ECON102 Study Guide

Site:	Saylor Academy
Course:	ECON102: Principles of Macroeconomics (2024.A.01)
Book:	ECON102 Study Guide

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Date:	Thursday, May 16, 2024, 11:47 PM

Navigating this Study Guide
Unit 1: What is Macroeconomics?
Unit 2: Gross Domestic Product, Inflation, and Unemployment
Unit 3: Aggregate Demand, Supply, and Equilibrium
Unit 4: Money, Banking, and Monetary Policy
Unit 5: Fiscal Policy
Unit 6: International Trade and Finance

Navigating this 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
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 this Study Guide

Review the entire course by reading the learning outcome summaries and suggested resources.
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: What is Macroeconomics?

1a. Define economics and explain its importance

What are economics and scarcity?
Why does scarcity drive society's need to acknowledge, track, and allocate limited resources?
What is the relationship between production and division of labor?

"Economics is the study of how humans make decisions in the face of scarcity." Human wants for goods, services, and resources exceed the resources available. The limited resources needed to produce and acquire these desired goods and services include labor, tools, land, raw materials, and time.

Government agencies often publish economic and social data to measure and track economic issues and problems. The categories include:

Money, banking, finance
Population, employment, labor markets (including income distribution)
National accounts (gross domestic product and its components), the flow of funds, and international accounts
Production and business activity (including business cycles)
Prices and inflation (the consumer price index, the producer price index, and the employment cost index)
International data from other nations
U.S. regional data
Academic data (including Penn World Tables and NBER Macrohistory database)

We must often make economic decisions that require choosing between two paths. Perhaps you had to decide whether to enroll in college without the full required tuition and costs in hand. You may have decided to take one or two courses while working part-time. Or you may have decided to take out student loans to study full-time so you could begin your career sooner and hopefully earn a higher salary. Unfortunately, this option requires you to pay off a significant debt after graduation.

What questions help you decide? What do you give up when you choose one path? What do you gain? Given your resource constraints, you should consider the cost of your next best alternative to optimize the return on your time and money. This is an opportunity cost.

Adam Smith (1723–1790) introduced the concept of the division of labor to meet the challenge of scarcity in The Wealth of Nations (1776). He gave three reasons why workers specialize in certain tasks.

Specialization allows workers to focus on the parts of the production process where they have an advantage.
Workers who specialize can produce more quickly with higher quality.
Economies of scale mean the average cost to produce each unit declines as the production level increases.

The workers can produce much more by specializing than when each worker tries to produce the entire good or service by themselves. These two aspects of efficiency, division of labor and specialization, allow workers to use limited resources most effectively.

To review, see [1.1 What Is Economics, and Why Is It Important?] and [2.1 How Individuals Make Choices Based on Their Budget Constraint].

1b. Compare microeconomics and macroeconomics

What is the difference between microeconomics and macroeconomics?
What are the major economic aggregates that 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 regard to the macroeconomy?

Microeconomics focuses on individuals, businesses, and their decisions in the marketplace. Microeconomics examines theories of consumer and business behavior, how markets for labor and other resources work, and how markets sometimes fail to work properly.

Conversely, macroeconomics studies the entire aggregate economy in a given country. It uses statistics to compare similar economic trends in other countries.

Macroeconomics focuses on broad economic issues, such as production, unemployment, inflation, government deficits, and levels of exports and imports. It calculates the level of economic activity in a society – how many goods and services are in demand, the number of jobs available, the standard of living, what causes the economy to speed up or slow down, what causes an increase or decrease in the number of workers, and what causes economic growth. It examines the goals of growth in the standard of living, low unemployment, and low inflation. Governments use monetary and fiscal policy to pursue these goals.

To review, see [1.1 Microeconomics and Macroeconomics].

1c. Describe how theories, models, and tools are used to perform economic analysis

What are the differences between theories and models in economics?
How do economists use theories to perform economic analysis?
How would you compare and contrast traditional, command, and market economies?
What is gross domestic product (GDP)?

A theory is a simplified representation of how two or more variables interact. A model is an applied or empirical representation of a theory. Note that many use these terms interchangeably despite these nuanced differences.

Economists use theories and models to analyze issues and problems based on assumptions about human behavior. For example, we discuss the circular flow model in Unit 1.

Economists have created three categories to describe how societies organize themselves in the complex modern economy (production of goods and services, buying and selling, and employment).

Traditional economies are the oldest economic systems. Individuals consume what they produce, and occupations stay in the family. There is little room for economic progress or development.
Command economies have a centralized economic decision-making structure. Economic effort is devoted to the goals a ruler or ruling class dictates. The government dictates what goods and services will be produced, what prices will be charged, the methods of production, and wages for workers. An example is communism.
Market economies have a decentralized decision-making structure based on private enterprise. Businesses supply goods and services based on demand. Income is based on a person's ability to convert resources (such as labor) into something society values. Market forces determine economic decisions, not the government.

Whether a society's economic decision-making is centralized or decentralized, challenges arise due to trends of globalization. Factors such as culture, politics, and economic connections impact the increased buying and selling of goods, services, and assets across national borders.

One measure of globalization relates to exporting and importing goods and services. Gross domestic product (GDP) measures the size of total production in an economy. The ratio of exports divided by GDP measures the share of a country's total economic production sold in other countries.

To review, see:

1d. Analyze resource allocation based on scarcity, opportunity cost, and making decisions at the margin

What are the concepts of scarcity and opportunity cost?
How can you analyze resource allocation based on making decisions at the margin?

Humans have unlimited wants. There is no way to satisfy everyone's desires in a world with limited resources. The scarcity of resources necessitates choices about using the amount of resources to satisfy a given amount of wants. Scarcityexists when there is not enough of something (product, service, resource) to satisfy everyone's wants at no cost. Even if the desired item were free, enough would not be available to satisfy its demand.

Opportunity cost is the highest-valued foregone alternative when any choice is made. The cost of one item means the lost opportunity to do something else. It is the value of the next best alternative.

People and societies rarely make all-or-nothing choices. Too much of a good thing is too much! We have discussed the need to consider the opportunity cost of foregone alternatives when making rational decisions. A rational consumer will only purchase additional units of a product if the utility (satisfaction from the product) exceeds the opportunity cost.

When we purchase or consume more units of a product, we derive less satisfaction from each additional unit. This equalizes the choice between the product and the next best-valued alternative.

Marginal analysis examines the cost and benefits of choosing a little more or a little less of a good. Rather than examine the total cost and benefit, we should compare how costs and benefits change from one option to another.

Let's say you are hungry and pay $20 for a big, sloppy pizza. After the fourth slice, you may start thinking about the new book you could have bought with the $20. How about after the sixth slice? You may feel queasy and wish you had bought the book instead. This is the law of diminishing utility! It says the additional (marginal) utility from each additional unit of the good declines as you receive more of a good.

To review, see:

[1.2 Choice in a World of Scarcity]
[1.2 Resources, Scarcity, and Choice]
[1.2 How Individuals Choose Based on Budget Constraints]
[1.4 Opportunity Cost]

1e. Apply the production possibilities curve to identify production combinations that are efficient, inefficient, and unattainable

What is the production possibilities curve?
What is the production possibilities frontier (PPF)?
What do efficient, inefficient, and unattainable positions on the PPC curve look like?
What are some objections to economic models such as the PPF curve?

The production possibilities curve visually displays all potential production combinations of two goods, given that all production factors are utilized completely and efficiently.

The production possibilities frontier highlights various economic principles, including allocative efficiency, economies of scale, opportunity cost, productive efficiency, and resource scarcity.

The graph below shows a PPC for spending on roads and defense. Because there is a limited number of resources (money) to use for these categories, points on the curve (E, B, C) depict points where we can only spend money on roads or defense by taking dollars away from the other category. These points are efficient.

Point A shows where the government can spend on both categories. However, this point is inefficient because dollars are left on the table or wasted (to spend on something else?). Point D is outside the curve. It is unattainable because there are not enough resources (money) available to spend the amount depicted on roads and defense. All points on the curve or inside the curve are attainable; points outside the curve require more resources.

Note that, as succinct and illustrative economic models, graphs, and theories are, their conclusions are often open to interpretation and opinion. We study two objections to this economic decision-making approach: 1. People, firms, and society do not act like this, and 2. People, firms, and society should not act this way. Human behavior is difficult to predict and not always accurate. However, the economics approach can help analyze and understand the tradeoffs of economic decisions.

To review, see:

[1.3 The Production Possibilities Frontier and Social Choices]
[1.3 Objections to the Economic Approach]
[1.3 The Production Possibilities Curve (PPC)]
[1.3 The PPC and Resource Changes]

1f. Define demand, supply, and market equilibrium

What are demand, supply, and market equilibrium?

Markets include buyers and sellers. Demand describes the behavior of buyers in the marketplace.

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

Demand Determinants – Many factors affect demand, including income, prices of related goods, population, and preferences. 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. Make sure you can distinguish between normal and inferior goods and the effects of income on demand for each type 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; and
Buyer expectations.

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 the quantity supplied and the price of a good? Do producers have an incentive to produce and sell more or less of a good when the 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; and
The number of sellers.

Market equilibrium – The equilibrium is the point where the supply curve and the demand curve intersect. The equilibrium price is the only price where the amount of product consumers want to buy (quantity demanded) equals the amount of product producers want to sell (supply quantity).

For example, at an equilibrium price of $1.40 for 600 million gallons of gasoline, any price above this quantity supplied exceeds the quantity demanded, resulting in excess supply. At a price below market equilibrium, the quantity demanded exceeds the quantity supplied, resulting in excess demand.

Answer this question. What happens to the demand curve when incomes rise or when the price of complementary goods falls? What about when tastes and preferences change to favor a particular good or service or when the number of people or population rises?

Increased demand means that at every given price, the quantity demanded is higher. The demand curve shifts to the right.

Hint: Is this all about the quantity or a change in the demand situation?

To review, see:

[1.5 Demand, Supply, and Equilibrium in Markets for Goods and Services]
[1.5 More on Demand]
[1.5 More on Supply]
[1.5 Market Equilibrium]
[1.5 Shifts in Demand and Supply for Goods and Services]
[1.6 Changes in Equilibrium Price and Quantity: The Four-Step Process]

1g. Explain how changes in demand and supply affect the demand and supply curves and alter the equilibrium prices and quantities

What factors can shift the supply curve?
What factors can shift the demand curve?

Pay particular attention to the different 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 will cause a movement along the demand curve.

Many students confuse demand and quantity demanded. Consider that the quantity demanded is illustrated at 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 if demand for a good changes when its price changes, the answer is "no," Demand itself does not shift; only the quantity demanded changes.

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 a demand shifter causes a change in demand. 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.

In addition, 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?

Many students also confuse the supply and quantity supplied. Consider that the 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 if the supply of a good changes when its price changes, the answer is "no." The supply itself does not shift; only the quantity supplied changes.

In the graphs below, pay attention to the movement along the supply curve due to changes in the price of the good versus the graph that shows a shift in the supply curve due to the changes in supply.

Remember, factors that can shift the supply curve include:

Shifts supply curve to the right:

Favorable conditions for production
A fall in input prices
Improved technology
Lower product taxes, lower regulations

Shifts supply curve to the left:

Poor natural conditions for production
A rise in input prices
A decline in technology
Higher product taxes, more regulations

It is important 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.

To review, see:

[1.5 Demand, Supply, and Equilibrium in Markets for Goods and Services]
[1.5 More on Demand]
[1.5 More on Supply]
[1.5 Market Equilibrium]
[1.5 Shifts in Demand and Supply for Goods and Services]
[1.6 Changes in Equilibrium Price and Quantity: The Four-Step Process]

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

What are the business sector, household sector, government sector, financial sector, and the global marketplace?
What is the flow of payments and resources among these economic entities?

A circular flow diagram is one of the most important economic models 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 of income describes how money flows among different sectors of the economy.

The circular flow diagram illustrates the exchange between households and businesses within the goods and services sector and the employment sector. Arrows indicate that households acquire products and services and compensate businesses in the goods and services sector. Conversely, in the employment sector, households supply labor and are compensated by businesses via wages, earnings, and perks.

This representation includes the five main sectors: households, firms, government, the financial sector, and the global marketplace and their contribution to the circular flow of money. For example, note that households contribute through taxes to the government, consumer spending, and private savings. Can you see where other sectors contribute?

To review, see [1.1 What Is Economics, and Why Is It Important?] and [1.6 The Circular Flow of Income and Expenditures].

1i. Analyze price controls and how they create product shortages or market surpluses

Compare price controls, price ceilings, and price floors.
What happens to the equilibrium point if the government imposes a price control (such as a price ceiling or a price floor)? Note that government intervention means the market is no longer free and unable to respond freely. Remember to distinguish between price controls that are binding or effective and those that are not.

In a free market, capitalist economic system, economists say that buyers and sellers 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.

Many governments pass laws to regulate prices called price controls to protect certain citizens or businesses from the effects of the market.

For example, many governments impose price ceilings when the market equilibrium price is too high for certain populations to meet certain policy goals. Examples include restrictions against price gouging during a natural disaster – when a retailer could impose a steep price increase to take advantage of high demand for certain goods or services, such as for gas and bottled water during a hurricane when citizens need to get out of harm's way or when clean water is scarce. Rent control policies prevent landlords from increasing the rent for apartments in high-demand areas in response to the lack of affordable housing. These price controls may create long waiting lists because the demand for cheap gas, bottled water, or affordable housing remains high.

A price floor is a government regulation that restricts employers or businesses from selling items too cheaply. For example, minimum wage laws restrict employers from paying employees too little or offering salaries below a certain threshold or living wage. Similarly, the government may impose a price floor to protect valued businesses or industries, such as by imposing a minimum price buyers pay for milk to protect the local dairy industry. A price floor can create market surpluses, such as when dairy farmers raise more cows to sell more milk to take advantage of the above-market price. The government might also support the industry by buying extra milk to give to school children.

Can you think of other examples of price ceilings or price floors? As you review, it may help to draw graphs of supply and demand to review changes in the equilibrium point from shifts in demand or supply.

To review, see:

[1.7 Price Ceilings and Price Floors]
[1.7 More on Price Ceilings and Price Floors]
[1.7 Demand, Supply, and Efficiency]

Unit 1 Vocabulary

change in demand
change in quantity demanded
change in quantity supplied
change in supply
circular flow diagram
command economies
demand
demand determinants
division of labor
economies of scale
equilibrium price
globalization
gross domestic product (GDP)
law of demand
law of diminishing utility
law of supply
macroeconomics
marginal analysis
market economies
market equilibrium
microeconomics
model
opportunity cost
production possibilities curve
production possibilities frontier
scarcity
specialization
supply
supply determinants
supply shifter
theory
traditional economies
utility

Unit 2: Gross Domestic Product, Inflation, and Unemployment

2a. Identify the components of the business cycle and track real GDP

What are business cycles?
What are economic contraction, recession, and trough?
What are economic expansion, boom, and peak?
What is real GDP, and what is the difference between real and nominal values?
How do economists calculate real values?
What is the GDP deflator, and how do economists use it to calculate real GDP?

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

Figure 5.2 Expansions and Recessions, 1960–2011

Economists use real GDP to evaluate and compare economic activity over time. Economists say the economy is in 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.

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 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 price rise, 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 the economy is contracting.

Note that while GDP measures economic activity, it is not an accurate measurement of the true standard of living in a country. An example of this limitation is that while GDP includes "what a country spends on environmental protection, healthcare, and education, it does not include the actual levels of environmental cleanliness, health, and learning".

To review, see:

2b. Compare real and nominal gross domestic product

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?

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.

A country's overall economy can be measured by its gross domestic product (GDP): the value of all final goods and services produced within the country in a given year.

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

market value of
final goods and services
within one country
in one given year

Gross domestic product (GDP) tallies up the services, durable goods, nondurable goods, structures, and changes 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 changes in inventories.

We just explored services.
Durable goods include long-lasting items, such as cars and refrigerators.
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!).
Structures include homes, office buildings, shopping malls, and factories.
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, see:

2c. Define inflation, deflation, hyperinflation, and stagflation

Why can an economy 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.

Stagflation occurs when a recession and inflation coincide – a highly undesirable situation.

Aggregate demand (AD) is the total demand for all finished goods and services produced domestically in an economy. If consumer consumption rises because many people are employed and spending more, aggregate demand for goods and services will increase. Additionally, if investment increases due to decreased interest rates, production and output will increase. Therefore, aggregate demand will rise.

Aggregate supply (AS) is the total quantity of output firms produce and sell (in other words, real GDP). The aggregate supply (AS) curve shows the total quantity of output firms produce and sell at each price level.

To review, see:

2d. Compute inflation by calculating the price of a basket of goods and the corresponding price index.

What specific baskets of goods do various price indexes measure?
What is the 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), the 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 inflation rate, take the percentage change in the cost of the basket or the percentage change in the price index.

In this section, we learn more about how the CPI has historically been used to measure inflation, deflation, and hyperinflation in the United States and other countries. One downside of indexing is that it tends to be partial. Some people are indexed against inflation, and some are not. It falls to the potential victims of inflation to seek out ways to protect themselves.

Review "Indexing and Its Limitations" for a discussion on the pros and cons of indexing. The discussion of the Federal Open Market Committee's (FOMC) challenge to create price stability while juggling inflation and economic growth tells us that good monetary policy is necessary to reach acceptable economic targets.

To review, see:

2e. Define the price index and compare real variables using the corresponding price index

What is a price index, and what variables make up a 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, which 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, which should not be attributed to deflation.

To review, see:

2f. Define economic growth and explain the role it plays in a country's success and why

How does a small difference in growth rates among countries lead to large differences in total production over an extended period of time?

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

Labor productivity is the value each employed person creates per unit of their input.

Human capital is the skills and knowledge that make workers productive.

Physical capital includes the plant and equipment that firms use and things like roads (infrastructure).

Production function is the technical relationship by which economic inputs like labor, machinery, and raw materials are turned into outputs like goods and services that consumers use.

Entrepreneurship is the process of setting up a business by anticipating needs and turning new ideas to market. Entrepreneurs accept the risks of a startup and are rewarded with profits and growth opportunities. Newly created firms use capital and labor to produce goods and services, thereby contributing to economic growth.

How does an increase in savings contribute to increased investment?
Will a household decision to consume less and save more (increase total investment) enhance a country's long-term economic growth?

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 lead to higher output.

Consider a typical household decision regarding dividing income between spending and saving.

Two key factors in a country's economic growth are whether it has a strong rule of law with a government that protects property rights and contractual rights. Can you give an example of a contractual right?

To review, see:

2g. Define unemployment, the three types of unemployment, and how economists measure it

What are 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 they are available and actively looking for a job. For economists, the unemployment rate provides a key measure of 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 everyone who is not officially employed. So, for example, the unemployment rate does not include retirees, full-time students, people who work from home and do not earn a salary, children, 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

Unemployment rate = Unemployed people / Total labor force × 100

To review, see:

2h. Compare frictional, structural, and cyclical unemployment and their impact on economic production.

Are frictional, structural, and cyclical unemployment 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?
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?

Economists distinguish three types of unemployment: frictional, structural, and cyclical unemployment. In the long run, the unemployment that results from a combination of income, social, and political factors that exist at a time, assuming the economy is not booming or in recession, is called the natural rate of unemployment.

These factors account for the fact that an economy will always have an unemployment rate above zero. Because it takes time for workers to find appropriate new employment or to relocate to a new job, workers remain unemployed during this period. This is called frictional unemployment. Structural unemployment includes individuals who are unemployed because they lack skills valued by the labor market. Cyclical unemployment is a short-term problem because it is caused by an economy that is in recession.

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:

2i. Analyze and apply the natural unemployment rate and full employment

What are natural employment and full employment?

The "natural" rate of unemployment includes frictional and structural unemployment. Structural unemployment is impacted by people finding their skills are not a match for current hiring needs. Think of industries that have changed over time, for example, cars replacing horse-drawn carriages. Over time, these people can retrain to meet current skill demands.

Frictional unemployment reflects the people who are looking for a job and have skills that are in demand. Employers are searching for appropriate candidates. These people, in all likelihood, will eventually find jobs with their current skills. Theoretically, the closer the unemployment rate is to the natural rate of unemployment, the less need there is for the government to intervene with monetary and fiscal policies.

To review, see:

2j. Explain the GDP deflator and the four elements of GDP – consumption, investment, government purchases, and net exports

Which component reflects new home purchases?
What common unit of measurement do economists use to measure GDP?
Which of the components of GDI is the largest?

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. Note that these GDP calculations 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 and 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 services (expenditure approach)

Until now, we 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 of each product sold. This calculation describes an income-based approach.

To calculate GDP, the expenditure approach focuses on consumer demand or the total amount households, businesses, governments, 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:

Consumption – consumer spending or expenditures on final goods and services;
Investment – business spending or expenditures on new capital equipment, inventory, structures, and consumer spending or expenditures on new homes;
Government – expenditures;
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 domestic goods and services. 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

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.

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 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 GDP Deflator and Calculating Real GDP with a Deflator Example.

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

What are 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?
How can GDP 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. For example, the true productivity of a country can be overstated or understated. Statisticians may double-count goods as they flow through the production stages. Therefore, only final goods and services are counted. Intermediate goods are excluded from GDP calculations.

An underground economy of services paid "under the table" and illegal sales are not counted because they are impossible to track. Goods that are not sold in the marketplace are also not counted in GDP.

While GDP measures a country's economic activity, it does not capture unpaid work or leisure time. A country's standard of living is not necessarily reflected in its GDP. For example, the measurement of productivity may be equal in two countries, but a comparison may show that the standard of living is better in a country with a lower GDP.

To review, see How Well GDP Measures the Well-Being of Society.

Unit 2 Vocabulary

aggregate demand
aggregate supply
business cycle
consumption
cyclical unemployment
deflation
depression
durable good
economic growth
entrepreneurship
frictional unemployment
government
gross domestic income (GDI)
human capital
inflation
infrastructure
inventory
investment
labor force
labor productivity
leisure
market value
national income
nondurable good
physical capital
price index
production function
real GDP
recession
service
stagflation
standard of living
structural unemployment
structure
substitution
trade balance
underground economy
unemployment rate

Unit 3: Aggregate Demand, Supply, and Equilibrium

3a. Graphically represent and interpret the aggregate demand curve and explain why it slopes downward

Why does the product demand curve slope downward?
Why does a change in the price level lead to a change in demand in terms of real GDP?

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 lead to the negative slope of the aggregate demand curve, which are all caused by a change in the price level, including the wealth effect, the interest rate effect, and the foreign price effect.

The wealth effect, the interest rate effect, and the foreign price effect influence the downward slope of the aggregate demand curve. Although "a higher price level for final outputs reduces the aggregate demand level for all three reasons", this does not result in a large change in price level.

The wealth effect argues that the buying power of the savings people have saved in bank accounts and other assets diminishes as the price level increases. Consumption spending falls as the price level rises due to a rise in the price level. The people's wealth falls, and it is eaten away by inflation to some extent.

The interest rate effect argues that the buying power of savings people have saved in bank accounts and other assets diminishes when the price of outputs increases. In effect, purchases require more money or credit. In addition, the increased demand for money and credit pushes interest rates even higher. In turn, higher interest rates cause businesses to limit borrowing for investment, and households borrow less to purchase homes and cars – reducing consumption and investment spending.

The foreign price effect argues that U.S. goods are relatively more expensive than goods in the rest of the world when U.S. prices rise (but remain fixed in other countries). Since U.S. exports become relatively more expensive, the quantity of U.S. exports sold will fall. The quantity of U.S. imports rises because importing goods from abroad is relatively cheaper. Consequently, higher domestic price levels, relative to price levels in other countries, reduce net export expenditures.

Review this graph, which illustrates factors that comprise aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M. As price levels rise, total spending on domestic goods and services declines.

– From OpenStax, https://openstax.org/books/principles-macroeconomics-3e/pages/11-4-shifts-in-aggregate-demand

Aggregate demand (AD) slopes down, showing the amount of total spending on domestic goods and services decreases as the price level rises.

The demand curve for goods and services slopes down due to the availability of substitute goods, not the wealth effect, interest rate, or foreign price effects associated with aggregate demand curves.

To review, see:

3b. Analyze factors leading to shifts in the aggregate demand curve

What factors lead to shifts in the aggregate demand 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.

Short-run aggregate supply is upward-sloping and represents the total production of goods and services available in an economy at different price levels while some resources are fixed. The long-run aggregate supply is an economy's production level when all available resources are used efficiently. It equals the highest level of production an economy can sustain. Changes in prices of factors of production shift the short-run aggregate supply curve. Changes in capital stock, the stock of natural resources, and technology levels can also cause the short-run aggregate supply curve to shift. The long-run aggregate supply curve is perfectly inelastic and vertical because firms can adapt to price-level changes better in the long run than in the short run.

We can look at all of the factors above and think of them as necessary for the production of other goods and services. When these "inputs'' become less or more available, productivity is impacted. In the long run, the most important factor that shifts the aggregate supply curve is due to growth in productivity. For example, the same quantity of labor can produce more output. This moves the AS curve rightward since better productivity lets firms make more output at each price.

The AS curve shifts out from short-run aggregate supply SRAS₀ to SRAS₁, to SRAS₂, etc. The equilibrium shifts from E₀ to E₁ to E₂, etc. Because of increased productivity, workers produce more GDP. At full employment, this leads to a higher potential GDP and a rightward shift of the long-run supply curve from LRAS₀ to LRAS₁ to LRAS₂.

The AS curve shifts out from short-run aggregate supply SRAS0 to SRAS1, to SRAS2, etc. The equilibrium shifts from E0 to E1 t

Increased costs for inputs like labor and energy push the SRAS curve left. At every output price, higher input costs lower production due to decreased profit potential. A shift occurs to the left for a new equilibrium. This new relationship between price levels for inputs and decreased GDP can bring recession, higher unemployment, and inflation (stagflation).

A decline in the price of inputs will have the reverse effect. A decline in the price of a key input will shift the SAS to the right, thereby providing an incentive for firms to produce more at every given price level of output. This can result in economic expansion, lower unemployment, and a decline in inflation. Other key inputs that may shift the SRAS curve include the cost of labor (wages) and the cost of imported goods used as inputs for other products. (The long-run aggregate supply curve usually does not shift with a change in input prices, only the short-run aggregate supply curve).

To review, see:

3c. Graphically represent and interpret a short-run aggregate supply curve and explain why it slopes upward

Why does the product supply curve slope 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.

See the diagrams below to see examples of movement along the SRAS curve. Changes in price levels may cause movements along the SRAS curve. When prices increase, businesses record profits and increase their production levels. Conversely, when price levels fall, they reduce production levels. This change in price levels and quantity supplied (output) causes movement along the aggregate supply curve. The aggregate supply curve will shift when costs such as labor or other inputs rise or fall. Shocks to input goods, such as labor markets, imported goods used as inputs for other products, etc., may also shift the aggregate supply curve.

Image credit: http://www.economicshelp.org

To review, see:

3d. Analyze the factors leading to shifts in the short-run aggregate supply curve

What factors lead to wage and price stickiness?
What role do employment contracts play in maintaining a fixed wage?
How do efficiency wage theory, implicit contracts theory, the adverse selection of wage cuts argument, the insider-outsider model of the labor force, and the relative wage coordination argument help explain wage stickiness?

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.

To review these theories, see:

3e. Graphically represent and interpret a long-run aggregate supply curve and short-run and long-run equilibrium

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.

The image below depicts the long-run aggregate supply curve at full employment. You will notice it is vertical!

The image depicts the long-run aggregate supply curve at full employment. You'll notice it is vertical!

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

3f. Examine how aggregate demand and aggregate supply determine the equilibrium price level and level of real GDP

How do aggregate demand and aggregate supply determine the equilibrium price level and level of real GDP?

The diagrams below help us to understand how new equilibriums are established with changes in price levels and real GDP.

– From OpenStax, https://openstax.org/books/principles-macroeconomics-3e/pages/11-5-how-the-ad-as-model-incorporates-growth-u

"A shift in aggregate demand from AD₀ to AD₁, when it occurs in the area of the SRAS curve that is near potential GDP, leads to a higher price level and pressure for a higher price level and inflation. The new equilibrium (E₁) is at a higher price level (P₁) than the original equilibrium. A shift in aggregate supply from SRAS₀ to SRAS1 will lead to a lower real GDP and pressure for a higher price level and inflation. The new equilibrium (E₁) is at a higher price level (P₁), while the original equilibrium (E₀) is at a lower price level (P₀)."

To review, see:

3g. Apply the AD-AS model to explain demand-pull and cost-push inflation and recession

What are 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. See the illustration below for a graphic description of what occurs relative to the factors listed on the left in cost-push inflation and demand-pull inflation.

Image credit: https://slidesharenow.blogspot.com/2019/10/cost-push-vs-demand-pull.html

To review, see:

3h. Explain recessionary and inflationary gaps, the natural unemployment rate, and potential income

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 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?

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.

A Recessionary Gap -– From https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/s10-03-recessionary-and-infl

A Recessionary Gap

"When employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap Y_P − 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)."

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.

– From https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/s10-03-recessionary-and-inflationary-.html

An Inflationary Gap

"When employment is above the natural level, the output must be above the potential. The inflationary gap equals Y₁ − Y_P. 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, see How the AD/AS Model Incorporates Growth, Unemployment, and Inflation and Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium.

3i. Explain different schools of thought about the shape of the aggregate supply curve

What actions can governments take to help re-establish the long-run equilibrium to eliminate a recessionary gap?
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?
What did classical economic theorists and Keynesians recommend policymakers do when a long-run disequilibrium occurs to help the economy move toward equilibrium?

The intersection of the short-run aggregate demand and supply curves describes a short-run equilibrium of the price level and real GDP. We 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 common policy disagreement exists about the options a country has to address long-run disequilibrium. According to 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, see Keynes' Law and Say's Law in the AD/AS Model and Macroeconomic Viewpoints.

Unit 3 Vocabulary

aggregate demand curve
cost-push inflation
demand-pull inflation
foreign price effect
inflationary gap
interest rate effect
long-run equilibrium
recessionary gap
wealth effect

Unit 4: Money, Banking, and Monetary Policy

4a. Define money and identify its functions

What are the three functions of money: medium of exchange, unit of account, and store of value?
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, a unit of account, and a store of value.

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

To review, see:

4b. Show how money is measured and explain the role of banks in the money creation process

Why do banks consider checkable deposits a liability?
What happens to a bank when loans go 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 essentially lend your money to a bank. In turn, the bank will lend your deposit out to other individuals and businesses as 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 is 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.

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	0.0	0.0
Total assets	$12,497.20	Total liabilities	$11,155.40
0.0		Net worth	$1,341.80

This balance sheet for U.S. commercial banks shows their seasonally adjusted financial situation in billions of dollars in January 2012.

To review, see:

4c. Apply the money multiplier formula to calculate the change in money supply in a fractional reserve banking system

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 the government and the central bank impose to affect the money multiplier?

Money Multiplier = 1 / Required Reserves Ratio

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

Study the money creation process by following the money path 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 created from the initial deposit.

To review, see:

4d. Explain the structure, functions, and goals of the U.S. Federal Reserve

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 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; and
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, see:

4e. Show the importance of the Fed's independence from the government and explain how the Fed's structure and decision-making process promote independence

What is the structure of the Federal Reserve System?
How does this structure help to promote independent decision-making?
Why does the Chairman of the Fed have such power and influence in economic policy-making?

The mission of the Federal Reserve is to establish and maintain confidence in the public's monetary and banking system. Obviously, this cannot be accomplished without a great deal of trust. Consequently, it is important that the public believes the Fed is independent and not subject to outside pressures, such as politics, when making decisions. Today, the Fed plays an even greater role in preserving our nation's healthy economy.

The Federal Reserve's roles in conducting monetary policy, supervising banks, and providing payment services to depository institutions help it maintain the financial system's stability.

The Federal Reserve System (the central bank of the United States) has 12 districts throughout the United States. A subset of this larger group is a seven-member Board of Governors that is appointed by the U.S. president and approved by the Senate. Each member serves a 14-year term.

The U.S. president appoints one member of this seven-member board as chair of the Federal Reserve for a four-year term. They can serve multiple terms. The larger 12-member Federal Open Market Committee (FOMC), the policy-making group within the Fed, conducts all open market operations (the buying and selling of government securities).

The terms of the Board of Governors are staggered. This helps insulate the Board from political pressures so they can base their policy decisions on economic merits. Each member (except the Fed chair) only serves one term to further ensure independent decision-making. Finally, the Fed's policy decisions do not require Congressional approval. The U.S. president cannot force a Federal Reserve Governor to resign.

The chair of the Federal Reserve only has one vote, but they control the agenda and are the public voice of the Fed. These responsibilities bestow great power and influence on the Fed chair position.

To review, see:

4f. Identify three tools of monetary policy and how they are used to change the economy's money supply

How do open market operations, reserve requirements, and changing the discount rate influence the money supply?

The central bank has three tools to implement monetary policy: 1. open market operations, 2. changing reserve requirements, and 3. changing the discount rate. Open market operations occur when the central bank buys or sells U.S. Treasury bonds. This influences the quantity of bank reserves and the level of interest rates. Decisions are made by the Federal Open Market Committee (FOMC). The Fed can also raise or lower the discount rate, which is the interest rate banks pay for loans from the Fed. Finally, the central bank can raise or lower the reserve requirement, that is, the percentage of each bank's deposits that it is legally required to hold either as cash in its vault or on deposit with the central bank.

"Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks (the key component of reserves) and thus the federal funds rate – the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution. Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and, ultimately, a range of economic variables, including employment, output, and the prices of goods and services."

— From The Federal Reserve: Monetary Policy

To review, see:

4g. Explain and illustrate how the bond market works and the relationship between bond prices and interest rates

How does the bond market work?
What is the relationship between bond prices and interest rates?
What happens to demand when interest rates are lowered because of the sale of bonds by the Fed?

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

In the information below, we review the effect the U.S. Federal Reserve's buying and selling of bonds has on demand, bond prices, and interest rates. Note the diagrams, Panels a, b, c, and d, that graphically explain the effect of 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 increases 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 (bond prices and interest rates are negatively related). See panel b.

When the U.S. Federal Reserve buys bonds, it essentially adds reserves to 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 (b) to see what happens to price levels and demand when the Fed responds to a recession by buying bonds.

Image credit: https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/section_14/3dc155679333f3e164a58c85166db2

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). (Note: You can also see diagrams and an explanation of how the Fed can react when it considers inflation a threat and employs a contractionary monetary policy.)"

To review, see Monetary Policy and the Federal Reserve and Bond Prices and Interest Rates.

4h. Explain how the foreign exchange market works and how changes in the interest rate affect the exchange rate for a country's currency

How does the foreign exchange market work?
How do changes in the interest rate affect the exchange rate for a country's currency?
Why can a stronger U.S. dollar be both a blessing and a curse, depending on the party's role in a transaction?

The information below will guide you in the highlights of the material. The readings indicated for review below are strongly recommended to provide more insight into these topics.

Most of the international economy occurs in multiple national currencies, where individuals and firms convert one currency to another when they sell, buy, hire, borrow, travel, or invest in foreign countries. People and businesses purchase foreign currencies in the foreign exchange market.

Businesses that buy and sell on international markets learn that they must pay the costs to their workers, suppliers, and investors in the currency where the production occurs. Still, their revenues from sales are measured in the currency of the nation where their sales occurred. For example, a Chinese firm exporting abroad will earn another currency from the sale – perhaps U.S. dollars – but it will need Chinese yuan to pay its workers, suppliers, and investors who live in China. In the foreign exchange market, the Chinese business is a supplier of U.S. dollars and a demander of Chinese yuan.

The foreign exchange market works through financial institutions and operates on several levels. Most people and firms who exchange a substantial quantity of currency go to a bank. Most banks provide foreign exchange to their customers. Banks and other firms, known as dealers, then trade the foreign exchange. This is called the interbank market.

A currency appreciates or strengthens when the exchange rate for a currency rises (we can buy a lot more Euros with a set amount of dollars). A currency depreciates or weakens when the exchange rate for it falls, so it trades for less than other currencies (we can only buy a few Euros with a set amount of dollars).

Movements in the exchange rate affect exporters, tourists, and international investors differently. A stronger dollar hurts U.S. businesses that sell products abroad. A strong U.S. dollar means foreign currencies are correspondingly weak. When the U.S. exporter is paid or earns foreign currencies from its export sales and converts them into U.S. dollars to pay its workers, suppliers, and investors who live in the United States, the foreign currency buys fewer U.S. dollars (because the U.S. dollar is stronger).

Consequently, the firm's profits (measured in U.S. dollars) fall. The U.S. company may decide to reduce its exports (waiting for the U.S. dollar to fall), or it may raise its selling price, which also tends to reduce its exports. Because of this, stronger currencies reduce countries' exports.

A stronger dollar is a blessing for foreign firms that sell products to the United States. Each dollar they earn from export sales in the United States will buy more home currency than they had anticipated before the dollar strengthened. Consequently, a stronger dollar means foreign exporters will earn more profits than they had expected. The company will seek to expand sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. A stronger U.S. dollar means consumers buy more foreign products, expanding the country's level of imports.

Try to turn this scenario around to see what happens when the U.S. dollar weakens.

To review, see:

4i. Graphically represent the money demand and the money supply functions and determine the equilibrium interest rate and quantity of money in the money market

What is the shape of the money supply curve?
What factors can shift the money supply curve?
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?
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. The figure below 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).

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

In the figure below, we put money demand and money supply together on the same graph to analyze the relationship between the money market and the 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.

Money Market Equilibrium

To review, see:

4j. Use graphs to analyze the effect of changes in the bonds and money markets on the equilibrium real GDP and the price level

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 governments 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 determine 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.

– From https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/s13-01-the-bond-and-foreign-exchange-.html

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, see Interest as Rent for Money and Money Supply, Money Demand, and Interest Rates.

Unit 4 Vocabulary

bond
bond market
commodity money
coupon rate
discount rate
face value
fiat money
financial intermediary
foreign exchange market
money supply
open market operations
secondary market

Unit 5: Fiscal Policy

5a. Identify the major components of the U.S. government revenues and spending

What are some examples of government purchases?
What is the effect of a change in government spending on GDP?
What are 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?
What are the elements of federal government revenue: payroll taxes, individual income taxes, and corporate income taxes?
How does the tax rate change with the business cycle?
How does a change in the tax rate affect GDP?
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?

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).

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. Define budget surplus, budget deficit, and balanced budget and how they are related to 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 in health and longevity?

Essentially, a budget surplus exists when income exceeds expenditures. In this case, the government may choose to lower taxes. A budget deficit has the opposite effect. When spending exceeds income, the government may need to borrow money in order to finance its activities.

Economists calculate the national debt as the sum of all past federal deficits minus all surpluses. As the baby boomer generation retires en masse, government spending on Social Security is one of the largest components of the U.S. national debt.

To review, see:

5c. Identify the goals and tools of discretionary fiscal policy and distinguish them from automatic stabilizers

What is the difference between discretionary and nondiscretionary spending?
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 the government use spending programs and taxes to promote economic expansion and economic contraction?
What economic circumstances can prompt a government to employ an expansionary or contractionary fiscal policy?

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.

As their name implies, automatic stabilizers work automatically and usually in a direction that is opposite to the direction the economy is taking to 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.

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

Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

"In Panel (a), the economy faces a recessionary gap (Y_P − 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 − Y_P). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap."

Fiscal policy describes the policies governments enact to influence the aggregate economy, real GDP, and 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 is 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.

To review, see:

5d. Identify the lags in carrying out discretionary fiscal policy

What are 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 over-inflated. 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 when a policy is enacted and when the economy feels its impact.

To review, see:

5e. Analyze how government borrowing causes crowding out of private investment

Why does an increase in government borrowing increase interest rates?
What is 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, see:

5f. Use the Phillips curve to identify the relationship between inflation and unemployment

What is the Phillips Curve, and how does it show the relationship between inflation and unemployment?
What are the three phases of unemployment: the Phillips phase, stagflation, and the recovery phase?

The Short-Run Phillips Curve

In 1958, A. W. Phillips (1914–1975), 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.

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.

Connecting the Points: Inflation 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.

Inflation – Unemployment Phases

In a typical Phillips Curve, increased inflation is associated with lower unemployment in the short run. The long-run Phillips curve reflects the natural rate of unemployment (full employment). This is shown as a vertical line because, at this natural rate, it does not depend on the rate of inflation, regardless of the price level. At the natural unemployment level, we have a certain output that is sustainable for the economy (full employment). Also, see Figure 16.10 in Learning Outcome 5g for an additional graphical representation of inflation and unemployment in the long run on the Phillips Curve.

To review, see Phillips Curve and Changes in the AD-AS Model and the Phillips Curve.

5g. Use the model of aggregate demand and aggregate supply to explain a Phillips, stagflation, and recovery phase

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

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, in the long run, the Phillips curve is vertical at the natural rate of unemployment and shows no trade-off between inflation and unemployment.

The Phillips Curve in the Long Run

"Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with a 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, see Changes in the AD-AS Model and the Phillips Curve.

5h. Compare and contrast 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 are some similarities between fiscal and monetary policy?
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 level. 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.

There are several significant differences between fiscal and monetary policy. While both policies can shift AD to the right or left, monetary policy is indirect manipulation through the central bank (the Federal Reserve in the U.S.) printing money to increase the supply of money to be lent. This lowers the interest rates and leads to a willingness to borrow and invest money.

The government drives fiscal policy. It refers to government spending and tax policies used to influence the economy. It is up to Congress to approve various bills that are proposed and to oversee the budgets for income dollars (taxes) and spending. Fiscal policy directly impacts the economy because the government buys goods and services by ratcheting up debt.

An expansionary fiscal policy lowers the tax rates to increase spending to increase aggregate demand and economic growth. A contractionary fiscal policy raises rates or cuts spending to prevent or reduce inflation.

To review, see:

5i. Explain Classical, Neoclassical, Keynesian, and Monetarist beliefs on policies to stabilize the economy

How did the Great Depression shatter these classical macroeconomic beliefs?
What policy prescriptions did neoclassical 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.

The Keynesian perspective focuses on macroeconomics in the short run and on aggregate demand. The neoclassical perspective looks at the macroeconomy in the long run and focuses on the crucial role of supply.

As the name neoclassical implies, this macroeconomic perspective is a "new" version of the "old" classical economic model. The classical perspective was the predominant economic philosophy before the Great Depression. It argued that any short-term fluctuations in economic activity would adjust back to full employment rather quickly, with flexible prices. This perspective suggested that when the economy is at full employment, increasing demand won't boost the overall GDP; it would only lead to higher prices. Therefore, it recommended a "hands-off" approach, meaning the government and central bank should avoid intervening.

For example, an economy that slips into recession (a leftward shift of the aggregate demand curve) will temporarily exhibit a surplus of goods. Falling prices will eliminate this surplus, and the economy will return to a full employment level of GDP. No active fiscal or monetary policy is needed. The classical perspective held that if the government or central bank tried to stimulate the economy by spending more money or cutting interest rates, it would mostly lead to inflation instead of boosting economic output or GDP. However, the long-lasting effects of the Great Depression shifted this mindset. Keynesian economics prescribed active fiscal policy to alleviate weak aggregate demand and became the more mainstream perspective.

According to classical economic theorists, free markets will automatically adjust to clear any disequilibrium that occurs in the labor and products 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).

Neoclassical economists say the government should focus on long-term growth and on controlling inflation rather than worry about recession or cyclical unemployment. This perspective is more useful for long-term economic analysis. Conversely, the Keynesian economic perspective encourages short-run analysis.

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

Keynes' income-expenditure model suggests recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. When consumption expenditures decline, firms will anticipate a drop in profits and decrease their investment expenditure. When aggregate demand declines, the demand for labor and goods shifts to the left. Due to sticky wages and prices, wages and prices remain at their original level.

This creates an excess supply of labor and goods that leads to additional spending and additional income. The economy is in a recession when this happens to many labor markets and goods markets across an economy.

According to Keynes, spending not only affects the equilibrium level of GDP but it causes a disproportionate change in GDP. Because one person's spending is another person's income, that leads to additional spending and additional income. The cumulative impact on GDP is larger than the initial increase in spending. Conversely, when spending collapses, it causes a much larger decrease in real GDP. The size of the multiplier is a critical element in formulating fiscal policies.

Economists use the neoclassical and Keynesian perspectives to analyze the economy in the long and short term.

To review, see:

Unit 5 Vocabulary

automatic stabilizer
budget deficit
budget surplus
classical perspective
crowding out effect
discretionary fiscal policy tools
discretionary spending
fiscal policy
impact lag
implementation lag
income-expenditure model
John Maynard Keynes
Keynesian perspective
multiplier
national debt
neoclassical perspective
non-discretionary spending
Phillips phase
price level
recognition lag
recovery phase
stagflation phase

Unit 6: International Trade and Finance

6a. Explain trade balances and their connection with financial capital flows (and the savings and investment identity)

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

Countries have an absolute advantage when they use fewer resources to produce a good than other countries. This advantage may be due to a country's natural endowment (such as its geography or resources).

Countries have a comparative advantage when they can produce a good at a lower opportunity cost in terms of other goods. Be sure to consider the opportunity cost of producing a good to trade. For example, if a country uses its resources to produce wheat, it cannot use those resources to produce soy. A country with a necessary natural resource or location has an absolute advantage in the cost to produce the product for trade. The country with the lowest opportunity cost to produce a good relative to another country will have a comparable advantage.

Production Possibility Frontier for the U.S. and Brazil

Production Possibility Frontier for the United States and Brazil

The U.S. PPF is flatter than the Brazil PPF, implying that the opportunity cost of wheat in terms of sugar cane is lower in the United States than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The United States has a comparative advantage in wheat, and Brazil has a comparative advantage in sugar cane.

International trade is based on the principle of comparative advantage. Countries specialize in producing goods and services where 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.

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.

To review, see:

6b. Discuss how we use economic indicators to compare global income levels and standard of living

What are the goals a country may have for its standard of living?
As an economic measure, what classifications does the gross national income (GNI) allow the World Bank to update each year?
What are some causes of global unemployment?
What is the difference between a country's level of trade and trade balance?

Economic indicators include unemployment, inflation, and balance of trade and policies across countries. These indicators relate to universal macroeconomic goals that impact a country's standard of living. To gauge a country's quality of life of its citizens, economists look at factors such as low levels of unemployment, price stability (low levels of inflation), and the ability to trade.

The World Bank ranks countries as high-income, middle-income, and low-income to measure and compare where countries stand relative to income and growth.

High-income countries are challenged with creating a more educated workforce that can create, invest in, and apply new technologies.
Challenges in middle-income economies relate to political and governmental controls in banking and financial regulations.
Growth policies for economically challenged (low-income) countries must address the lack of economic and legal stability and market-oriented institutions. These factors make it difficult to foster domestic economic growth and attract foreign investment.

A country's balance of trade is any gap between the dollar value of its exports (what its producers sell abroad) and the dollar value of its imports (the foreign-made products and services households and businesses buy). If exports exceed imports, the economy has a trade surplus. If imports exceed exports, the economy has a trade deficit. If exports equal imports, the economy has a balanced trade.

We measure a nation's trade level by its exports of goods and services as a percentage of its GDP. A high level of trade indicates the country exports a good portion of its production. The level of trade indicates the degree of an economy's globalization.

To review, see:

6c. Explain the effects of net exports on aggregate demand

How do changes in exports and imports affect net exports?
Define the relationship between net exports and aggregate demand.
How does international trade affect the equilibrium levels of real GDP and the price level?

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

Net Exports = Exports – Imports

Remember, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). Any increase in net exports creates a greater amount of total spending at every price level. This would shift aggregate demand to the right. A shift in aggregate demand to the left for net exports means that a lesser amount of total spending occurs at every price level. Two factors can cause shifts in aggregate demand for export and import demand: changes in relative growth rates between countries and changes in relative prices between countries.

Relative to net exports, aggregate demand decreases when there is a decrease in foreign demand or when there is a relative price increase of U.S. goods. Aggregate demand increases with an increase in foreign demand or a relative price drop of U.S. goods.

Note the various arguments for restricting imports, such as unsafe consumer products, national interest, the need for higher environmental standards for low-income countries, etc. Do you agree or disagree with some of the reasons for these types of policies? What benefits or adverse effects do you perceive with unrestricted trade?

To review, see:

6d. Identify the components of the U.S. balance of payments

What are two main sources of supply of financial capital in the U.S. economy?
What are two main sources of demand for financial capital in the U.S. economy?

The U.S. balance of payments reflects transactions between the United States and foreign residents. Three major categories in the balance of payments include the current account, the capital account, and the financial account. The U.S. current account refers to the U.S. transactions trade in goods and services, its net earnings on foreign investments, and its net transfer payments over a defined period of time (i.e., quarterly, yearly).

A country's balance of trade is the difference between the monetary value of its exports minus its imports (X-M). More about this component is discussed in Learning Outcomes 2g and 6b above. As mentioned in Learning Outcome 6b, a nation's level of trade is measured by its exports of goods and services as its share of GDP.

While the balance of trade tracks imports and exports, the current account also includes income from investments and transfers. Unilateral transfers are payments from governments, charities, and individuals when they send money abroad without receiving any direct good or service.

There are two primary sources for the supply of financial capital in the U.S. economy: individual and business savings (S) and the inflow of financial capital from foreign investors (this inflow is the trade deficit or imports minus exports M – X).

Two primary sources of demand for financial capital in the U.S. economy are private sector investment (I) and government borrowing. The government must borrow when government spending, G, is higher than the taxes collected, T.

Supply of financial capital = Demand for financial capital

S + (M – X) = I + (G – T)

There are times when various components of the national savings and investment identity can switch roles. For example, when the government needs to borrow funds to offset deficits, it can become a borrower (G – T > 0) and a demander of financial capital on the right side of the equation. However, the government would appear on the left side of the equation as a supplier of financial capital if the government is experiencing a surplus (T – G > 0).

To review, see:

6e. Analyze the pros and cons of having a large trade deficit and financial account surplus

How can borrowing money or running a trade deficit result in a healthy economy?
How can borrowing money or running a trade deficit result in a weaker economy?
When does it make economic sense for a national economy to borrow from abroad?

When a country's imports exceed its exports, its economy has a trade deficit. It receives a net inflow of foreign capital from abroad. Much of that foreign capital is invested in railroads and public infrastructure (roads, water systems, schools). These invested funds help the U.S. economy to grow. In this way, the trade deficit and the accompanying investment of funds help the U.S. economy. This inflow of foreign money can also cause harm if investing countries withdraw it quickly when they are concerned about the economic health of the recipient country. A rapid departure of foreign capital can negatively impact the country's economy and banking system and lead to a recession.

A trade surplus can create robust economic health. It can also negatively impact economic growth. For example, Japan has faced recessionary fears since 1990 due to slow GDP growth and increasing unemployment rates. Japan's trade surplus reflects a high rate of domestic savings (more than it can invest domestically). Therefore, Japan invests its extra funds abroad. Their consumption of imports is low, and the growth of consumption is slow. Exports continually exceed imports and result in a high trade surplus in most years. In Japan's case, a trade surplus, with slow GDP growth and an increasing unemployment rate, does not guarantee good economic health.

To review, see Pros and Cons of Trade Deficits and Surpluses and The Difference between the Level of Trade and the Trade Balance.

6f. Define and compare the main types of exchange rate systems

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?

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

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.

An exchange rate is the rate at which one currency can be exchanged for another. It represents the value of one country's currency in relation to another currency. Exchange rates can be either fixed or floating. A fixed or pegged rate is determined by the government or the central bank of a country, while a floating rate is determined by market forces, specifically by the supply and demand dynamics in the foreign exchange market.

The Market for Dollars

A shift in 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.

To review, see Exchange Rate Policies.

6g. Identify the main arguments in support of international trade and link this with comparative advantage

How do tariffs and quotas restrict free trade?
How do trade restrictions affect each trading 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 trading partners since it allows countries to specialize in producing the goods and services where they enjoy a comparative advantage. Nevertheless, policymakers frequently argue against free trade policies and impose trade restrictions, such as tariffs and quotas.

Consumers may suffer when governments impose tariffs and quotas; foreign businesses pass along any additional fees they must pay for the tariff to consumers 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, see:

Unit 6 Vocabulary

absolute advantage
balanced trade
balance of trade
comparable advantage
comparative advantage
current account
economic indicators
exchange rate
free trade
high-income countries
international trade
low-income countries
middle-income countries
quota
tariff
trade deficit
trade surplus
U.S. balance of payments

ECON102 Study Guide

Table of contents

Navigating this Study Guide

Study Guide Structure

How to Use this Study Guide

Unit 1: What is Macroeconomics?

1a. Define economics and explain its importance

1b. Compare microeconomics and macroeconomics

1c. Describe how theories, models, and tools are used to perform economic analysis

1d. Analyze resource allocation based on scarcity, opportunity cost, and making decisions at the margin

1e. Apply the production possibilities curve to identify production combinations that are efficient, inefficient, and unattainable

1f. Define demand, supply, and market equilibrium

1g. Explain how changes in demand and supply affect the demand and supply curves and alter the equilibrium prices and quantities

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

1i. Analyze price controls and how they create product shortages or market surpluses

Unit 1 Vocabulary

Unit 2: Gross Domestic Product, Inflation, and Unemployment

2a. Identify the components of the business cycle and track real GDP

2b. Compare real and nominal gross domestic product

2c. Define inflation, deflation, hyperinflation, and stagflation

2d. Compute inflation by calculating the price of a basket of goods and the corresponding price index.

2e. Define the price index and compare real variables using the corresponding price index

2f. Define economic growth and explain the role it plays in a country's success and why

2g. Define unemployment, the three types of unemployment, and how economists measure it

2h. Compare frictional, structural, and cyclical unemployment and their impact on economic production.

2i. Analyze and apply the natural unemployment rate and full employment

2j. Explain the GDP deflator and the four elements of GDP – consumption, investment, government purchases, and net exports

Demand or Expenditure Side of GDP

Measuring Total National and Domestic Income

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

Unit 2 Vocabulary

Unit 3: Aggregate Demand, Supply, and Equilibrium

3a. Graphically represent and interpret the aggregate demand curve and explain why it slopes downward

3b. Analyze factors leading to shifts in the aggregate demand curve

3c. Graphically represent and interpret a short-run aggregate supply curve and explain why it slopes upward

3d. Analyze the factors leading to shifts in the short-run aggregate supply curve

3e. Graphically represent and interpret a long-run aggregate supply curve and short-run and long-run equilibrium

3f. Examine how aggregate demand and aggregate supply determine the equilibrium price level and level of real GDP

3g. Apply the AD-AS model to explain demand-pull and cost-push inflation and recession

3h. Explain recessionary and inflationary gaps, the natural unemployment rate, and potential income

3i. Explain different schools of thought about the shape of the aggregate supply curve

Unit 3 Vocabulary

Unit 4: Money, Banking, and Monetary Policy

4a. Define money and identify its functions

4b. Show how money is measured and explain the role of banks in the money creation process

4c. Apply the money multiplier formula to calculate the change in money supply in a fractional reserve banking system

4d. Explain the structure, functions, and goals of the U.S. Federal Reserve

4e. Show the importance of the Fed's independence from the government and explain how the Fed's structure and decision-making process promote independence

4f. Identify three tools of monetary policy and how they are used to change the economy's money supply

4g. Explain and illustrate how the bond market works and the relationship between bond prices and interest rates

Expansionary Monetary Policy

4h. Explain how the foreign exchange market works and how changes in the interest rate affect the exchange rate for a country's currency

4i. Graphically represent the money demand and the money supply functions and determine the equilibrium interest rate and quantity of money in the money market

Money Market Equilibrium

4j. Use graphs to analyze the effect of changes in the bonds and money markets on the equilibrium real GDP and the price level

Unit 4 Vocabulary

Unit 5: Fiscal Policy

5a. Identify the major components of the U.S. government revenues and spending

5b. Define budget surplus, budget deficit, and balanced budget and how they are related to the national debt

5c. Identify the goals and tools of discretionary fiscal policy and distinguish them from automatic stabilizers

5d. Identify the lags in carrying out discretionary fiscal policy

5e. Analyze how government borrowing causes crowding out of private investment

5f. Use the Phillips curve to identify the relationship between inflation and unemployment

The Short-Run Phillips Curve

Inflation – Unemployment Phases

5g. Use the model of aggregate demand and aggregate supply to explain a Phillips, stagflation, and recovery phase

5h. Compare and contrast fiscal and monetary policy

5i. Explain Classical, Neoclassical, Keynesian, and Monetarist beliefs on policies to stabilize the economy

Unit 5 Vocabulary

Unit 6: International Trade and Finance

6a. Explain trade balances and their connection with financial capital flows (and the savings and investment identity)

6b. Discuss how we use economic indicators to compare global income levels and standard of living

6c. Explain the effects of net exports on aggregate demand

6d. Identify the components of the U.S. balance of payments

6e. Analyze the pros and cons of having a large trade deficit and financial account surplus

6f. Define and compare the main types of exchange rate systems

6g. Identify the main arguments in support of international trade and link this with comparative advantage

Unit 6 Vocabulary