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IB Economics: Unit 2 – Macroeconomics study guide Name:_____________ The level of overall economic activity Circular flow of income 1: 2: 3: 4 3 1 2 4: Methods of measurement: Output Income (Y) Components Rent is paid to suppliers of _____________ Example: Wages are paid to suppliers of ____________ Example: Interest is paid to suppliers of ____________ Example: Profits are paid to suppliers of ____________ Example: 1 Expenditure Components: C is for: ______________ Definition: Example: I is for ______________ Definition: Example: G is for _____________ ______________ Definition: Example: (X – M) is for _________ minus __________ (a.k.a. NX for ________ _________) Definition: Example: Definition of Gross Domestic Product: Distinction between: Gross Domestic Product (GDP) and Gross National Product (GNP) or Gross National Income (GNI) Nominal GDP and real GDP GDP per capita versus total GDP 2 3 Revised circular flow diagram with leakages and injections: 4 Differences and similarities between Gross Domestic Product (GDP) versus Gross National Product (GNP) or Gross National Income (GNI) as measures of growth: GDP GNP/GNI Definition of growth: Meaning and significance of “green GDP” Value and limitations of using GDP for making comparisons over time Value and limitations of using GDP as a measure to compare welfare between countries 5 Macroeconomic models Diagram illustrating business cycle/trade cycle Output (in real GDP) Time (in years) “There are no great limits to growth because there are no limits of human intelligence, imagination and wonder” -President Ronald Reagan Keynesian versus New Classical (monetarist) approach: Aggregate demand—components: Aggregate supply—components: Long-run aggregate supply Short-run aggregate supply curve (new classical/monetarist approach only) 6 Deflationary gap (a.k.a. Recessionary gap) Keynesian AD & AS Diagram Price Level PPC Curve Goods Output (Real GDP) Services Full employment/equilibrium level of national income Keynesian AD & AS Diagram Price Level PPC Curve Guns Output (Real GDP) Butter Inflationary gap (above full employment) Keynesian AD & AS Diagram Price Level PPC Curve Capital Goods Output (Real GDP) Consumption goods 7 Deflationary gap (a.k.a. Recessionary gap) New Classical (Monetarist) AD & AS Diagram Price Level PPC Curve Goods Output (Real GDP) Services Full employment/equilibrium level of national income New Classical (Monetarist) AD & AS Diagram Price Level PPC Curve Guns Output (Real GDP) Butter Inflationary gap (above full employment) New Classical (Monetarist) AD & AS Diagram Price Level PPC Curve Capital Goods Output (Real GDP) Consumption goods 8 What are the implications of the Keynesian model for government intervention? Explain. What are the implications of the new classical model for government intervention? Explain. Monetary policy Central banks (Fed in the U.S.) have three tools for changing the money supply and impacting the interest rates of an economy: Changing the reserve ratio Open market operations Changing the interest rate charged to banks Illustrations of an increase in the money supply: Diagram of the loanable funds market: Impact on AD/AS: 9 Demand-side and supply-side policies How is policy decided? Fiscal Policy _____________ branch of government decides budget. Officials accountable to the voters in a democracy Monetary Policy _______________ bank makes decisions independently. Bankers accountable to elected officials, but not directly to voters Demand- Goal 1: Stop a recession 1. ________ government side spending and/or policies 2. ________ taxes in order to ________ consumption Goal 1: Stop a recession ________ the money supply in order to ________ interest rates, thus ________ consumption and investment Goal 2: Fight inflation 1. ________ government spending and/or 2. ________ taxes in order to ________ consumption Goal 2: Fight inflation ________ the money supply in order to ________ interest rates, thus ________ consumption and investment Advantage: Money spent on lowincome households has substantial ___________ effect when stopping a recession Advantage: Can address problems __________ because policy decided by unelected few Advantage/disadvantage: Can not only manage the overall economy, but can also ________ wealth towards specific groups Disadvantage: Laws take long time to enact; economy may have changed when they come into effect. Exception: Automatic stabilizers. Welfare spending instantly ___________ and taxes instantly ___________ in a recession Disadvantage: Policy decided by unelected few Advantage/disadvantage: Can manage the overall economy, but more difficult to __________ wealth towards specific groups Disadvantage: More popular to increase AD than decrease it in the short term. Election cycle makes fighting _________ unpopular 10 Supplyside policies Fiscal Policy Monetary Policy Goal: Increase potential output and decrease prices Goal: Increase potential output and decrease prices 1. Offer incentives for firms to purchase _________ Ex.: Tax breaks for wealthy 2. Offer incentives for households to supply more _________ Ex.: Lower taxes or welfare benefits for workers 3. Relax environmental legislation that restricts the use of __________ Advantage: Can _________ output and _________ prices simultaneously 1. _________ the money supply in order to _________ interest rates, thus _________ investment in the short-term and adding to the capital stock 2. _________ the money supply in order to _________ interest rates, thus fighting inflation and __________ investment in the long-term Advantage: #2 successful in producing long-term price stability Disadvantage: Long- and short-term goals can be at odds with each other Disadvantage: Takes time for capital to increase _______________ after initial investment. (AD shifts faster than LRAS) Disadvantage: Unproven. Was introduced under Reagan with ________________ fiscal policy 11 Unemployment and inflation Unemployment Full employment and underemployment Unemployment rate Difficulties in measuring unemployment Consequences of unemployment (economic and social) Types of unemployment Frictional Structural—caused by changes in the demand for particular labor skills, changes in the geographical location of industries, and labour market rigidities. Seasonal Cyclical/demand-deficient Measures to deal with unemployment 12 Inflation Definitions of inflation and deflation Inflation: Disinflation Deflation: Difficulties in measuring inflation Different income earners may experience a different rate of inflation when their pattern of consumption is not accurately reflected by the CPI. Example: Inflation figures may not accurately reflect changes in consumption patterns and the quality of the products purchased. Example: Core inflation (excludes food and fuel). Purpose and limitations: Producer Price Index (PPI) and future inflation. Steel and plastic examples: Consequences of inflation Greater uncertainty (Investment decisions and shoe leather/menu costs) Redistributive effects 1. People on fixed v. flexible incomes 2. Borrowers v. lenders Less saving Damage to export competitiveness Consequences of deflation—high unemployment, bankruptcies Causes of inflation: cost push 13 demand pull 14 Distribution of income • Direct taxation Example: Income tax • Indirect taxation Example: Sales tax • Progressive taxation Example: Federal income tax (10% for earnings under about 10K/year, 35% over about 400K/year) • Regressive taxation Example: Sales tax, capital gains tax (modest 15%, applies mostly to the wealthy) • Proportional taxation Example: Social Security tax (Normally 6.2% for earnings up to about $120k/year) • Transfer payments Example: Social Security payments • Other government policies to affect distribution of income 15