Chapter 8: Measuring Total Production and Income (GDP)

Microeconomics vs. Macroeconomics

• Microeconomics studies individual markets and the behavior of households and firms.

• Macroeconomics examines the economy as a whole, focusing on aggregate measures such as GDP, unemployment, and inflation.

Gross Domestic Product (GDP)

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

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

• Formula:

• Shortcomings: Does not account for non-market transactions, underground economy, environmental quality, or income distribution.

Nominal vs. Real GDP

• Nominal GDP: Measured using current prices.

• Real GDP: Measured using base-year prices to remove the effects of inflation.

• Relationship: In the base year, nominal GDP equals real GDP. In other years, they differ due to price changes.

• Calculation:

  • Nominal GDP:

  • Real GDP:

Growth Rates

• Formula:

Chapter 9: Unemployment and Inflation

Labor Market Definitions

• Employed: Individuals currently working for pay.

• Unemployed: Individuals not working but actively seeking work.

• Not in the Labor Force: Individuals not working and not seeking work.

• Discouraged Workers: Individuals who have stopped looking for work due to lack of success.

Key Labor Market Measures

• Labor Force:

• Unemployment Rate:

• Labor Force Participation Rate:

• Employment-Population Ratio:

Types of Unemployment

• Frictional: Short-term unemployment from job search or transitions.

• Structural: Mismatch between workers' skills and job requirements.

• Cyclical: Caused by economic downturns.

Natural Rate of Unemployment

• The sum of frictional and structural unemployment; also called the full employment rate of unemployment.

Factors Affecting Unemployment

• Unemployment insurance, minimum wages, labor unions, efficiency wages, employment protection laws.

Price Level and Inflation

• Price Level: Average of current prices across the entire spectrum of goods and services produced in the economy.

• Inflation Rate:

GDP Deflator

• Definition: Measures the price level of all new, domestically produced, final goods and services in an economy.

• Formula:

Consumer Price Index (CPI)

• Definition: Measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

• Formula:

• Biases: Substitution bias, quality change bias, new product bias, outlet bias.

Producer Price Index (PPI)

• Measures the average change over time in the selling prices received by domestic producers for their output.

Adjusting for Inflation

• To convert past dollars to current dollars:

• To convert nominal to real:

Interest Rates

• Nominal Interest Rate: Stated interest rate on a loan.

• Real Interest Rate: Adjusted for inflation.

Effects of Inflation

• Anticipated vs. unanticipated inflation, menu costs, redistribution of income between borrowers and lenders.

Chapter 10: Economic Growth, Financial System, and Business Cycles

Long-Run Economic Growth

• Measured by increases in real GDP per capita over time.

• Rule of 70: Estimates the number of years for a variable to double:

Determinants of Long-Run Growth

• Increases in labor productivity, property rights, capital per hour worked, technological change.

Sources of Economic Growth

• Gains from trade, entrepreneurial discovery, investment.

Institutions and Policies Promoting Growth

• Legal system, competitive markets, stable money and prices, minimal regulation, low tax rates, trade openness.

Potential GDP

• The level of real GDP attained when all firms are producing at capacity.

Financial System

• Facilitates the flow of funds from savers to borrowers.

• Financial Markets: Directly connect savers and borrowers (e.g., stock and bond markets).

• Financial Intermediaries: Indirectly connect savers and borrowers (e.g., banks, mutual funds).

• Key Services: Risk sharing, liquidity, information.

Market for Loanable Funds

• Shows the interaction of borrowers and lenders determining the market interest rate and the quantity of funds exchanged.

• Supply: Savings; Demand: Investment.

• Equilibrium determines the real interest rate and quantity of loanable funds.

Crowding Out

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

Business Cycles

• Alternating periods of economic expansion and contraction.

• Phases: Expansion, peak, contraction (recession), trough.

• During expansion: GDP rises, unemployment falls, inflation rises. During contraction: GDP falls, unemployment rises, inflation falls.

Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand (AD)

• Shows the relationship between the price level and the quantity of real GDP demanded.

• Downward Sloping Due To: Wealth effect, interest-rate effect, international-trade effect.

• Shifters: Interest rates, government purchases, taxes, expectations, foreign income, exchange rates.

Long-Run Aggregate Supply (LRAS)

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

• Shifters: Labor force, capital stock, technology.

Short-Run Aggregate Supply (SRAS)

• Upward sloping due to sticky wages and prices.

• Shifters: Labor force, capital stock, technology, expectations about price level, supply shocks, natural disasters.

AD-AS Model Adjustments

• Changes in AD or SRAS shift the curves, affecting output and price level in the short run.

• Self-corrective mechanisms: Input prices and interest rates adjust, moving the economy back to long-run equilibrium.

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

Barter and Double Coincidence of Wants

• Barter requires both parties to want what the other offers; money eliminates this problem.

Money

• Definition: Any asset accepted as payment for goods and services.

• Types: Commodity, receipt, fiat, fractional.

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

• Criteria: Acceptable, standardized, durable, valuable relative to weight, divisible.

Monetary Aggregates

• M1: Currency in circulation, checking deposits, savings deposits.

• M2: M1 plus small-denomination time deposits, noninstitutional money market mutual fund shares.

Banking System

• Reserves: Deposits banks keep on hand.

• Fractional Reserve Banking: Banks keep only a fraction of deposits as reserves.

• Money Creation: Banks create money through lending; illustrated with T-accounts.

• Money Multiplier:

Federal Reserve System

• Central bank of the U.S.; regulates money supply and oversees banking system.

• FDIC: Insures deposits.

• Federal Open Market Committee (FOMC): Sets monetary policy; voting members include Board of Governors and regional Fed presidents.

Monetary Policy

• Actions by the Fed to manage the money supply and interest rates to pursue macroeconomic goals.

• Open Market Operations: Buying/selling government securities to influence reserves and interest rates.

• Shadow Banking System: Non-bank financial intermediaries.

Quantity Theory of Money

• Quantity Equation:

• Inflation Prediction:

• Hyperinflation often results from governments monetizing debt.

Chapter 15: Monetary Policy

Conduct of Monetary Policy

• Conducted by the Federal Reserve.

• Goals: Price stability, high employment, financial stability, economic growth.

Key Interest Rates

• Federal Funds Rate: Rate banks charge each other for overnight loans.

• Discount Rate: Rate the Fed charges banks for loans.

• Interest on Reserve Balances (IORB): Interest paid by the Fed on bank reserves.

Federal Funds Market

• Demand curve: Downward sloping; supply curve: Vertical (scarce reserves) or horizontal (ample reserves).

• Pre-2008: Scarce reserves regime; post-2008: Ample reserves regime.

• ON ORP: Interest rate on overnight reverse repurchase agreements; sets a floor for rates.

• Floor Operating System: Fed sets rates by adjusting IORB and ON ORP.

Monetary Policy Tools

• Most Important: IORB, ON ORP.

• At Zero Lower Bound: Quantitative easing, forward guidance.

• Traditional: Open market operations, discount policy, reserve requirements.

Expansionary vs. Contractionary Policy

• Expansionary: Fed increases money supply, lowers interest rates to stimulate consumption and investment; shifts AD right.

• Contractionary: Fed decreases money supply, raises interest rates to reduce consumption and investment; shifts AD left.

Countercyclical vs. Procyclical Policy

• Countercyclical: Policies that move against the business cycle to stabilize the economy.

• Procyclical: Policies that reinforce the business cycle, potentially destabilizing the economy.

Chapter 16: Fiscal Policy

Fiscal Policy

• Conducted by Congress and the President; involves changes in government spending and taxation to influence aggregate demand.

• Federal Government Expenditures vs. Purchases: Expenditures include all spending; purchases are spending on goods and services.

• Budget Deficit: When expenditures exceed revenue; Surplus: When revenue exceeds expenditures.

• National Debt: Accumulated deficits over time.

Automatic Stabilizers

• Programs that automatically increase spending or decrease taxes during recessions (e.g., unemployment compensation, progressive income tax).

Expansionary and Contractionary Fiscal Policy

• Expansionary: Increase government purchases or decrease taxes to boost AD.

• Contractionary: Decrease government purchases or increase taxes to reduce AD.

Multiplier Effect

• Initial change in spending leads to a larger change in GDP.

• Formulas:

  • Government purchases multiplier:

  • Transfer payments multiplier:

  • Tax multiplier:

Crowding-Out Effect

• Government borrowing raises interest rates, reducing private investment; effect can differ in short and long run.

Timing Difficulties

• Delays in recognizing economic conditions, enacting policy, and seeing effects can reduce fiscal policy effectiveness.

Chapter 7: Comparative Advantage and International Trade

Comparative and Absolute Advantage

• Absolute Advantage: Ability to produce more of a good with the same resources.

• Comparative Advantage: Ability to produce a good at a lower opportunity cost.

• Gains from trade arise when countries specialize according to comparative advantage.

Specialization and Trade

• Without trade: Production and consumption limited to domestic possibilities.

• With trade: Countries can consume beyond their production possibilities.

Sources of Comparative Advantage

• Climate, natural resources, relative abundance of labor and capital, technology, external economies.

Trade Policies

• Autarky: No trade.

• Free Trade: No barriers to trade.

• Tariffs: Taxes on imports.

• Quotas: Limits on quantity of imports.

• Voluntary Export Restraint (VER): Exporting country limits exports.

Economic Surplus and Trade Barriers

• Surplus is higher with free trade; tariffs and quotas reduce surplus.

• Quotas are generally worse than tariffs because they do not generate government revenue.

Other Barriers to Trade

• Health and safety requirements, national security concerns.

Globalization and Trade Restrictions

• Reasons for restrictions: Anti-globalization, protectionism (jobs, wages, infant industries, national security), dumping.

• Special interest groups, logrolling, concentrated benefits and dispersed costs, and the seen and unseen effects perpetuate barriers.

Key Formulas (All Chapters)

Note: You must know these formulas for the exam; no formula sheet will be provided.