement and reporting.

Seller receives income from the sale of the product or service (income approach)

Product or service (market value)

Buyer spends money to purchase the product or service (expenditure approach)

Until this point, we have calculated GDP in terms of the supply side, business income, and total production of domestically-produced goods and services. This task is straightforward: take the quantity of everything a country produces and multiply this quantity by the price for each product sold. This calculation describes an income-based approach.

To calculate GDP, the expenditure approach focuses on consumer demand or total amount households, business, government, and foreign sectors spend to purchase domestic goods and services.

Demand or Expenditure Side of GDP

From the demand or expenditure perspective, GDP includes four main components:

  1. Consumption – consumer spending or expenditures on final goods and services;
  2. Investment – business spending or expenditures on new capital equipment, inventory, structures, and consumer spending or expenditures on new homes;
  3. Government – expenditures;
  4. Spending or expenditures on net exports – the trade balance.

Note that we need to remove imported goods from our equation of gross domestic product (GDP). As its name suggests, GDP should only reflect goods and services produced domestically. Imports describe goods and services produced in a foreign country. In our equation for GDP from the demand side, we must subtract imports (M) because consumption (C) includes ALL consumption spending, including the purchase of imported goods.

GDP = Consumption + Investment + Government + Trade balance (exports – imports)

GDP = C + I + G + (X – M)

Measuring Total National and Domestic Income

  • Define national income and gross domestic income (GDI).
  • Define employee compensationprofitsrental incomenet interestdepreciation, and indirect taxes.
  • Which component of GDI is the largest?

National income includes all wages or employee compensation, profits, rental income, net interest, depreciation, and indirect taxes. Gross domestic income (GDI) restricts national income to the income residents earn within a country's borders.

To review gross domestic income (GDI), see:

 

2c. Distinguish between real and nominal values

  • Define real GDP and explain the difference between real and nominal values?
  • How do economists calculate real values?
  • Define the GDP deflator and how economists use it used to calculate real GDP?

Consider the measure of gross domestic product (GDP) we studied in the previous section as nominal GDP because it describes total spending in the economy: we measure the prices for goods and services at the time of the calculation.

While nominal GDP measures overall spending, it may not accurately portray whether the economy has really grown, or has really been more productive from one year to the next. We need to eliminate the effect of inflation when making these types of comparisons to get a more accurate reading of how well the economy is really doing.

For example, when we compare nominal GDP in 2017 ($18 trillion dollars) to nominal GDP in 2018 ($20 trillion dollars), we do not know if the $2 trillion increase was due to higher production levels or higher prices (inflation). The economy grew if the increase was due to higher production levels − a great outcome. However, if the $2 trillion increase was due to a rise in prices, we attribute the increase in nominal GDP to inflation, not production. A large increase in inflation could hide the fact that production levels may have held stagnant or even dropped.

The concept of "real" GDP removes the effect prices and inflation have on GDP. An increase in real GDP always means the economy is growing; a drop in real GDP always means that the economy is contracting.

To review, see:

The Business Cycle

Economists use real GDP to evaluate and make comparisons about economic activity over time. Economists say the economy is in a recession when GDP falls for two successive quarters. A depression describes a severe or prolonged economic downturn, specifically a recession that lasts more than two years. We explore the business cycle in more detail in Unit 4.

Figure 6.10 U.S. GDP, 1900–2014

U.S. GDP, 1900–2014

This figure shows the pattern of U.S. real GDP since 1900. The generally upward long-term path of GDP has been regularly interrupted by short-term decline. A significant decline in real GDP is called a recession. An especially lengthy and deep recession is called a depression. The severe drop in GDP that occurred during the Great Depression of the 1930s is clearly visible in the figure, as is the Great Recession of 2008–2009.

To review, see Tracking Real GDP over Time.

 

2d. Analyze the problems associated with using GDP as a measure of well-being

  • Define service sectorhousehold productionunderground economy, and leisure.
  • Explain some measurement problems that exist with GDP calculations, such as when we measure production from the service sector, household production, the underground economy, and leisure.
  • Explain how GDP can present a misleading measure of economic well-being, such as toxic elements of production or negative byproducts, such as crime, disease, and pollution.

While gross domestic product (GDP) provides a good overall measure of economic well-being, it is not a perfect measure. Certain measurement problems reduce its accuracy.

2e. Identify the components of the expenditure and the income approaches to the measurement of GDP

Review the components of the expenditure and income approaches to the measurement of GDP in learning outcome 2b above.

 

2f. Explain how consumer income relates to spending and saving

In economics, investment refers to investment in physical capital, not investment in financial capital. Consumption refers to household spending on new final goods and services, except for new home purchases which we consider investment.

For example, economic investment includes spending on machinery and equipment, factories, inventories, and new houses. Investments in financial assets, such as stocks and bonds, are not economic investments for the purposes of economic theory.

Savings and consumption are linked to disposable income. We spend disposable income (after-tax income) in two ways: for consumption and savings. Saved income is a funding source for investment.

For example, we consider the money we deposit into a savings account, "savings". However, the bank where we deposit our money, will loan our savings out to other individuals and businesses, who may use the money to expand or start a new business (investment).

Consumption + Savings = Disposable Income

Savings = Investment

To review, see Investment and Consumption.

 

2g. Describe the consumption and savings functions and the terms attached to their slopes

Review the shape of the long-run aggregate supply curve and factors that shift this curve over time. We review the production possibility curve in more detail in Unit 4.

To review, see Aggregate Demand and Aggregate Supply and Long-Run Aggregate Supply.

 

2h. Define automatic stabilizers, and explain changes in government spending and taxing during a macroeconomic recession and expansion

  • Define automatic stabilizer.
  • Define transfer payments and progressive income taxes.
  • Explain how transfer payments, progressive income taxes, budget deficits, and budget surpluses work as automatic stabilizers.

Fiscal policy describes the power governments have to influence the aggregate economy, real GDP, and the price level (inflation or deflation) through spending and taxation. Governments use discretionary fiscal policy tools (laws and legislation) and automatic stabilizers to influence the economy. We will review discretionary fiscal policy in more detail in unit 5.

As their name implies, automatic stabilizers work automatically and usually in a direction that is opposite to the direction the economy is taking to achieve stabilize the economy. For example, automatic stabilizers stimulate aggregate demand and real GDP during periods of recession. They reduce aggregate demand and real GDP during economic upswings or periods of economic growth, because too much expansion can cause inflation to spiral out of control. Unemployment and welfare benefits, and the individual and business tax rate, are examples of automatic stabilizers.

2i. Describe how savings and investment contribute to economic growth

Review how savings and investment contribute to economic growth in learning outcome 2f above.

 

2j. Define economic growth in terms of changes in the production possibilities curve and in real gross domestic product

Review economic growth and real gross domestic product where we discuss aggregate demand in learning outcome 2g. Review the production possibilities curve in learning outcome 7d in Unit 7.

 

Unit 2 Vocabulary

  • Automatic stabilizer
  • Business cycle
  • Consumer demand
  • Consumer preferences
  • Consumption
  • Depreciation
  • Depression
  • Disposable Income
  • Double counting
  • Durable good
  • Employee compensation
  • Export
  • Final good and service
  • Financial capital
  • Foreign national
  • GDP deflator
  • GDP per capita
  • Government expenditure
  • Gross domestic income (GDI)
  • Gross domestic product (GDP)
  • Gross national product (GNP)
  • Household production
  • Import
  • Income
  • Indirect tax
  • Interest
  • Intermediate good
  • Investment
  • Market value
  • National
  • National income
  • Net national product (NNP)
  • Nominal value
  • Nondurable good
  • Physical capital
  • Progressive income tax
  • Real GDP
  • Real value
  • Recession
  • Savings
  • Service sector
  • Trade balance
  • Trade deficit
  • Trade surplus
  • Transfer payment
  • Underground economy

Unit 3: Unemployment and Inflation

3a. Define unemployment rate

  • Define employed and unemployed.
  • Define labor force. Name some examples of the types of people who are part of, and outside the labor force.

According to the U.S. Bureau of Labor Statistics, individuals are unemployed if they are not working, but available, and actively looking for a job. For economists, the unemployment rate provides a key measure for how well the economy is doing. The unemployment rate details the percentage of adults who are part of the labor force who do not have a job, not the percentage of every person who is not officially employed. So for example, the unemployment rate does not include children, retirees, full-time students, people who work from home and do not earn a salary, volunteers, and people who are not actively seeking employment.

You need to calculate the total labor force to calculate the unemployment rate.

Unemployment rate = Unemployed people / Total labor force × 100

This figure helps identify unemployed members of the labor force.

Figure 5.4 Computing the Unemployment Rate

Computing the Unemployment Rate

To review unemployment, see:

 

3b. Calculate the unemployment rate

Review how to calculate the unemployment rate in learning outcome 3a above.

 

3c. Identify and distinguish between the different forms of unemployment

  • Define frictionalstructural, and cyclical unemployment.
  • Explain whether these three types of unemployment are good, acceptable, or undesirable.
  • Which type of unemployment indicates the economy is performing poorly and may need a correction?
  • Can an economy achieve a zero unemployment rate?
  • Define natural employment level or full employment.

Economists distinguish three types of unemployment: frictional, structural, and cyclical unemployment.

To review the different forms of unemployment, see:

 

3d. Analyze the problems associated with the unemployment rate

  • Name some imperfections in the process the U.S. Bureau of Labor Statistics uses to measure unemployment.
  • Define hidden unemploymentunderemployment, and what economists mean when they refer to discouraged workers.
  • What factors cause the unemployment rate to overstate the true level of unemployment?
  • What factors cause the unemployment rate to understand the true level of unemployment?

As with many policy calculations, the unemployment rate provides an imperfect measure of the economy. The unemployment rate may understate or overstate real unemployment in the economy.

To review, see Unemployment.
 

3e. Describe the three types of unemployment and factors that relate to them

Review these three types of unemployment (cyclical, frictional, and structural) in learning outcome 3c above.

 

3f. Define inflation and deflation, and explain how each affects the price and economic growth of an economy

  • Define inflationdeflation, and hyperinflation.
  • Explain why an economy can experience a period of inflation while some prices are falling.
  • Does an economy experience inflation when prices have been high for a long time?
  • Explain how inflation, deflation, and hyperinflation can negatively impact borrowers, lenders, retirees, and the general economy.

Inflation refers to a rise in the average price level. Deflation describes a fall in the average level of prices. Governments aim to steer their economies toward a steady, one or two percent inflation rate, rather than zero percent.

To review inflation and deflation, see:

 

3g. Define, interpret, and calculate inflation rate and the consumer price index

  • Define consumer price index (CPI)producer price index (PPI)GDP deflator (or implicit price deflator), employment cost index, and international price index.
  • What specific baskets of goods do each of these price indexes measure?
  • Define base period and the value of an index in the base period.

Economists use various price indexes to calculate and compare price fluctuations for specific baskets of goods and services during specific time periods. The three primary price indexes economists in the United States use include: the consumer price index (CPI), producer price index (PPI), and the GDP deflator (or implicit price deflator).

Review these steps for calculating the inflation rate.

  • Identify the basket of goods you want to use to calculate the inflation rate. For example, for the consumer price index (CPI) you need to identify the specific goods and services a typical consumer buys, such as specific foods, gas, or clothes.
  • To calculate the cost of the basket of goods and services for the base and current years, multiply the price of each good by its quantity and add all of the goods and services in the basket.
  • To calculate the price index, divide the cost of the basket in the current year by the cost of the basket in the base year.
  • To calculate the rate of inflation, take the percentage change in the cost of the basket or the percentage change in the price index.

To review these calculations, see:

 

3h. Describe the problems and biases associated with the consumer price index

While a consumer price index (CPI) provides a useful measure of inflation, as with all economic variables, it has some limitations. Think about the following sources of bias for the consumer price index.

  • Since economists calculate indexes based on a fixed basket of goods and services, they do not account for substitutions consumers use when prices change.
  • Companies frequently offer consumers new goods, services, and innovations that are not included in the baskets the economists study.
  • Price increases could reflect quality improvements manufacturers make to their goods and services, that we should attribute to economic growth, not inflation.
  • Price decreases could reflect a choice consumers make to shop at different locations (such as online) to obtain lower prices that should not be attributed to deflation.

To review some techniques the U.S. Bureau of Labor Statistics uses to overcome the issue of substitutions, new products, and biases when calculating the consumer price index (CPI), see Inflation and Price-Level Changes.

 

3i. Articulate sources of inflation, and explain how they can affect economic stability

  • Define demand-pull inflation and cost-push inflation.

To identify sources of inflation, consider the demand and supply framework where companies determine equilibrium price and quantity. A shift in demand to the right or a shift in supply to the left will increase prices.

Review demand-pull and cost-push inflation in Demand-Pull Inflation under Johnson and Cost-Push Inflation.

 

3j. Use the model of aggregate demand and aggregate supply to explain stagflation

  • Define stagflation.

Stagflation occurs when a recession and inflation occur at the same time – a highly undesirable situation. We study aggregate demand and aggregate supply in more detail in Unit 4.

To review, see Stagflation.

 

3k. Explain the relationship between inflation and unemployment

  • Define the Phillips phase. Under what economic circumstances is it likely to occur?
  • Define the stagflation phase. Under what economic circumstances is it likely to occur?
  • Define the recovery phase. Under what economic circumstances is it likely to occur?
  • How and why does the economy transition between phases?

The Short-Run Phillips Curve

In 1958, A. W. Phillips, a New Zealand economist, suggested that an inverse relationship exists between inflation and unemployment. In other words, a high inflation rate is associated with a low rate of unemployment and vice versa. This theory provides the basis for the Phillips curve.

Figure 16.2 The Short-Run Phillips Curve in the 1960s

The Short-Run Phillips Curve in the 1960s

Inflation–Unemployment Phases

An economy may move from a Phillips phase to a stagflation phase and then to a recovery phase. The theory behind the Phillips curve did not hold true during the 1970s when global oil shocks threw the economy into stagflation – a simultaneous increase in prices and unemployment.

The figure shows the way an economy may move from a Phillips phase to a stagflation phase and then to a recovery phase.

Figure 16.4 Connecting the Points: Inflation and Unemployment

Connecting the Points: Inflation and Unemployment

Figure 16.5 Inflation – Unemployment Phases

Inflation–Unemployment Phases

To review unemployment and inflation, see Relating Inflation and Unemployment and Unemployment vs. Inflation.
 

3l. Describe and analyze the Classical as well as the Keynesian views on unemployment

According to classical economic theorists, free markets will automatically adjust to clear any disequilibrium that occurs in the labor and product markets. Governments do not need to intervene to help an economy recover from any negative shocks. Many economists disagree. For example, they argue that this theory does not explain why so many countries are plagued by sustained unemployment that lingers after a recession has ended (a period of disequilibrium).

John Maynard Keynes (1883–1946), a British economist, argued that wage and price stickiness or rigidity can cause disequilibrium, to allow an economic downturn to persist for an extended period of time. Government intervention is needed to push aggregate demand toward recovery.

To review classical and Keynesian economic theory, see Classical–Keynesian Controversy.

 

3m. Discuss various explanations for wage and price stickiness

  • Identify factors that lead to wage and price stickiness? (For example, think about the role employment contracts play for maintaining a fixed wage.)
  • Identify how each of the following helps explain wage stickiness:
    • Efficiency wage theory;
    • Implicit contracts theory;
    • The adverse selection of wage cuts argument;
    • The insider-outsider model of the labor force;
    • The relative wage coordination argument.

Prices and wages often fail to adjust quickly to changes in the economic environment. As Keynes argued, sticky wages and sticky prices can contribute to sustained periods of economic divergence from long-run equilibrium. We review the mechanism of price adjustments in more detail in Unit 4.

To review sticky wages and sticky prices, see Aggregate Demand and Aggregate Supply and Unemployment.

 

Unit 3 Vocabulary

  • Adverse selection of wage cuts argument
  • Base year
  • Basket of goods and services
  • Consumer price index (CPI)
  • Core inflation index
  • Cost-of-living adjustment (COLA)
  • Cost-push inflation
  • Cyclical unemployment
  • Deflation
  • Demand-pull inflation
  • Discouraged workers
  • Efficiency wage theory
  • Employed
  • Employment cost index
  • Frictional unemployment
  • Full employment
  • GDP deflator
  • Hidden workers
  • Hyperinflation
  • Implicit price deflator
  • Implicit contract
  • Index number
  • Indexed
  • Inflation
  • Insider-outsider model
  • International price index
  • Labor force
  • Natural rate of unemployment
  • Out of the labor force
  • Phillips curve
  • Phillips phase
  • Producer price index (PPI)
  • Quality/new goods bias
  • Recovery phase
  • Relative wage coordination argument
  • Stagflation phase
  • Structural unemployment
  • Substitution bias
  • Underemployed
  • Unemployed
  • Unemployment rate

Unit 4: Aggregate Economic Activities and Fluctuations

4a. Graphically represent and interpret a short-run aggregate supply curve, and explain why it slopes upward and factors leading to its shift outward or inward

  • Define the product supply curve and explain why it slopes upward.

The short-run aggregate supply curve resembles the product supply curve we reviewed in Unit 1. The short-run aggregate supply curve slopes upward to reflect the positive relationship between price level (on the vertical axis) and real GDP (on the horizontal axis).

Just as when we studied the supply and demand curves for a limited customer base or business, remember that the short-run aggregate supply curve is a ratio plotted on a graph that depicts the relationship between price (the y-axis) and Real GDP (the x-axis), so a price fluctuation will cause a movement along the short-run aggregate supply curve (you can see the points on the supply curve refer to Real GDP based on a given price). Price fluctuations do not shift the short-run aggregate supply curve.

Factors that shift the short-run aggregate supply curve include:

  • Aggregate stock, or amount, of available capital;
  • Aggregate stock, or amount, of available natural resources;
  • Aggregate level of technology and innovation; and,
  • Aggregate cost, or prices of the factors of production.

To review the short-run aggregate supply curve, see AS-AD ModelAggregate Demand and Aggregate Supply, and Short-Run Aggregate Supply.

 

4b. Define aggregate demand, and identify the reasons for its negative slope

  • Define the product demand curve and explain why it slopes downward.
  • Define the wealth effectinterest-rate effect, and international trade effect.
  • Why does a change in the price level lead to a change in demand in terms of real GDP?
  • Define consumptioninvestmentgovernment spending, and net exports and explain why changes in these variables cause the aggregate demand curve to shift.
  • Define the spending multiplier.
  • What can we say about the total effect on aggregate demand on Real GDP, considering the role of the spending multiplier?

The aggregate demand curve resembles the product demand curve we reviewed in Unit 1. The aggregate demand curve slopes downward to reflect the negative relationship between price level (on the vertical axis) and real GDP (on the horizontal axis).

Three important effects that lead to the negative slope of the aggregate demand curve, which are all caused by a change in price level, include the wealth effect, the interest-rate effect, and the international trade effect.

Just as when we studied the supply and demand curves for a limited customer base or business, the aggregate demand curve is a ratio plotted on a graph that depicts the relationship between price level (the y-axis) and Real GDP (the x-axis) from a national perspective: a price level fluctuation will cause a movement along the aggregate demand curve (you can see the points on the aggregate demand curve refer to Real GDP based on a given price level). Price level fluctuations do not shift the aggregate demand supply curve.

Factors that shift the aggregate demand curve include national levels of consumption, investment, government spending, and net exports.

To review the aggregate demand curve, see Aggregate Demand and Aggregate Supply, Aggregate Demand, and Shifts in Aggregate Demand.

 

4c. Explain the factors leading to a shift in the consumption function

  • Define marginal propensity to consume (MPC).
  • How does MPC relate to the slope of the consumption function?
  • Define marginal propensity to save (MPS) and explain how it is related to MPC.
  • What variables shift the consumption function?
  • What is the relationship between consumption and aggregate expenditures in the economy?

To analyze the consumption function, it is important to determine the relationship between disposable income and the choice households make to spend or save.

4d. Define short-run equilibrium and long-run equilibrium, and discuss how they differ

Review short-run and long-run equilibrium in learning outcome 4c above.

 

4e. Describe the four phases of a business cycle, including references to income and real output

  • Define business cycle.
  • Define economic contractionrecession, and trough.
  • Define economic expansionboom, and peak.

Business cycles describe the periodic natural fluctuations in the economy, in which recession, economic expansion, and economic booms alternate. The phases of a business cycle include peak, contraction, recession, trough, recovery, and expansion.

This figure depicts the Great Recession the United States experienced from 2008 to 2009, and an economic expansion from 2009 to 2011.

Figure 5.2 Expansions and Recessions, 1960–2011

Expansions and Recessions, 1960–2011

The chart shows movements in real GDP since 1960. Recessions – periods of falling real GDP – are shown as shaded areas. On average, the annual rate of growth of real GDP over the period was 3.1 percent per year.

To review the business cycle, see 

 

4f. Graphically represent and interpret a long-run aggregate supply curve, and explain its connection to natural level of unemployment

  • Define the natural level of employment.
  • What types of employment does the natural level of employment represent and exclude?
  • What is the shape of the long-run aggregate supply (LRAS) curve?
  • What factors shift the aggregate supply curve over time?

The long-run aggregate supply curve compares the price level to the level of real GDP in the long-run. Note that we draw the long-run aggregate supply curve vertically at a fixed level of real GDP (the level of real GDP associated with the "natural level of employment"). An economy that experiences employment levels lower than the "natural level of employment", indicates the presence of cyclical unemployment.

To review the aggregate supply curve, see Aggregate Demand and Aggregate Supply and Long-Run Aggregate Supply.

 

4g. Describe how short-run equilibriums occur above and below the output level associated with the natural rate of unemployment

  • Define recessionary gap.
  • What can we say about the level of real GDP during a recessionary gap?
  • What is the level of employment during a recessionary gap?
  • Do sticky wages cause a recessionary gap to persist?
  • What actions can a government take to help re-establish the long-run equilibrium to eliminate a recessionary gap?

The intersection of the short-run aggregate demand and supply curves describes a short-run equilibrium of the price level and real GDP. We can describe this equilibrium as a long-run equilibrium, when the level of real GDP equals the level associated with the "natural level of employment", or equals the real GDP for the long-run aggregate supply (LRAS) curve.

 

A Recessionary Gap

A recessionary gap is not the same as a recession. A recessionary gap describes an economic situation where unemployment exceeds the natural levels. A recession, on the other hand, indicates a falling real GDP. A recession can, and often does, lead to a recessionary gap.

Figure 7.10 A Recessionary Gap

If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve (AD) and the short-run aggregate supply curve (SRAS) intersect to the left of the long-run aggregate supply curve (LRAS).

To review the recessionary gap, see Aggregate Demand and Aggregate Supply.

 

An Inflationary Gap

  • Define inflationary gap.
  • What can we say about the level of real GDP during an inflationary gap?
  • What is the level of employment during an inflationary gap?
  • Do sticky wages cause an inflationary gap to persist?
  • What actions can help reestablish the long-run equilibrium to eliminate an inflationary gap?

An inflationary gap is a long-run disequilibrium situation. An inflationary gap describes the opposite situation to a recessionary graph, as illustrated in the graphs.

Figure 7.11 An Inflationary Gap

Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationary gap, shown in Panel (b), equals Y1 − YP. The aggregate demand curve (AD) and the short-run aggregate supply curve (SRAS) intersect to the right of the long-run aggregate supply curve (LRAS).

To review the inflationary gap, see Aggregate Demand and Aggregate Supply.

 

Restoring Long-Run Macroeconomic Equilibrium

  • Without active government policy, how will adjustments among wages and prices (unsticking) eventually lead to a shift of the short-run aggregate supply curve toward the long-run equilibrium real GDP?
  • Explain what classical economic theorists and Keynesians recommend policy makers do when a long-run disequilibrium occurs, to help the economy move toward equilibrium?

A common controversy exists among the options a country has to address long-run disequilibrium. In the classical view, an economy can recover from a downturn through adjustments in the labor market. This requires flexible wages and prices.

We know wages and prices are sticky. A long-run disequilibrium can persist until the wages and prices are able to adjust to changes in the economy. Wages and prices need to unstick.

To review classical and Keynesian views of how quickly an economy self-adjusts, see:

 

Unit 4 Vocabulary

  • Aggregate demand (AD)
  • Aggregate demand (AD) curve
  • Aggregate demand/aggregate supply model
  • Aggregate expenditures
  • Aggregate supply (AS)
  • Aggregate supply (AS) curve
  • Business cycle
  • Consumption
  • Depression
  • Economic boom
  • Economic contraction
  • Economic expansion
  • Economic recession
  • Full-employment GDP
  • Government spending
  • Inflationary gap
  • Interest rate effect
  • International trade effect
  • Investment
  • Long-run aggregate supply (LRAS) curve
  • Marginal propensity to consume
  • Marginal Propensity to save
  • Natural level of employment
  • Neoclassical economists
  • Net exports
  • Peak
  • Potential GDP
  • Product supply curve
  • Production possibility curve
  • Recession
  • Recessionary gap
  • Short-run aggregate supply (SRAS) curve
  • Spending multiplier
  • Stagflation
  • Sticky prices
  • Sticky wages
  • Trough
  • Wealth effect

Unit 5: Fiscal Policy

5a. Explain the effect of government spending, taxation, and budget deficits and surpluses on GDP

The government budget typically includes government spending (government purchases), transfer payments, and taxation. Government spending and transfer payments cause an outflow of government funds (expenses); taxation causes an inflow of funds (income or revenue).

Government Spending

  • Name some examples of government purchases.
  • Have federal government purchases increased during the past 50 years in the United States?
  • Have state and local government purchases increased during the past 50 years in the United States?
  • Have government purchases, as a percentage of GDP, increased during the past 50 years in the United States?
  • How do government purchases change with the business cycle?
  • What is the effect of a change in government spending on GDP?

Transfer Payments

  • Define and name some examples of transfer payments.
  • What does a drastic increase in transfer payments, as a percentage of GDP, say about the state of our welfare system?
  • How do transfer payments change with the business cycle?

Government Revenues

  • Define elements of federal government revenue: payroll taxes, individual income taxes, and corporate income taxes.
  • Define elements of state and local government revenue: property taxes, sales taxes, individual income taxes, corporate income taxes, and federal government revenue.
  • How has the tax rate changed during the past 50 years in the United States?
  • How does the tax rate change with the business cycle?
  • How does a change in the tax rate affect GDP?

Government Budget

  • How do governments finance a budget deficit?
  • How does the government budget fluctuate with the business cycle?
  • Is it better for a government to have a budget surplus, a budget deficit, or a balanced budget?

When government revenues exceed total government spending and transfer payments, we experience a budget surplus. When government revenues are less than total government spending and transfer payments, we experience a budget deficit. When government revenues equal total government spending and transfer payments, we have a balanced budget.

To review, see:

 

5b. Explain how the various kinds of lags influence the effectiveness of discretionary fiscal policy

  • Define recognition lagimplementation lag, and impact lag.
  • Name some inherent obstacles in government that exacerbate these time lags.

Governments often run into delays, or time lags, when they use fiscal policy to influence the economy.

A recognition lag describes a delay in the time it takes policymakers to become aware of a problem in the economy. For example, while the housing bubble grew in the United States in 2004-07, most policymakers ignored indicators that suggested housing prices were overinflated and the banking system was systematically offering risky loans to people who could not afford to repay them. Officials should not have been surprised when the housing bubble burst in 2007-08.

An implementation lag refers to a delay in the time it takes policymakers to enact a remedy for a problem. For example, Congress waited until 1964 to enact a tax cut President John Kennedy proposed in 1960 to alleviate a mild economic slowdown. By the time Congress passed the legislation, the U.S. economy was beginning to experience inflation and needed a different fiscal remedy.

An impact lag describes a delay between the time a policy is enacted and when the economy feels its impact.

To review policy lags, see Problems and Controversies of Monetary Policy.

 

5c. Explain how discretionary fiscal policy works and influences aggregate demand

  • Define fiscal policy.
  • Define and differentiate between discretionary and nondiscretionary spending.
  • Define automatic stabilizer in terms of fiscal policy (review this material in Unit 2).
  • How do changes in household taxes influence disposable income, consumption, and aggregate demand?
  • How do changes in business taxes influence investment and aggregate demand?
  • How do changes in government spending influence aggregate demand?
  • How do changes in aggregate demand influence real GDP and inflation?
  • How does government use spending programs and taxes to promote economic expansion and economic contraction?
  • Describe the economic circumstances that prompt a government to employ an expansionary or contractionary fiscal policy.

Fiscal policy describes the policies governments enact to influence the aggregate economy, real GDP, and the price level. Policymakers use two primary discretionary fiscal policy tools: government spending and taxation.

Discretionary spending refers to spending policies federal, state, and local legislators approve or enact via the appropriations and legislative process. For example, in the United States, Congress, the legislative branch that has the "power of the purse". Congress authorizes spending to fund programs that support national defense, transportation, education, foreign aid, etc.

Congress has also passed certain automatic, mandatory, non-discretionary spending programs that they have agreed do not warrant annual authorization. These programs receive automatic, annual, funding increases. These non-discretionary spending programs include social security, Medicare, and Medicaid. Keep in mind that Congress has the power to reduce or eliminate these programs, but chooses not to.

Automatic stabilizers (reviewed in Unit 2) describe the programs Congress has legislated that automatically stimulate aggregate demand during an economic slowdown, and automatically reduce aggregate demand during a period of inflation. Examples of automatic stabilizers include unemployment and welfare benefits, and the individual and business tax rate.

Recall how we measured aggregate expenditure and aggregate demand in Unit 2:

Aggregate Demand = Consumption + Investment + Government Spending + Net Exports

Figure 12.8 Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate demand to AD2 to close the gap. In Panel (b), the economy faces an inflationary gap (Y1 − YP). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap.

To review fiscal policy, see:

 

5d. Identify the major components of US government spending and their sources

Review the major components of U.S. government spending and their sources in learning outcome 5a above.

 

5e. Define the terms budget surplus, budget deficit, and balanced budget

Review what it means for the government to project a budget surplus, budget deficit, and balanced budget in learning outcome 5a above.

 

5f. Explain the difference between a budget deficit and the national debt

  • What happens to the national debt when a country runs chronic budget deficits over many years?
  • How does the U.S. national debt compare with that of other countries, in absolute terms and as a percentage of GDP?
  • Should Americans be concerned about the national debt level in the United States?
  • How do economists project the U.S. national debt will fare in the coming years as more baby boomers retire and we experience improvements to health and longevity?

Economists calculate the national debt as the sum of all past federal deficits, minus all surpluses. Government spending on the social security program, as the baby boomer generation retires en masse, is one of the largest components of the U.S. national debt.

To review the budget deficit and the national debt, see:

 

Unit 5 Vocabulary

  • Automatic stabilizers
  • Balanced budget
  • Budget deficit
  • Budget surplus
  • Contractionary fiscal policy
  • Corporate income tax
  • Discretionary spending
  • Expansionary fiscal policy
  • Fiscal policy
  • Government purchases
  • Government revenue
  • Impact lag
  • Implementation lag
  • Individual income tax
  • National debt
  • Nondiscretionary spending
  • Payroll tax
  • Property tax
  • Recognition lag
  • Sales tax
  • Taxes
  • Transfer payments

Unit 6: Monetary Policy and Various Complexities behind Macroeconomic Policies

6a. Compare and contrast as well as discuss fiscal policy and monetary policy

  • Name some additional similarities between fiscal and monetary policy.
  • What economic agency is responsible for implementing fiscal policy in the United States?
  • What economic agency is responsible for implementing monetary policy in the United States?
  • What is the difference in lags between fiscal and monetary policy?
  • Is fiscal or monetary policy better for achieving a country's economic goals?

Governments use fiscal and monetary policy to influence the country's real GDP and price levels. They use expansionary fiscal policies and expansionary monetary policies to shift the aggregate demand curve to the right. They use contractionary fiscal policies and contractionary monetary policies to shift the aggregate demand curve to the left.

Responses to the following questions will help articulate some key differences between fiscal and monetary policy.

To review the difference between fiscal and monetary policy, see Monetary and Fiscal PolicyProblems and Controversies of Monetary Policy, and Monetary and Fiscal Policy.

 

6b. Define the money multiplier, and explain the money creation process

  • How do we calculate the total change in the money supply by using an initial deposit value and the money multiplier?
  • How can banks increase or reduce money creation?
  • How do individuals participate in the money creation process? Can they influence the final outcome?
  • What kinds of policies can government and the central bank impose to affect the money multiplier?

To understand the process of money creation, you should study the structure of a bank's balance sheet. Notice the reserves category under the assets side of the balance sheet. Banks are required to keep a certain percentage of their deposits in the form of reserves (or required reserves). Bankers call any reserves it holds in excess of the required reserves, excess reserves.

Study the money creation process by following the path of money through the banking system from an initial new deposit. Analyze the bank's balance sheet and how it reflects the money flow.

For example, a bank splits an initial deposit into required and excess reserves. Excess reserves become a source for money lending. Once the bank lends this money out, the next bank in the banking system (or possibly the same bank) will categorize it as a new deposit, and so on. When the same money circulates between deposits and loans multiple times, it leads to a multiplication of money. The money multiplier (or deposit multiplier) is a variable that helps us measure the total amount of money creation from the initial deposit.

Money Multiplier = 1 / Required Reserves Ratio

As you review this material, think about factors that could affect the money creation process.

To review the money multiplier and money creation, see:

 

6c. Distinguish between the types of money (i.e., between commodity money and fiat money), identifying examples of each

  • Define the three functions of money: medium of exchangeunit of account, and store of value.
  • Define commodity money and fiat money.
  • What kind of money describes most major currencies, such as the dollar, Euro, rupee, yen, etc.?
  • Are these currencies backed by gold or another precious commodity?

An item needs to serve three functions to be suitable for use as money: a medium of exchange, unit of account, and store of value.

Commodity money describes money that has its own intrinsic value. For example, prisoners may use cigarettes as a form of money or payment. Fiat money does not have intrinsic value. It is backed solely by the trust the money holder places on the institution that issues it.

To review commodity and fiat money, see What Is Money?, Money, and Money.

 

6d. Define money supply, and its related definitions (M1 and M2); draw and interpret a money demand curve, and explain how changes in other variables may lead to shifts in the money demand curve

  • Define the M1 and M2 categories of money.
  • Define liquidity.
  • Is the M1 or M2 monetary category more liquid?
  • Define money supply.
  • What is the shape of the money supply curve?
  • Name the factors that shift the money supply curve.
  • Define the three main reasons people demand money: transactionsprecautionary, and speculative reasons.
  • How does a change in the interest rate influence the demand for money, or the motivation people have to hold onto money or cash?
  • How does money demand change with fluctuations in real GDP, the price level (inflation or deflation), expectations, transfer costs, and preferences.

The money supply describes the total quantity of money in the economy. Figure 10.5 is a graph of the money demand curve. Note the relationship between the variables: the quantity of money on the horizontal axis and the interest rate on the vertical axis.

Money demand represents the relationship between the quantity of money people demand, or want to hold onto as ready cash or in a readily-available, non-interest-bearing account (for transactional, precautionary, or speculative reasons), and the opportunity cost of money, or interest rate (what you would earn if you invested your money into an interest-bearing account).

Figure 10.5 The Demand Curve for Money

The Demand Curve for Money

The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope shows a negative relationship between the quantity of money demanded and the interest rate.

 

Money Market Equilibrium

  • How does a shift of the money demand curve, due to changes in factors of money demand, affect the equilibrium interest rate?
  • What about shifts in the money supply curve?

In Figure 10.8, we put money demand and money supply together on the same graph to analyze the relationship between the money market and equilibrium interest rate. The supply curve for the money supply is a vertical line because it represents the fixed, total amount of money that exists in various bank deposits or reserves, as determined by the U.S. Federal Reserve. The market for money is in equilibrium when the quantity of money demanded equals the total quantity of money supplied. In this figure, equilibrium occurs at interest rate r.

Figure 10.8 Money Market Equilibrium

Money Market Equilibrium

To review the money supply and the money demand curve, see:

 

6e. Explain and illustrate the relationship between a change in demand for or supply of bonds and macroeconomic activity

  • Define bondface valuecoupon ratebond marketsecondary market.
  • What is the difference between the interest rate and the coupon rate of bonds?
  • How does an increase in government borrowing (reflected as a new issue of bonds) affect the economy's interest rate?
  • How do bonds compare with stocks?

The bond market is a financial market that allows firms and government to borrow money directly from the public without going through financial intermediaries, such as banks. When an institution issues and sells a bond, it is essentially borrowing an amount of money (the bond's face value), at a predetermined interest rate (the bond's coupon rate), for a specific period of time (the bond's maturity date).

Once bonds are issued, investors can resell them on the secondary market. The demand and supply of bonds in the bond market determines the equilibrium price of bonds.

The bond price is negatively related to the interest rate. This means that when the price of a bond increases, the bond yield will decrease. This occurs because bonds have a fixed face value and a fixed coupon rate (if they have a coupon rate at all). Paying more for an existing bond will reduce its rate of return.

Figure 10.1 The Bond Market

The Bond Market

The equilibrium price for bonds is determined where the demand and supply curves intersect. The initial solution here is a price of $950, implying an interest rate of 5.3 percent. An increase in borrowing, all other things being equal, increases the supply of bonds to S2 and forces the price of bonds down to $900. The interest rate rises to 11.1 percent.

To review the bond market, see The Bond and Foreign Exchange Markets and Overview of Bonds.

 

6f. Explain the functions of a bank, and describe a bank's balance sheet

  • Define commercial bank.
  • Why do banks consider checkable deposits a liability?
  • What happens to a bank when loans going bad during a financial crisis?
  • What does it mean when a bank's net worth is too low?
  • Describe the relationship among assets, liabilities, and net worth?

A bank is a financial intermediary – an institution that facilitates the flow of money among borrowers and lenders. When you deposit money into a savings or checking account you are essentially lending your money to a bank. In turn, the bank will lend your deposit out to other individuals and businesses in the form of a loan. The bank charges these individuals and businesses interest for the privilege of being able to borrow money.

The bank reimburses you with a portion of the proceeds it earns from its borrowers, in the form of an interest rate. A higher interest rate serves as a form of encouragement – it encourages you to make more deposits so the bank can offer even more loans, and earn even more money).

This table illustrates the components of a bank's balance sheet.

The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012

Assets

Liabilities and Net Worth

Reserves

$1,592.90

Checkable deposits

$8,517.90

Other assets

$1,316.20

Borrowings

1,588.10

Loans

$7,042.00

Other liabilities

1,049.40

Securities

$2,546.10

   

Total assets

$12,497.20

Total liabilities

$11,155.40

 

Net worth

$1,341.80

This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, in January 2012. 

6g. Explain the primary functions of the Federal Reserve, and describe the three tools it can use as part of monetary policy

  • Define reserve requirement, the discount rate, and open market operations.
  • How does the U.S. Federal Reserve use each of these three monetary policy tools to affect the money supply?
  • Which of these three monetary policy tools does the U.S. Federal Reserve use most widely?
  • How does the U.S. Federal Reserve structure support its independence from politics and government?

The U.S. Federal Reserve (the Fed) serves as the central bank for the United States government. The system includes 12 regional banks located in different regions of the country. We do not consider the Federal Reserve System part of the federal government. It is a semi-private institution that is not financed nor regulated by the U.S. government.

As with most central banks, the U.S. Federal Reserve performs the following functions:

  • Serves as the central bank for the federal government;
  • Serves as the bank for its member banking institutions;
  • Regulates banks in the United States;
  • Conducts U.S. monetary policy;
  • Oversees and stabilizes the U.S. financial system.

The U.S. Federal Reserve has three main tools at its disposal to control the U.S. money supply: the reserve requirement, the discount rate, and open market operations.

To review the U.S. Federal Reserve system and the monetary policy tools, see:

 

6h. Explain how the bond market works, and discuss the relationship between bond prices and interest rates

Review how the bond market works and the relationship between bond prices and interest rates in learning outcome 6e above.

 

6i. Describe the relationships among changes in money demand or money supply, in the interest rate, in the prices of stocks and bonds, in aggregate demand, in real GDP, and in the price level

  • What steps would you follow to analyze contractionary monetary policy?

The most widely used monetary policy tool of the U.S. Federal Reserve is open market operations. Be sure to review how the U.S. Federal Reserve affects the following interconnected markets: bond market, money market, goods and services market, foreign exchange market.

The figure below illustrates the effects the U.S. Federal Reserve will have on these four markets when it employs an expansionary monetary policy to close a recessionary gap.

 

Expansionary Monetary Policy

The U.S. Federal Reserve starts the process by buying government bonds on the bond market. This creates an increase in demand for bonds on the bond market – a shift of demand for bonds to the right. The increased demand causes bond prices to increase, and interest rates to decrease (bonds prices and the interest rate are negatively related). See panel b.

When the U.S. Federal Reserve buys bonds, it essentially adds reserves in the banking system (the U.S. Federal Reserve prints the extra money it needs to buy the bonds out of thin air, or simply adds the additional assets it buys to its balance sheet). This is graphically illustrated in the money market as a shift of the money supply curve to the right, and a decrease in the equilibrium interest rate. See panel c.

Lower interest rates encourage households and businesses to spend money (especially spending on credit). The consumption and investment components of aggregate demand increase, causing a shift of the aggregate demand curve to the right in the goods and services market. The price level rises in equilibrium. See panel a.

Finally, the higher price level makes domestic goods and services appear more expensive to foreigners, which discourages U.S. exports. At the same time, foreign goods appear relatively cheaper, which encourages Americans to increase imports. These effects put pressure on the value of the dollar as follows: demand for dollars decreases and the supply of dollars increases, leading to a cheaper dollar in the foreign exchange market. See panel d.

Figure 11.1 Expansionary Monetary Policy to Close a Recessionary Gap

Expansionary Monetary Policy to Close a Recessionary Gap

In Panel (a), the economy has a recessionary gap YP − Y1. An expansionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed buys bonds, shifting the demand curve for bonds to D2 and increasing the price of bonds to Pb2. By buying bonds, the Fed increases the money supply to M′ in Panel (c). The Fed's action lowers interest rates to r2. The lower interest rate also reduces the demand for and increases the supply of dollars, reducing the exchange rate to E2 in Panel (d). The resulting increases in investment and net exports shift the aggregate demand curve in Panel (a).

To review these changes, see Monetary Policy in the United StatesMonetary Policy, and Monetary Policy.

 

6j. Identify and discuss domestic policies that contribute to economic growth

Review domestic policies that contribute to economic growth in learning outcome 6i above.

 

6k. Explain the linkages among income, consumption, and net investment, relating them to economic growth

  • Define the sources of economic growth: laborcapitalraw materials (land), and entrepreneurship.
  • How does a small difference in growth rates among countries lead to large differences in total production over an extended period of time?
  • How does an increase in saving contribute to increased investment?
  • Will a household's decision to consume less and save more (increase total investment) enhance a country's long-term economic growth?

Economic growth refers to the national increase in potential output, which is often determined by the country's available resources: labor, capital, raw materials (land), and entrepreneurship.

Countries often generate long-term economic growth by increasing investment in physical and human capital. Worker productivity can increase via improvements in technology and education, which leads to higher output.

Consider a typical household decision regarding how to divide income between spending and saving.

To review the determinants of investment and factors that contribute to changes in investment demand, see Economic GrowthInvestment and Economic Activity, and Slow Growth Model.
 

6l. Describe how crowding out occurs and its connections to fiscal and monetary policies

  • Define crowding out.
  • Why does an increase in government borrowing increase interest rates? Think about the effect of increased demand for loanable funds on the incentives of lenders.

The crowding-out effect is a negative effect of expansionary fiscal and monetary policy. Expansionary fiscal policy not only increases the government budget deficit, but causes interest rates to increase which can squeeze, reduce, or "crowd out" private investment. Higher interest rates will hurt businesses that borrow capital to expand or sustain their operations.

To review crowding out, see Government and Fiscal Policy.

 

6m. Discuss the arguments for side supply approaches to economic growth separating macroeconomic and microeconomic variables

  • How does a rightward shift in the aggregate supply curve affect real GDP and the price level?
  • What type of fiscal policies promote an increase in aggregate supply?
  • Describe some positive and negative elements of this type of policy.
  • Name some examples of past U.S. governments that promoted supply-side policies.

Supply-side economics describes a fiscal policy that promotes increasing the aggregate supply curve.

To review, see Supply-Side Economics.

 

6n. Summarize the bases of the philosophical differences between the Classics and Keynesians

  • Describe the classical school of macroeconomic theory that preceded the U.S. Great Depression (1929–1933)?
  • How did the Great Depression shatter these classical macroeconomic beliefs?
  • Define and describe how the Keynesian school of macroeconomic theory differs from the preceding classical school.
  • What policy prescriptions did classical and Keynesian economists promote?
  • What economic thought prevailed during the economic expansion in the 1960s?
  • How can we reconcile the existence of contradictory schools of economic thought?

Economic events during the past century have influenced how economists analyze the effects the economy has on a country's real GDP and price level.

To review classical and Keynesian thought, see A Brief History of Macroeconomics Thought and Policy and The Phillips Curve.

 

6o. Describe the key components of the monetarist perspective

Review the key components of the monetarist perspective in learning outcome 6n above.

 

6p. Explain why the Phillips curve is vertical in the long run

Review the short-run Phillips curve in Unit 3. In the long run, the economy operates at its full employment levels. The unemployment rate includes only structural and frictional unemployment. Consequently, the long-run aggregate supply curve is vertical at the potential level of real GDP. This means that in the long-run, real GDP is fixed and the unemployment rate is also fixed at the natural rate of unemployment.

Changes in aggregate demand can only lead to changes in the price level with no permanent effects on real GDP. Consequently, the long run the Phillips curve is vertical at the natural rate of unemployment and shows no trade-off between inflation and unemployment.

Figure 16.10 The Phillips Curve in the Long Run

The Phillips Curve in the Long Run

Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with price level of P0, the same as in the last period. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate demand curve shifts to AD2, in the short run output will increase to Y1, and the price level will rise to P1. In Panel (b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel (a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long-run, the Phillips curve is vertical.

To review the long-run Phillips curve, see Inflation and Unemployment in the Long Run and The Phillips Curve.

 

Unit 6 Vocabulary

  • Assets
  • Balance sheet
  • Bond
  • Bond market
  • Capital
  • Central bank
  • Classical economics
  • Commercial bank
  • Commodity money
  • Contractionary monetary policy
  • Coupon rate
  • Crowding out
  • Deposit multiplier
  • Discount rate
  • Entrepreneurship
  • Excess reserves
  • Expansionary monetary policy
  • Face value
  • Federal funds rate
  • Federal reserve
  • Fiat money
  • Financial intermediary
  • Fiscal policy
  • Fractional reserve banking system
  • Interest rate
  • Keynesian economics
  • Liabilities
  • Liquidity
  • Long-run Phillips curve
  • M1
  • M2
  • Maturity date
  • Medium of exchange
  • Monetarist economics
  • Money
  • Money demand
  • Money multiplier
  • Money supply
  • Monetary policy
  • Net worth
  • Open market operations
  • Phillips curve
  • Precautionary
  • Required reserves
  • Required reserves ratio
  • Reserves
  • Secondary market
  • Speculative
  • Stock
  • Store of value
  • Transactional
  • Unit of account

Unit 7: International Trade

7a. Compare and contrast and discuss absolute advantage and comparative advantage

  • Define absolute advantage and comparative advantage.
  • Why is trade based comparative rather than absolute advantage?
  • In a simple model of two countries and two goods, does one country always have comparative advantage in one good, while the other has comparative advantage in the other good?
  • Name some goods and services U.S. businesses specializes in and export?
  • Name some goods and services Americans import?

International trade is based on the principle of comparative advantage. Countries specialize in the production of goods and services in which they have a comparative advantage. They export these goods and services to other countries and import the goods and services the other countries produce. The international marketplace has become increasingly robust, as it has become easier and more cost-effective to transport goods and services across great distances.

7b. Explain how the foreign exchange market works, how it reflects changes in the demand for or the supply of a country's currency, and how it relates to a country's net exports

  • How do changes in exports and imports affect net exports?
  • Define the relationship among net exports and aggregate demand.
  • How does international trade affect the equilibrium levels of real GDP and the price level?
  • Define exchange rate.
  • What changes in the foreign exchange market will bring about currency appreciation?
  • What about changes that depreciate the currency?
  • How does a change in the value of a currency affect the country's exports and imports, and therefore, its net exports?

Innovations in communications technologies and transportation have generated increased levels of international trade and globalization. Exports and imports across the globe have increased. Additional factors that have contributed to increased trade include income levels, relative prices, the exchange rate, trade policies, consumer preferences, and technology innovation.

Net Exports = Exports – Imports

Businesses and consumers who want to import goods and services from a foreign country need to purchase a sufficient amount of foreign currency to buy the goods or services they want to import. For example, a Japanese consumer who wants to buy certain American toys and games needs to buy enough U.S. dollars to cover the costs of the purchase.

Businesses, investors, banks, and consumers buy currencies on the foreign exchange market. Like other types of markets, the foreign exchange market is subject to the laws of supply and demand. When Japanese consumers exhibit a strong demand to buy American products and services, the price of the U.S. dollar increases.

The Market for Dollars

The Market for Dollars

A shift of demand and/or supply of dollars will affect the value of the U.S. dollar. For example, a shift of the demand for dollars to the right raises the equilibrium value of the dollar (the dollar will appreciate) and vice versa.

7c. Identify tariffs and quotas in international trade and how they relate to net exports

  • Define tariffs and quotas and explain how they restrict free trade?
  • How do trade restrictions affect each trade partner (importer and exporter), in terms of the price level for the goods subject to the tariff or quota, job availability, and the value of its currency?
  • How do trade restrictions affect final goods and services, when intermediate goods and services are subject to a tariff or quota?
  • How do trade restrictions affect market efficiency?

Free trade generally increases the well-being of both trade-partners since it allows countries to specialize in producing the goods and services in which they have comparative advantage. Nevertheless, policymakers frequently argue against free trade policies and impose trade restrictions, such as tariffs and quotas.

Consumers usually suffer when governments impose tariffs and quotas because foreign businesses pass along any additional fees they must pay for the tariff by increasing prices. Businesses may feel less pressure to make needed improvements to gain a competitive advantage in the global marketplace – since they no longer face competition from foreign companies.

To review how trade barriers such as tariffs and quotas affect international trade, see Net Exports and International FinanceTrade Barriers, and Free Trade.

 

7d. Explain how comparative advantage relates to the gains from international trade

International trade that operates in a free market benefits all trading partners. Exporting countries are able to sell additional goods and services, increase their economic activity, and promote employment in industries where they enjoy a comparative advantage. Consumers in importing countries have the opportunity to buy a greater variety of goods and services, that cost less than what is available in their own country. International trade allows trading partners to buy and sell goods in a marketplace beyond their own limited borders.

Figure 2.9 Production Possibilities Curves and Trade

Production Possibilities Curves and Trade

Suppose the world consists of two continents: South America and Europe. Both produce two goods: food and computers. We assume each continent has a linear production possibilities curve (panels a and b). South America has a comparative advantage in food production. Europe has a comparative advantage in computer production.

Free trade allows the continents to operate on the bowed-out curve GHI (panel c). If the continents refuse to trade, the world operates inside its respective production possibilities curve.

For example, if each continent produces at the midpoint of its production possibilities curve, the world produces 300 food units and 300 computers at point Q during each period. However, if the world adopts a policy of free trade, so each continent can specialize in the good where it has a comparative advantage, world production can increase to point H. The world produces more food and more computers.

To review the gains from trade, see Applications of the Production Possibilities Model.

 

7e. Describe the role of international trade in the exchange of currencies

Review the role of international trade in the exchange of currencies in learning outcome 7b above.

 

Unit 7 Vocabulary

  • Absolute advantage
  • Comparative advantage
  • Currency appreciation
  • Currency depreciation
  • Export
  • Foreign exchange market
  • Free trade
  • Gains from trade
  • International trade
  • Import
  • Net export
  • Net import
  • Opportunity cost
  • Production possibilities curve
  • Quota
  • Tariff
  • Trade restrictions