Macroeconomics Study Guide 2

CPI Criticisms

-Changes in the CPI are based on a typical market basket of products that does not match the actual market basket purchased by many consumers. Therefore, it can either overstate or understate the impact of inflation on different consumers. -Also, the BLS has difficulty adjusting the CPI for changes in quality. Thus, a portion of the price increase can reflect better quality instead of simply a higher price for the same item. -Finally, the use of a single base-year market basket ignores the law of demand. If the price of a product rises, consumers purchase substitutes, and a smaller quantity is demanded. To deal with this substitution bias problem, the BLS takes annual surveys to keep up with the changing consumption patterns and correct for the fixed market basket limitations of CPI.

Social Costs of Inflation

1. Capricious Redistribution of Income 2. Political Unrest & Changes of Government. When people suffer from inflation, they start blaming the government. Jimmy Carter, despite winning a Nobel Peace Prize, was not elected for a second term with inflation playing a role in the voters' decision.

Economic Costs of Inflation

1. Decrease in Current Output. Occurs during hyperinflation. When people prepare for inflation, they use some of the available resources in the economy, making the amount of resources available for production decrease, and the amount of output decreases. 2. Decrease in Future Output. Partly caused by depreciation. Inflation creates uncertainty and decreases investment. Savings decrease, so investment will too, decreasing output. 3. Distortion of Resource Allocation. As compared to a non-inflation period, there will be a distortion in the allocation of resources, shifting more towards current output and saving less for future output.

Goals of Macroeconomic Theory

1. What determines the total output (GDP) each year that the economy produces? 2. Will the quantity of output be equal to full employment output? 3. If not, then how can full employment be restored, or how can the economy recover?

John Maynard Keynes

A British economist (1883-1946) whose influential work offered an explanation of the Great Depression and suggested, as a cure, that the government should play an active role in the economy. The father of macroeconomics. He explained that unless aggregate spending is adequate, the economy can experience prolonged and severe unemployment. Demand creates its own supply.

Deflation

A decrease in the general (average) price level of goods and services in the economy.

Lump-Sum Taxes

A fixed amount of taxes the government collects each year, regardless of income. In the real world, taxes are proportional to our income. When taxes go up, the equilibrium income goes down by a multiple of the increase in taxes, or the tax multiplier. T↑ , Y*↓ ; T↓ , Y*↑

Classical Economists

A group of economists whose theory dominated economic thinking from the 1770's to the Great Depression. The founder of this school of economics was Adam Smith. It was primarily based on microeconomic market equilibrium theory. To them, market economies have a natural tendency toward full employment due to the forces of demand and supply.

ARM (Adjustable-Rate Mortgage)

A home loan that adjusts the nominal interest rate to changes in an index rate, such as rates on Treasury securities that reflect changes in inflation. A way for mortgage lenders to protect themselves against declining real interest rates on their loans.

Competitive Market

A market in which sellers compete with each other to sell their product. They compete by lowering prices. Buyers compete with each other by paying more money for products.

Wage Price Freeze

A phenomenon that causes people to think prices will go up in the future, causing inflation to continue. A 1971 economic policy imposed by Richard Nixon. For 90 days, the movements of wages and product prices were put on hold to combat inflation.

Price Level

A reason the consumption function shifts. Any change in the general level of prices shifts the consumption schedule by reducing or enlarging the purchasing power of financial assets (wealth) with fixed nominal value. Once the real value of financial wealth falls, families are poorer and spend less at any level of real disposable income. As a result, the consumption function shifts downward. P↑ , C↓ , S↑ ; P↓ , C↑ , S↓

Expectations

A reason the consumption function shifts. Consumer expectations are optimistic or pessimistic views of the future that can change consumption spending in the present. More spending will shift the consumption function parallel upward. 🙂 , C↑ , S↓ ; 🙁 , C↓ , S↑

Interest Rate

A reason the consumption function shifts. The consumption schedule includes the option of borrowing to finance spending. When this is lower, it encourages consumers to borrow more and shift the consumption function upward. High interest rates for savings accounts and other such financial assets, on the other hand, encourage people to save more and consume less. i↑ , C↓ , S↑ ; i↓ , C↑ , S↓

Disinflation

A reduction in the rate of inflation. It does not mean that prices are falling; rather, it means the rate of increases in prices is falling.

Demand-Pull Inflation

A shift in demand to the right in all markets, and the prices of all goods increase. Caused by an increase in income of consumers. As income goes up, consumers are able to buy more. This occurs at or close to full employment, when the economy is operating at or near full capacity.

Cost-Push Inflation

A shift in the supply curve in all markets to the left because of changes in resource costs and/or a higher cost of production, causing prices to go up. Also occurs with increases in wages; after all, two resources used in everything are labor and energy. Any sharp increase in costs to businesses can be a potential source. Businesses can also contribute to this by raising prices to increase profits.

Wage-Price Spiral

A situation that occurs when increases in nominal wage rates are passed on in higher prices, which, in turn, result in even higher nominal wage rates and prices. This spiral continues when management believes it can boost prices faster than the rise in labor costs.

Creeping Inflation

A subtle rise in the general price level. An annual inflation rate in the single digits (< 9%). Applies to all of the US' annual infation rates except for 15% in the 1970's.

Base Year

A year chosen as a reference point for comparison with some earlier or later year. The value of the CPI in this is always 100 because the numerator and the denominator of the CPI formula are the same here.

45 Degree Line

A.k.a. the income line. The line that makes a 45° angle with both axes. Any point on this line will be equidistant to both axes, forming a perfect square every time. The height of this line at any level of income shows that level of income.

Inventory Accumulation

All levels above the equilibrium. People don't buy all the output produced, and inventory grows. This encourages businesses to decrease output for the next period. AE < Y

Inventory Depletion

All levels below the equilibrium. People are spending more than what they earn by using their savings. They buy more than what the economy produces, and inventory will shrink. AE > Y

Hyperinflation

An extremely rapid rise in the general price level. Most economists would agree that an inflation rate of about 100% per year or more is considered this. It is conducive to rapid and violent social and political change stemming from 4 causes: 1. Individuals businesses develop an inflation psychosis causing them to buy quickly today in order to avoid paying even more tomorrow. 2. Huge unanticipated inflation jeopardizes debtor-lender contracts, such as credit cards, home mortgages, life insurance policies, pensions, bonds, and other forms of savings. 3. It sends a wage-price spiral in motion. 4. Because the future rate of inflation is difficult or impossible to anticipate, people turn to more speculative investments that might yield higher financial returns that don't contribute to expanding the PPC.

Inflation

An increase in the general (average) price level of goods and services in the economy. It does not mean that all prices of all products in the economy rise during a given period of time, nor is it an increase in the price of any specific product.

CPI (Consumer Price Index)

An index that measures changes in the average prices of consumer goods and services. It includes only consumer goods and services in order to determine how rising prices affect the purchasing power of consumers' incomes. Unlike the GDP chain price index, it does not consider items purchased by businesses and government. It instead gathers a "market basket" of items and records the average price of that. It = (Average of Prices During Current Period / Average of Prices in Base Period) x 100

Law of Demand

As the Price of a good decreases, the Quantity demanded of that good increases. As the Price increases, the Quantity demanded of that good decreases. All other things remaining constant. Its purpose is to know what determines the quantity of a good/service that consumers will buy. People buy more if they have more money, if they like a good/service, and if there are more consumers overall.

Law of Supply

As the Price of a good increases, the Quantity supplied increases. As the Price of a good decreases, the Quantity supplied decreases. All other things remaining constant.

Say's Law

Developed in the early 1800's by Jean-Baptiste Say; the theory that supply creates its own demand. This theory states that long-term underspending is impossible because the production of goods and services (supply) generates an equal amount of total spending (demand) for these goods and services. It claims that long periods of recession and unemployment are rare and not a concern, that was until 1929's stock market crash when the economy didn't automatically repair itself.

Annual Inflation Rate

How much prices change from one year to another. Only applicable if the two years being used are adjacent. It = ((CPI in Given Year - CPI in Previous Year) / CPI in Previous Year) x 100

Expectational Inflation

Inflation that occurs when people expect inflation to occur in the future, causing inflation at the present time. They take steps now to protect themselves against higher future prices, which will cause prices to go up at the present time.

Winners

People who gain from inflation: -People whose incomes adjust for inflation, like retailers. Their profit margin will increase. -Those who keep their wealth in the form of physical assets (real estate, property). In fact, the value of these assets will increase faster than inflation because expectational inflation will encourage people to buy more physical assets, especially in less developed countries without a stock market. -Borrowers. They borrow a larger purchasing power and end up having to return a smaller purchasing power. Includes farmers, young families, businesses, and students (financial aid / loans).

Losers

People who suffer from inflation: -People with fixed income. Prices may go up, so their purchasing power decreases. -Those who rely on fixed retirement / pension payments. When prices go up, the real value of these payments decreases. -People who keep their wealth in the form of assets (stocks, bonds, deposits). -Savers. People who are looking forward to their retirement. -Lenders. When someone borrows a fixed amount of money, if inflation occurs, then the lender gets back the same amount of money now with less purchasing power.

Shortage

Qs < Qd. To combat this sellers will increase the price, and this shrinks.

Surplus

Qs > Qd. At that price, sellers want to sell this much more than people want to buy. This shrinks as price lowers towards the equilibrium.

Induced Spending

Spending that is dependent on the level of real disposable income.

a (Autonomous Spending)

Spending that is independent of the level of real disposable income. It is the amount of consumption expenditures that occur even when real disposable income is zero. Humans have basic needs like food, shelter, and clothing in order to survive.

Real Income

The actual number of dollars received (nominal income) adjusted for changes in the CPI. This type of income measures the amount of real goods and services that can be purchased with one's national income (purchasing power). If inflation or the CPI increases and your nominal income remains the same, this falls. It = (Nominal Income / CPI) x 100

Nominal Income

The actual number of dollars received over a period of time. The number of dollars written on your paycheck. The source of income can be wages, salary, rent, dividends, interest, or pensions. Unfortunately, inflation tends to reduce your standard of living through declines in the purchasing power of money. The greater the rate of inflation, the greater the decline in the quantity of goods we can purchase with this type of income.

Nominal Interest Rate

The actual rate of interest without adjustment for the inflation rate.

Dissaving

The amount by which real personal consumption expenditures exceed real disposable income. It is financed by drawing down previously accumulated financial assets, such as savings accounts, stocks, and bonds, or by borrowing. The vertical distance below the consumption function to the 45° line.

Inflationary Gap

The amount by which the aggregate expenditures exceed the amount required to achieve full-employment equilibrium. Governments can decrease their spending or transfer payments, or increase taxes by the same amount as this gap to close it.

Recessionary Gap

The amount by which the aggregate expenditures fall short of the amount required to achieve full-employment equilibrium. In the presence of this gap, the government must increase expenditure or transfer payments, or decrease autonomous taxes by the same amount as this gap.

TM (Tax Multiplier)

The change in aggregate expenditures (total spending) resulting from an initial change in taxes. It = 1 - SM It = 1 - Δ Real GDP

MPC (Marginal Propensity to Consume)

The change in consumption resulting from a given change in real disposable income. The ratio of the change in real consumption (ΔC) to the change in real disposable income (ΔYd). Synonymous with b in the consumption function, and represents its slope. It = ΔC / ΔYd

MPS (Marginal Propensity to Save)

The change in saving resulting from a given change in real disposable income. The ratio of the change in saving (ΔS) to the change in real disposable income (ΔYd). Synonymous with d in the saving function, and represents its slope. It = ΔS / ΔYd Also... (ΔC / ΔYd) + (ΔS / ΔYd) = 1 If you know this marginal propensity, you can calculate the other, and vice versa.

Income Expenditure Equilibrium

The condition where people spend exactly what they earn, and buy exactly what the economy produces. No more, no less. Inventories will remain constant because businesses have produced the right amount with no tendency to change. Y = AE

Investment Demand Curve

The curve that shows the amount businesses spend for investment goods at different possible rates of interest. Businesses will undertake all planned investment projects for which the expected rate of profit (r) exceeds or equals the interest rate (i). Planned investment and interest rate share an inverse relationship. r ≥ i This curve is unstable because of: -Business Expectations: 🙂 , I↑ ; 🙁 , I↓ -Business Taxes: T↑ , I↓ ; T↓ , I↑ -Technological Advance: 🖥️↑ , I↑ -Capacity Utilization: Cu↑ , I↑ ; Cu↓ , I↓ -Autonomous expenditure *If a business increases their inventories by 5%, but sales of inventories decrease by 5%, then inventory increases by 10%, because the unsold 5% is still there. This is an actual, not planned, change in inventory.

Autonomous Investment Curve

The curve that shows the amount businesses spend for investment goods regardless of level of output. It is represented by a horizontal line that shifts up and down dependent solely on investment demand. If interest rate increases, then this curve will shift downward. If interest rate decreases, then this curve will shift upward.

Aggregate Demand

The demand for all goods and services combined. A.k.a. Total Demand. If this exceeds the economy's productive capacity, prices go up and we have demand-pull inflation.

C (Consumption Function)

The graph or table established by Keynes that shows the amount households spend for goods and services at different levels of real disposable income. There is a direct relationship between changes in real disposable income and changes in consumption spending. Real Disposable Income (Yd) = Consumption (C) + Saving (S) C = a + bYd

Value Added

The market value a firm adds to a product. Any firm's contribution to the country's total output (GDP). Occurs as a product goes through production.

Keynesian Cross

The model that determines the equilibrium level of real GDP by the intersection of the aggregate expenditures and aggregate output and income (real GDP) curves. A.k.a. Aggregate Expenditure Model

Fiscal Policy

The name given to changes in government expenditure and/or taxes in order to keep the economy at full-employment with stable prices. The increase/reduction in government expenditure must equal the recessionary/inflationary gap. ΔG = Recessionary/Inflationary Gap

Real Interest Rate

The nominal interest rate minus the inflation rate. The occurrence of inflation means that this will be less than the nominal rate. When negative, lenders and savers lose because interest earned does not keep up with the inflation rate.

Saving Function

The part of disposable income households do not spend for consumer goods and services. This can be in various forms, such as funds in a passbook savings account, a certificate of deposit, stocks, or bonds. The vertical distance above the consumption function to the 45° line. S = -a + dYd

Capricious Redistribution of Income

The phenomenon in which some people become richer and other people become poorer, causing income to redistribute. 'Capricious' means arbitrary, or illogical; there's no real reason for the poor to become poorer.

Vicious Cycle of Inflation

The phenomenon related to expectational inflation. After inflation occurs, overprepared people may realize they made a mistake and overestimated the effects of inflation. Therefore, they intensify their preparations and cause prices to continue climbing higher.

APS (Average Propensity to Save)

The proportion of 1 additional dollar of disposable income that is saved. It = S/Yd (C/Yd) + (S/Yd) = 1

APC (Average Propensity to Consume)

The proportion of Total Yd that is consumed. It = C/Yd

SM (Spending Multiplier)

The ratio of change in real GDP to an initial change in any component of aggregate expenditures, including Consumption, Investment, Government spending, and net eXports. As a result, the AE curve shifts by a multiple of this number. When we refer to 'Multiplier,' we mean this. It = 1 / (1-b) ΔY* = 1 / (1-b) * ΔAutonomous Spending Y* = Change in Equilibrium Income

Equilibrium

The situation that is at rest with no tendency to change. In a market, if the price of a product does not change, the market is at this unless the price goes up. Here, every buyer will be able to buy a good at that price. The only price in which there is no shortage and no surplus.

AE (Aggregate Expenditure)

The total amount (in dollar terms) of all goods and services that people buy during a year.

Wealth

The value of the stock of assets owned at some point in time. It includes real estate, stocks, bonds, bank accounts, life insurance policies, cash, and automobiles. Inflation can benefit holders of this because the value of assets tends to increase as prices rise. A reason the consumption function shifts. Holding all other factors constant, the more of this households accumulate, the more they spend at any level of real disposable income, causing the consumption function to shift upward. A.k.a. the Wealth Effect. $↑ , C↑, S↓ ; $↓ , C↓ , S↑

Budget Constraint

What you do with your disposable income. You either spend, or save. Yd = C + S C↑ , S↓ ; C↓ , S↑ by the same amount. If S = 0, then Yd = C.

Break-Even Point

When the amount of disposable income owned by households is equivalent to their real consumption. Here, savings = 0, and the saving line intersects with the x-axis. When the consumption line intersects with the 45° line. At all levels of income above this point, saving is positive; at all levels below this point, saving is negative (consumers draw from their current savings and borrow money, which impedes future income).

Change in Demand

When the entire demand curve shifts to the right or to the left. When this occurs, at each and every possible price, people will buy a different quantity than before. Caused by a third variable: -Income of Consumers: y↑ , D↑ ; y↓ , D↓ -Number of Consumers: N↑ , D↑ ; N↓ , D↓ -Supply: S↑ , D↓; S↓ , D↑ Changes in demand also affect the equilibrium prices and quanitities: D↑ , PE↑ , QE↑ ; D↓ , PE↓ , QE↓

Change in Supply

When the entire supply curve shifts to the right or to the left. When this occurs, at each and every possible price, the quantity offered will be different than before. Caused by a third variable: -Price of Resources: Pr↑ , S↓ ; Pr↓ , S↑ -Number of Producers: N↑ , S↑ ; N↓ , S↓ -Technology of Production: T↑ , S↑ -Price of a Good: Pg↑ , S↑ ; Pg↓ , S↓ Changes in supply also affect the equilibrium prices and quanitities: S↑ , PE↓ , QE↑ ; S↓ , PE↑ , QE↓