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Econ Exam 1 Chapter 1- The Bid Ideas Objective of Economics: use stories/theories to help understand the world. Use graphs and charts to organize data (patterns consistent with theories?) Assess how the economy is performing based on factors measuring welfare Production – the level of growth rate of a nation’s income GDP – “gross domestic product” Decisions are made “on the margin” – margin=incremental (small change) Voluntary trade allows for specialization - people to produce goods based on comparative advantage - an individual has an absolute advantage in production if he can produce more of a good with the same amount of resources - an individual has the comparative advantage if he can produce the goods at a lower opportunity cost - voluntary trade and specialization allow for more production than what would be done if an individual or country tried to produce all goods and services on their own Incentives Matter - “it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own selfinterest” - Good institutions align self-interest with the social interest - “when markets work well, those who pursue their own interest end up promoting the social interest” – greed is good - when markets don’t properly align self interest with the social interest, government can sometimes improve the situation by changing incentives with taxes, subsidies, or regulations - Trade offs are everywhere – ex. Drug lag – the greater the cost of testing, the fewer new drugs there will be. Unsafe drugs can be approved and some safe drugs have not yet been approved (drug lag) Wealth Matters - individuals in wealthier economies typically have better health outcomes - individuals in wealthier economies have lower infant mortality rates - “” have better environments - if we want to improve the living standards, health outcomes, and the environmental quality, we want to have in place institutions that promote wealth accumulation (distribution of wealth matters) - institutions matter institutions – the rules of the game that help determine outcomes. Ex.) laws, customs, cultural values, principles, superstitions. They set people up to invest in the future. - rules shape how decisions are made - decisions determine outcomes institutions that are growth promoting should have the following properties/ characteristics: honest government – little or no corruption, does not deviate from its commitments, no risk of expropriation (taking private property and using it for public) political stability – limited internal conflict between individuals with different beliefs or backgrounds and limited attempts to overthrow by invaders/outsiders protect property rights – the right to receive any benefits from the property, right to sell or transfer, right to exclude others from using. Lack of property rights ex.) tragedy of the commons – no ownership means no incentive to take care of property dependable legal system competitive and open markets – encourage competition – firms will compete on price and quality; open markets allow firms to produce Institutions promote investments in the future. They encourage more education, more physical capital, entrepreneurship, and efficient use of the economy’s resources. Economic Booms and Busts Cannot be Avoided but Moderated - recessions and expansions are inevitable but we hope that economic policies can mitigate recessions - The Great Moderation – period from the early 1980’s when policy makers thought they could better “fine tune” the economy. Central bankers could adjust money supply and interest rates to keep inflation and GDP growth in narrow range and fiscal authority would provide a stable environment - why inflation? – due to too much money being printed - inflation = too much money chasing too few goods - prices rise when the government produces too much money = increase in general level of prices Chapter 6 – The Wealth of Nations and Economic Growth US Standard of Living Overtime - life expectancy at birth has increased dramatically over time (doubled over 40 years) - height in cm has increased over time – height is related to good health - average income has increased over time (50% inc. GDP per person every 25 years) - real GDP per capita affects the standard of living Gross Domestic Product – the market value of all goods and services that are newly produced in an economy during a period of time - measure of production and income - measures the total income of an entire economy - GDP = market value of goods - Measures all final goods and services produced within a country (doesn’t include intermediate inputs) Calculating GDP (growth rate of GDP) - percent change from one year to the next - Growth Rate = ((Yt – Yt-1)/Yt-1)*100 Why does GDP grow? - additional production an increase in average level of prices increase in production is a good thing increase in the average level of prices is not -Nominal GDP - market value of all final goods and services produced within a year using current prices - Real GDP – markert value of all final goods and services using a fixed, “base year” prices - nets out inflation (change in price over time). Nominal GDP growth minus inflation - real variables adjust for changes in the average price level - typically we are more interested in real variables (real GDP, quantity of goods and services) To Model the economy, we will consider real GDP as a quantity index – that is real GDP is a single measure that captures the total quantity of goods produced in the economy We can think of the ratio of nominal GDP to real GDP as a measure of the price level - since 1960, average real GDP growth has been roughly 3.1%. 1982 – 2007= the period of the great moderation. Since 2007 real GDP growth has been low and below the long term average Per Capita Real GDP is a better reflection of changing living standards Higher GDP growth = economy is expanding, Negative growth = economy contracting Recessions – a significant, widespread decline in economic activity spread across the economy lasting for more than a few months, visible as a decline in Real GDP, real income, employment, production, and wholesale-retail sales Procyclical Variable – if growth rate of a macroeconomic variable is positively correlated with deviations from the trend in Real GDP Countercyclical Variable – negatively correlated with the trend in Real GDP Acyclical Variable – no correlation How GDP is Computed - adding up Expenditures – add up purchases by consumption, investment, government expenditures, and net exports adding up Income Consumption – private household spending on goods and services. Goods = non durable and durable goods. Consumption of approximately 64.5% of GDP and by 2000 it increased to 70%. Output growth is more “volatile” than consumption growth Investment – spending on tools, plants, and equipment that is used to produce future output. Includes: fixed private investment – plants, machines, and equipment inventory investment – produced but not yet sold residential investment – purchase of houses Investment DOES NOT mean purchase of stocks and bonds. Investment growth is more volatile than consumption growth Government Expenditures – spending by all levels of government on final goods and services (ex. If gov. builds an airport). - transfer payments and entitlement programs are not included in gov. purchases (SS, medicare, Medicaid) - gov. expenditures = about 20.5% of GDP - no strong correlation btw. Growth in gov. expenditure growth and GDP growth Income Approach - Y = employee compensation + rent + interest income + profits - Y = wages + income to entrepreneurs + capital income - there are many goods and services for which we do not know the market value. GDP does not include non-recorded cash transactions - illegal activities (drug deals) - off the book transactions GDP does not count non-priced production – occurs when goods and services are produced but no explicit payment is made ex) when kids do “chores” (home production) GDP as a Measure of Welfare If GDP if a measure of well-being, there are some things we value not included in GDP for example, leisure time GDP does not include production of “bads” - pollution - depletion of resources - loss of animal/plant species - crime Most economies agree “bads” should be subtracted but agreement on how to value them is not widely agreed upon Problems With GDP as a Measure of… - production – some not accounted for - well-being – miss some aspects - cross country comparison – makes comparisons difficult Problems with GDP as a Measure of Output - doesn’t include non-recorded cash transactions - doesn’t count non-priced production GDP doesn’t measure the disposition of income (only measures the average person) - growth in per capita income doesn’t mean EVERYONE’s income is higher While growth in GDP is necessary for improvements in standards of living, but may not be sufficient numbers of the population Biases in GDP Statistics o -Home production in the 50’s and 60’s – stay at home parent work not counted o Biases across countries – hard to compare incomes across countries, in poorer countries there is more production that occurs in household (non market activity) 3 Ways to Measure GDP National spending approach Factor income approach Value added GDP statistics are imperfect GDP was developed to quantify economic growth and fluctuations Chapter 7 – Growth, Capital Accumulation, and the Economics of Ideas Preventing Early Deaths - every year 1.8 million children die from diarrhea - preventing these deaths requires 1 thing: economic growth - health and wealth go together Growth Facts 1. Per capita GDP varies enormously among nations 2. Everyone used to be poor 3. There are growth miracles and growth disasters The Rule of 70 – how long does it take for income in a country to double? - doubling time = 70/growth rate The US is one of the wealthiest countries due to long-run steady growth Real growth of other countries can be evaluated by comparing to US Growth Miracles - China – Real GDP per capita 19 times higher than in 1970. GDP growth rate of 8% per year - South Korea – 10 times higher than in 1970 - India – 6 times higher than in 1970 Growth Disasters - Argentina – 1900: one of the richest countries in the world. Now – per capita GDP is 1/3 that of US - Nigeria – poorer now that in 1974 Output if Determined by the Factors of Production - Physical Capital - the stock of tools, structures, and equipment - Human Capital – knowledge and skills that workers acquire through education and experience - Technical Knowledge – knowledge about how the world works that’s used to produce goods and services Countries that have lots of physical and human capital tend to have higher living standards Physical capital makes workers more productive as well as education and training Once we account for physical and human capital there is a lot left unexplained Total Factor Productivity – everything that influences how productive labor and capital are Proximate Cause – something that appears to have enabled an outcome Ultimate Cause – underlying reason outcome occurred ex.) The Ultimate Cause for high output (aka countries being rich) is institutions and incentives. Amount of resources only tells part of the story