Download Unit 2 study Guide

Unit 2 study Guide
Chapter 4, 5, and 6
CHAPTER 4
Macroeconomics: The Big Picture
Real GDP over Time
Real gross domestic product is the place to begin describing the subject matter of
marcoeconomics. Gross domestic product is the total value of all goods and services
produced in the economy during a specified period of time. The REAL means that the
measure of production is adjusted for the general increase in prices over time. The
general increase in prices is called inflation.
Economic growth rate: is the percentage increase in real GDP each year.
The phases of Business Cycles:
Recession: a decline in real GDP that lasts at least 6 months.
Peak: the highest point in REAL GDP before a recession
Trough: the lowest point of REAL GDP at the end of a recession.
Recovery: the early part of an economic expansion, immediately after the trough
of the recession.
REVIEW
 Economic Growth and economic fluctuations in real GDP occur
simultaneously.
 Economic growth provides lasting improvements in the well being of people.
But recessions interrupt its growth.
 The great depression of the 1930s was much a much larger downturn than the
recent recessions. It was about 20 times more severe than the 1990 1991
recession when measured by decline in REAL GDP.
Umployment, Inflation, and Interest Rates.
Real interest rate: is the interest rate minus the inflation rate.
Nominal interest rate: Is sometimes referred to as the interest rate on a loan, making no
adjustments for inflation.
Inflation and interest rates move together.
REVIEW
 The unemployment rate rises during recessions and falls during recoveries
 Inflation and interest rates rise prior to recessions and then fall during and just
after recessions.
 There was a longer term increase in interest rates and inflation in the 1970s.
Interest rates and inflation were lower in the 1990s.
MacroEconomic Theory and Policy
****Two goals of economic policy are:
1. Raise long term growth
2. Reduce the size of the short term economic fluctuations.
Macroeconomics is divided into two theories.
1. Economic growth theory: explains the long term upward rise of real GDP over
time.
2. Economic fluctuation theory, tries to explain the shorter term fluctuations in real
GDP.
Together the economic growth and the economic fluctuation theories combine to form
MACROECONOMIC THEORY.
Potential GDP: the economy’s long term growth trend for real GDP determined by the
available supply of capital, labor, and technology. REAL GDP fluctuates have and below
potential GDP.
Aggregate supply: the total value of all goods and services produced in the economy by
the available supply of capital, labor, and technology or (potential GDP)
Labor: the number of hours people work in producing goods and services.
PRODUCTION FUNCTION:= F(labor, capital, technology)
Supply side policies: economic policies that aim to increase long term economic growth,
because the concentrate on increasing the growth potential GDP, which is the aggregate
supply of the economy.
Fiscal Policy: The government’s policy concerning taxing, spending, and borrowing.
Monetary Policy: The government’s policy concerning the money supply and the control
of inflation.
Economic Fluctuations Theory and Policy.
Aggregate demand; the total demand for goods and services by consumers, businesses,
government, and foreigners.
The key assumption of the theory of Economic Fluctuations is that real GDP fluctuates
around potential GDP. The rationale for the assumption is that most of determinates of
potential GDP usually change rather smoothly.
REVIEW
 Economic growth theory concentrates on explaining the longer-term upward
path of the economy.
 Economic growth depends on three factors: the growth of labor, capital, and
technology.
 Government policy can influence long-term economic growth by affecting
these three factors. 1. To raise long term economic growth, government
fiscal policies can provide incentives for investment in capital, for research
and development of new technologies, for education, and for increased labor
supply. A monetary policy of low and stable inflation can also have a
positive effect on economic growth.
 Economic fluctuations theory assumes that fluctuations in GDP are de to
fluctuations in aggregate demand.
 Monetary policy and fiscal policy can reduce the fluctuations in real GDP.
Finding good policies is a major task of macroeconomics.
Conclusion
Key facts about economic growth in the United States.
1. Economic growth provides impressive gains in the well being of individuals over
the long term.
2. Economic growth is temporarily interrupted by recessions.
3. Unemployment rises before recessions and decline during and after recessions.
The most popular theory of economic fluctuations is that they occur because of
fluctuations in aggregate demand.
Macroeconomic policies include monetary and fiscal policies that are aimed at keeping
business cycles small and inflation low.
CHAPTER 5
Measuring the Production, Income, and Spending of
Nations.
Measuring GDP
GDP is a measure of the VALUE of all goods and services newly produced in a country
during some period of time.
What: Only newly produced goods and services are included
Where: goods and services produced in a country. Does not include goods produced by
citizens of the country in working in other countries, but does include citizens of other
countries working in this country.
When: Only newly produced goods and services during some specific time period.
Only final goods are part of GDP, intermediate goods are not.
Three ways to measure GDP.
1. Spending Approach
a. Consumption
b. Investment
c. Government purchases
d. Net exports. Why are net exports included? They are included because we
include foreign goods in consumption and investment, and 2nd, because
produced in the USA and exported are not consumed, invested or
purchased by the government.
Y=C+I+G+X
i. Y=spending
ii. C=consumption
iii. I=investment
iv. G=government spending
v. X=net exports
1. 9248=6255+1622+1628+(-257)
2. Income Approach
a. Aggregate Income
i. Labor income (wages, salaries fringe benefits)
ii. Capital income (profits, interest, rents)
iii. Depreciation
iv. Indirect business taxes
v. Net income of foreigners
vi. Statistical discrepancy
3. Production Approach
REVIEW
 Adding up all the spending- consumption, investment, government purchases
and net exports in the US economy gives a measure of total annual
production, gross domestic product. Inventory investment is treated as part
of investment spending to ensure that we get a measure of production. Net
exports are added to ensure that imported goods that are part of consumption
are not couned as US production and that US exports are counted as US
production.
 The sum of labor income, capital income, depreciation, sales taxes, and net
income paid to foreigners gives another way to measure GDP.
 GDP can also be measured by adding up production, but with this method we
must be careful not to double count. By adding up only the value added by
each firm or industry we automatically prevent double counting. Value
added is the difference between a firm’s sales and it’s payaments for
intermediate inputs to production.
Net Exports Saving Minus Investment
National savings=aggregate income minus consumption minus governement purchases.
S=Y-C-G
Where:
S= national savings
Y=Income
C=Consumption
G=Government purchases
SAVINGS EQUAL INVESTMENTS PLUS NET EXPORTS
Y=C+I+G+X
Y=income
C=consumption
I=investment
G=government purchases
X=net exports
REVIEW
 For an individual, saving equals income minus consumption. For the US,
national saving is defined as income minus consumption minus government
purchases. Government purchases are subtracted because so many of them
provide consumptionlike services.
 National saving minus investment always equals net exports (S-I=X) When
national saving is greater than investment then there is a trade surplus.
Real GDP and Nominal GDP
Adjusting GDP for inflation: Real GDP is a measure of production that corrects for
inflation.
Nominal GDP is the difference between GDP and REAL GDP.
Real Gross Domestic Product: a measure of the value of all goods and services newly
produced in a country during some period of time, adjusted for inflation.
Nominal GDP: gross domestic product without any correction for inflation; the same as
GDP the value of all goods and services newly produced in a country during some perid
of time usually a year.
GDP DEFLATOR: nominal GDP divided by real GDP; it measures the levels of prices of
goods and services included in real GDP relative to a given base year.
GDP deflator= nominal GDP/Real GDP
REAL GDP=nominal GDP/GDP deflator
The percentage change in the GDP deflator from year to the next is a measurement of the
rate of inflation.
ALTERNATE INFLATION MEASURES:
CPI=consumer price index: a price index equal to the current price of a fixed market
basket of consumer goods and services relative to a base year.
CPI is often critized for overstating inflation.
CPI is much more volatile than the GDP deflator.
PPI=producer price index, measures inflation by measuring the prices of raw materals
and intermediate goods as well as the prices of final goods sold by producers. Prices of
oil, wheat, copper are watched very closely as they are often indicators of inflation.
REVIEW
 REAL GDP corrects nominal GDP for inflation. Real GDP measures the
production of goods and services in the dollars of a given year, such as 1996
 Real GDP is a better measure of changes in the physical amount of production
in the economy than is nominal GDP.
 The GDP deflator is a measure of the price level in the economy. It is defined
as the ratio of nominal GDP to real GDP. The percentage change in GDP
deflator from year to year is a measure of inflation.
Price level: the average level of prices in the economy.
Shortcomings of the GDP Measure
1. There are revisions to GDP that can change the assessment
of the economy
2. GDP omits some production
3. Production of goods and services is only part of what
affects the quality of life.
Assignment question can be answered on page 109 at the bottom, concerning Home
work and production.
Leisure Activity: it is not counted unless it involves the purchase of something such as a
ticket to a movie.
REVIEW
 Real GDP per capita is not without its own shortcomings as an indicator of
well being in a society. Certain items are omitted, home production, leisure,
the underground economy, and some quality improvements
 There are other indicators of the quality of life, including vital statistics on
mortality and the environment, that can be affected by GDP per captia but
that are not conceptually distinct and independently useful.
Conclusion
KEY POINTS:
CHAPTER 6
The Spending Allocation Model
The Spending Shares
REVIEW
 Defining spending components as shares of GDP is a convenient way to
describe how spending is allocated
 Simple arithmetic tells us that the sum of all shares of spending in GDP must
equal 1
 Thus, an increase in the share of GDP going to government purchases must be
accompanied by a reduction in one or more of the other three sharesconsumption, investment, or net exports
The Effect of interest rates on Spending Shares
Consumption is negatively related to the interest rate.
A high interest rate gives people incentive to save for the future. Thus when people are
saving more they are consuming less.
The interest rate is like price, the higher the price the lower the consumption.
Investment has a negative relationship to the interest rate, but investment is more
sensitive to changes in the interest rate than consumption.
Net export are also negatively related to the interest rate.
The interest rate and the exchange rate.
The interest rate and the exchange rate are positively related.
A higher exchange rate increases the quantity demanded of imported goods.
A higher exchange also makes exported US goods more expensive and therefore less
attractive.
A high exchange rate means more imports and fewer exports.
In other words a high exchange rate means that net exports go down.
INTEREST RATE
Up
Down
REVIEW
EXCHANGE RATE
up
down
NET EXPORTS
down
up
 Consumption, investment and net exports are negatively related to the interest
rate.
 Higher interest rates raise the price of consumption this year relative to next
year. This means that fewer goods will be consumed.
 Business firms invest less when interest rate rise because higher interest rates
raise borrowing costs.
 Higher interest rates raise te exchange rate and thereby discourage exports and
encourage imports, leading to a decline in net exports.
 Other factors besides the interest rate may affect consumption, investment, and
net exports. When one of these factors changes the relationship between the
interest rate and consumption, investment, or net exports shifts.
Determining the Equilibrium Interest Rate.
Adding nongovernement shares graphically.
NG=C+I+X
The equilibrium interest rate is the rate at which the sume of the consumption, investment
and net exports shares is equal to the share of GDP available It is also the interest rate
for which the sum of all shares equals 1.
Shifts in Government Purchases and Consumption
The effect of a DECREASE in Government Purchases, causes a decrease in the share of
Government purchases, and an increase in the amount of nongovernment shares by the
same amount This causes a fall in the interest rate, thus an increase in investment,
consumption, and net exports as a part of GDP.
Crowding out: the decline in private investing owing to an increase in government
purchases.
Effects of a Shift in Consumption: If the amount of consumption relative to income rises
at every interest rate, perhaps because of a tax that reduces the tax on consumption, the
interest rate will rise. Both investment and net exports decline.
REVIEW
 The impact on capital accumulation of a change in government spending can
be analyzed by looking at what happens to the interest rat ad each
component of GDP.
 An increase in government spending shares reduces the share available for
nongovernement use by exactly the same amount. This means that interest
rates must rise. This rise in interest rates causes investment, consumption,
and net exports to fall.
 An upward shift in consumption causes investment and net exports to fall and
interest rates to rise.
The National Saving Rate
National savings = S=Y-C-G
The national savings rate is positively related to the interest rate. As it increases so does
the interest rate. This is true because the consumption share is negatively related to the
interest rate.
REVIEW
 The national savings rate is positively related to the interest rate. Equating the
national saving rate and the sum of the investment and net export shares is a
way to determine the interest rate.
 A downward shift in the national saving rate is equivalent to an upward shift in
the consumption share.
Conclusion
Key Points
The four spending shares must equal 1
Higher interest rates raise the price of consumption as a share of GDP
Higher interest rates also reduce investment
Higher interest rates lower net exports by causing the exchange rate to rise. A higher
exchange rate reduces exports and increases imports
The equilibrium interest rate is found by equating the sum of the consumption,
investment, and net exports shares to the share of GDP available for nongovernment use.
A decrease in government purchases crowds out the investment share in GDP by raising
interest rates, Consumption and net exports also fall, making the crowing out of
investment less severe.