Chapter 1: Foundations of Economics

Definitions

Economics is the study of how individuals, firms, and societies allocate limited resources to satisfy unlimited wants.

• Scarcity: The condition that arises because resources are limited while wants are unlimited.

• Trade-offs: The idea that because of scarcity, producing more of one good or service means producing less of another.

Three Key Economic Ideas

• People are rational: Individuals use all available information to achieve their goals.

• People respond to incentives: Changes in costs and benefits influence behavior.

• Optimal decisions are made at the margin: Most choices involve doing a little more or a little less of something.

Efficiency vs. Equality

• Efficiency: Resources are used in a way that maximizes the production of goods and services.

• Equality: The fair distribution of economic benefits among members of society.

• There is often a trade-off between efficiency and equality.

Positive vs. Normative Analysis

• Positive analysis: Objective statements about what is (can be tested).

• Normative analysis: Subjective statements about what ought to be (value judgments).

Types of Economies

• Market economy: Decisions are made by households and firms interacting in markets.

• Centrally planned economy: The government makes most economic decisions.

• Mixed economy: Features of both market and centrally planned economies.

Role of Economic Models

• Economic models are simplified representations of reality used to analyze real-world economic situations.

• They help in making predictions and understanding economic relationships.

Microeconomics vs. Macroeconomics

• Microeconomics: The study of individual markets and decision-makers.

• Macroeconomics: The study of the economy as a whole, including inflation, unemployment, and economic growth.

Chapter 2: Trade-offs, Comparative Advantage, and the Market System

Production Possibilities Frontier (PPF)

The PPF is a curve showing the maximum attainable combinations of two products that may be produced with available resources and technology.

• Points on the PPF are efficient; points inside are inefficient; points outside are unattainable.

• The slope of the PPF represents the opportunity cost.

Opportunity Cost

• The highest-valued alternative that must be given up to engage in an activity.

• Calculated as the loss of one good divided by the gain of another.

Comparative Advantage vs. Absolute Advantage

• Absolute advantage: The ability to produce more of a good with the same resources.

• Comparative advantage: The ability to produce a good at a lower opportunity cost.

• Trade is based on comparative, not absolute, advantage.

Complete Specialization and Gains from Trade

• When each party specializes in the good for which they have a comparative advantage, total production increases.

• Both parties can consume beyond their individual PPFs through trade.

Market System and Circular Flow Diagram

• The market system coordinates economic activity through prices and voluntary exchange.

• The circular flow diagram illustrates the flow of goods, services, and money between households and firms.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply

Perfectly Competitive Markets

• Many buyers and sellers, identical products, and no barriers to entry.

Law of Demand and Law of Supply

• Law of Demand: As price falls, quantity demanded rises, ceteris paribus.

• Law of Supply: As price rises, quantity supplied rises, ceteris paribus.

Supply and Demand Curves vs. Quantity Supplied and Quantity Demanded

• "Demand" and "Supply" refer to the entire curves; "quantity demanded" and "quantity supplied" refer to specific points on the curves at a given price.

Supply and Demand Schedules

• Tables showing the relationship between price and quantity demanded or supplied.

Effect of Change in Price

• A change in price causes a movement along the demand or supply curve (change in quantity demanded/supplied).

• Other factors cause the curves to shift.

Factors that Shift Demand

• Income, prices of related goods, tastes, population, and expectations.

Factors that Shift Supply

• Input prices, technology, number of sellers, expectations, and prices of related goods in production.

Substitutes vs. Complements; Normal vs. Inferior Goods

• Substitutes: Goods used in place of each other; an increase in the price of one increases demand for the other.

• Complements: Goods used together; an increase in the price of one decreases demand for the other.

• Normal goods: Demand increases as income increases.

• Inferior goods: Demand decreases as income increases.

Equilibrium: Identifying and Interpreting

• Market equilibrium occurs where quantity demanded equals quantity supplied.

• At equilibrium price, there is no shortage or surplus.

Interpreting Shifts and Double Shifts

• Shifts in demand or supply curves change equilibrium price and quantity.

• Double shifts require analyzing the relative magnitude and direction of each shift.

Chapter 8: Gross Domestic Product (GDP) and National Income

Gross Domestic Product (GDP)

• GDP measures the market value of all final goods and services produced within a country in a given period.

• It is a key indicator of economic activity.

Total Production = Total Income

• Every dollar spent on goods and services becomes income for someone else.

Components of GDP

• Consumption (C), Investment (I), Government Purchases (G), Net Exports (NX).

• GDP formula:

Shortcomings of GDP

• Does not account for nonmarket transactions, underground economy, environmental quality, or income distribution.

Calculating Nominal GDP, Real GDP, and the GDP Deflator

• Nominal GDP: Measured using current prices.

• Real GDP: Measured using constant base-year prices.

• GDP Deflator:

Calculating Inflation

• Inflation rate:

Other Measures of Total Production and Income

• Gross National Product (GNP), Net National Product (NNP), National Income, Personal Income, Disposable Personal Income.

Chapter 9: Unemployment and Inflation

Segmenting the Population for Unemployment

• Population is divided into employed, unemployed, and not in the labor force.

Household Survey and Establishment Survey

• Household survey (Current Population Survey) measures labor force status.

• Establishment survey (Payroll survey) measures jobs at businesses.

Calculating Unemployment Rate, Labor Force Participation Rate, and Employment-Population Ratio

• Unemployment rate:

• Labor force participation rate:

• Employment-population ratio:

Discouraged Workers

• Individuals not actively seeking work because they believe no jobs are available for them.

Types of Unemployment

• Frictional: Short-term, due to job search or transitions.

• Structural: Mismatch between skills and job requirements.

• Cyclical: Caused by economic downturns.

Full Employment and the Natural Rate of Unemployment

• Full employment occurs when there is no cyclical unemployment.

• Natural rate includes frictional and structural unemployment.

Calculating the Consumer Price Index (CPI)

• CPI measures the average change over time in the prices paid by urban consumers for a market basket of goods and services.

• Formula:

Indexation

• Adjusting payments or values for inflation using a price index.

Shortcomings of CPI

• Substitution bias, introduction of new goods, quality changes, outlet bias.

Nominal vs. Real Interest Rates

• Nominal interest rate: Stated rate without adjustment for inflation.

• Real interest rate: Adjusted for inflation.

• Formula:

Chapter 10: Economic Growth and the Financial System

Long-Run Economic Growth

• Increase in real GDP per capita over time.

Calculating Growth from One Year to the Next

• Growth rate:

Constant Growth Rule and Rule of 70

• Rule of 70: Years to double =

Determinants of Long-Run Economic Growth

• Increases in labor productivity, capital, technology, and human capital.

Actual vs. Potential GDP

• Actual GDP: Current output.

• Potential GDP: Output when all resources are fully employed.

Financial System: Markets vs. Intermediaries

• Financial markets: Direct finance (stocks, bonds).

• Financial intermediaries: Indirect finance (banks, mutual funds).

Savings and Investment Identity

• In a closed economy:

• So,

Market for Loanable Funds

• Shows the relationship between the real interest rate and the quantity of loanable funds supplied and demanded.

• Shifts in supply or demand affect equilibrium interest rates and investment.

Crowding Out

• When increased government borrowing raises interest rates and reduces private investment.

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand (AD)

• AD curve shows the relationship between the price level and the quantity of real GDP demanded.

• Downward sloping due to wealth effect, interest rate effect, and international trade effect.

Shifts of AD vs. Movement Along

• Change in price level causes movement along AD; changes in other variables (expectations, fiscal/monetary policy, foreign variables) shift AD.

Short-Run Aggregate Supply (SRAS) vs. Long-Run Aggregate Supply (LRAS)

• SRAS: Upward sloping; affected by input prices, technology, expectations.

• LRAS: Vertical at potential GDP; not affected by price level.

Macroeconomic Equilibrium

• Occurs where AD intersects SRAS and LRAS.

• Short-run and long-run equilibria may differ due to sticky prices and wages.

Static vs. Dynamic Model

• Static: Assumes no ongoing growth or inflation.

• Dynamic: Incorporates economic growth and inflation over time.

Causes of Inflation

• Demand-pull inflation: Increase in AD.

• Cost-push inflation: Decrease in SRAS (e.g., due to higher input costs).

Chapter 14: Money, Banks, and the Federal Reserve System

What is Money?

• Anything that is generally accepted as payment for goods and services.

Functions of Money

• Medium of exchange, unit of account, store of value, standard of deferred payment.

Types of Money

• Commodity money: Has intrinsic value (e.g., gold).

• Fiat money: Value by government decree (e.g., paper currency).

M1 and M2 Money Supply

• M1: Currency, checking deposits, traveler's checks.

• M2: M1 plus savings deposits, small time deposits, money market funds.

Fractional Reserve Banking and Reserve Requirement

• Banks keep a fraction of deposits as reserves and lend out the rest.

• Reserve requirement: Minimum fraction of deposits banks must hold as reserves.

Money Multiplier and Money Creation

• Money multiplier:

• Banks create money by making loans.

The Federal Reserve System

• Central bank of the U.S.; conducts monetary policy, supervises banks, provides financial services.

Quantity Theory of Money

• Equation:

• Where M = money supply, V = velocity, P = price level, Y = real output.

• Implies that increases in money supply lead to proportional increases in price level (inflation) if velocity and output are constant.

Chapter 15: Monetary Policy

Monetary Policy Goals

• Price stability, high employment, stability of financial markets, economic growth.

Monetary Policy Tools

• Open market operations, discount rate, reserve requirements.

Federal Open Market Committee (FOMC)

• Body within the Fed that sets monetary policy, especially open market operations.

Money Supply and Demand

• Money supply is controlled by the Fed; money demand depends on interest rates and income.

Federal Funds Market Graph

• Shows the equilibrium federal funds rate where money supply meets money demand.

Effects of Monetary Policy

• Expansionary policy lowers interest rates, increases investment and AD.

• Contractionary policy raises interest rates, decreases investment and AD.

The Taylor Rule

• Formula for setting the federal funds target rate based on inflation and output gaps.

Chapter 16: Fiscal Policy

Fiscal Policy Tools

• Government spending and taxation to influence the economy.

Automatic Stabilizers vs. Discretionary Fiscal Policy

• Automatic stabilizers: Built-in changes in taxes and spending that occur automatically with economic conditions (e.g., unemployment insurance).

• Discretionary policy: Deliberate changes by government.

Effects of Fiscal Policy

• Expansionary fiscal policy increases AD (higher spending, lower taxes).

• Contractionary fiscal policy decreases AD (lower spending, higher taxes).

Government Budget Deficits and Crowding Out

• Deficits can lead to higher interest rates and reduced private investment (crowding out).

Multipliers

• Government purchases multiplier:

• Tax multiplier:

• Balanced budget multiplier: Implies that equal increases in spending and taxes increase output by the amount of the spending increase.

Chapter 17: Inflation and Unemployment

The Phillips Curve

• Shows the inverse relationship between inflation and unemployment in the short run.

Short-Run vs. Long-Run Phillips Curve

• Short-run: Downward sloping.

• Long-run: Vertical at the natural rate of unemployment.

Structural Relationships and NAIRU

• NAIRU: Non-accelerating inflation rate of unemployment; the unemployment rate at which inflation does not change.

Role of Expectations

• Expectations of inflation can shift the short-run Phillips curve.

Solving for Real Wages

• Real wage:

Relationship Between Inflation, Unemployment, and Real Wages

• High inflation can erode real wages if nominal wages do not keep pace.

• Unemployment below the natural rate can lead to accelerating inflation.