ECON 261 Exam 2

Pigou's wealth effect

1- Pigou's wealth effect- recall that nominal value of money is fixed, but real value is dependent upon the price level. When a price level falls, more consumers spend thus a drop in price level induces consumers to spend more, increasing aggregate demand

1. Define aggregate demand and aggregate supply. Also model with Price =Price Level (CPI) on y-axis, Quantity= (Y)GDP - all goods and services on x-axis.

Aggregate demand is the demand for the GDP of a country and is represented by C + I + G + C Aggregate supply- total supply of goods and services that firms in the economy plan on selling during a period of time. It is the total amount of goods and series that firms are willing to sell at a given price.

4. Fractional reserve banking system....Explain why a commercial bank is required to maintain a reserve and why it isn't sufficient to cover deposits.

Aid in conduct of purchases and sales by Fed Reserve by helping to ensure a stable and predictable demand for reserves, increase control over short term interest rates, but prefer to keep a minimum requirement because they do not generate interest income.

4. How to use the loanable-funds model to analyze various government policies.

Allowing households to shelter from income taxes will encourage more saving at each interest rate, causing the supply of loanable funds to shift to the right. As lenders lower their interest rate, quantity of loanable funds increases--- equilibrium interest rate falls and equilibrium quantity of loanable funds rises. Implementation of new investment tax credit will encourage firms to invest more at every interest rate. Policy causes demand for loanable funds to shift right-> shortage of loanable funds at initial interest rate. Lenders will raise the interest rate they charge for loans, quantity of loanable funds increase. Equilibrium interest rate rises and equilibrium quantity of loanable funds saved rises.

12. Define economic growth

An increase in the amount of goods and services produced per head of the population over a period of time.

9. Differences between CPI and GDP Deflator

Both determine price inflation and reflect current economy. GDP Deflator takes into account goods produced domestically, not with imported goods and reflects prices of all commodities (services included), calculated quarterly CPI considers insignificant goods (even outdated), consumptions goods are priority of CPI measure, prices of other items used in production are not considered or the prices of investment goods, consumer items only not the machines used to make them.

1b. Explain what is meant by a business cycle. (Recession versus expansion).

Business cycle are the fluctuations in economic activity that an economy experiences over a period of time. During expansions, economy is growing in real terms (employment, production, sales, and incomes) and recession the economy is contracting and decreasing in factors above.

3. The model of the supply and demand for loanable funds in financial markets.

Comes from people who want to save and lend out their income. Savers sometimes lend directly by purchasing bonds in financial markets or indirectly by depositing funds with financial intermediaries to use deposit to make loans. The interest rate on the model indicates the return that lenders receive on their saving. Curve slopes upward and as interest rates rise, return on saving increases and quantity of loanable funds supply increase. As interest rate falls, saving becomes less attractive and consumption becomes more attractive so quantity decreases

8. Definition of CPI

Consumer Price Index- a measure of overall cost of goods and services bought by the typical consumer.

5. How government budget deficits affect the U.S. economy. (crowding out)

Crowding out is the reduction in the level of investment that occurs when the government borrows to finance a budget deficit. Public saving is negative when government runs a budget deficit, detracts from national saving which causes supply of loanable funds to shift left. There is a shortage of loanable funds at initial interest rate so lenders will raise interest rate, demand for loanable funds decrease, equilibrium interest rate rises and equilibrium quantity of loanable funds falls

2. Give three reasons why the aggregate demand curve slopes downward.

Downward slopes shows that a fall in price level raises overall quantity of goods and services demanded. 1- Pigou's wealth effect 2- Keynes's interest-rate effect 3- Mundell-Fleming's exchange rate

6. Explain the make up of the FED Reserve

Fed Reserve is run by a board of governors, which has 7 members appointed by president and confirmed by Senate Most important of governors is chairman Fed Reserve is made up of Fed Reserve Board in Washington, D.C., and 12 regional Federal Reserve Bank located in major cities in country.

1. Define financial intermediaries.

Financial institutions through which savers can indirectly provide funds to borrowers. Intermediary reflects role of these institutions in standing between savers and borrowers (banks and mutual funds)

The catch up effect

Hypothesis that poorer economies' per capita incomes will tend to grow faster than richer economies and as a result, all economies should eventually converge in terms of per capita income. Ex: workers with less tools who receive more tools increase productivity substantially in comparison to someone who has enough tools given more, productivity increases at a slower pace.

3. Know the difference in the income approach versus the expenditure approach and how that is shown in the Circular flow diagram

Income approach measures total incomes earn by households in year Expenditure approach measure total amount spent on goods produced by country in year When households buy goods and services from firms, these expenditures flow through the markets for goods and services. When firms use the money they receive sales to pay worker's wages, rent, and owner's profit. This income flows through market for factors of production

7. List shortcomings of real GDP per person as an index of social well-being, however name some ideas that are correlated to higher real GDP per person.

It measures everything in short except that which makes life worthwhile and what America is passionate about. It leaves out leisure time, the value of goods and services produced at home, volunteer work, quality of the environment. But, a larger GDP can buy better healthcare, edu—measures our ability to obtain many of the inputs into a worthwhile life.

13. Explain why growth is a desirable goal.

It represents that the economy has had an increase in productive capacity and improvements in the quality of life to the people in it

Keyne's interest-rate effect

Keynes's interest-rate effect- recall that the quantity of money demanded is dependent upon the price level. Consumers demand larger quantities of currency when the price is high and demand smaller amounts when price is high. Since consumers keep large amounts in bank, the currency in banks increase as well as the supply of loans and cost of loans decrease. A drop in the price of investments level decrease interest rate, which increases demand for investment and increases aggregate demand

3. Explain the shape of the long-run aggregate supply curve. (ideas of natural rate of output (full employment)

Long-run aggregate supply curve is a vertical line at economy's natural rate of output. The natural rate of outpu tis the level of output consistent with the economy's natural unemployment. It is the level of real GDP that the economy gravitates toward in the long run. Vertical at natural rate because the price level has no bearing on the economy's long run level of real output. Full employment, or the natural rate of unemployment, is considered to be consistent with a level of unemployment that predominantly comprises voluntarily unemployed workers. In other words, those members of the labor force who really want a job have one. When a company loses labor force, productive potential declines and curve shifts left Primary source of foreign oil decides to cease exports for political reasons, shifts left Natural disaster destroys production facilities, shifts left

Mundell-Fleming's exchange rate

Mundell-Fleming's exchange rate- as a price level falls the interest rate falls and domestic investors tend to invest in foreign countries when return on investment is higher. Real exchange decreases while increasing net exports because domestic goods are cheaper. An increase in net exports increases aggregate demand as net exports are a component of aggregate demand. As price level drops, interest rate falls, domestic investment in foreign countries increases and real exchange rate depreciates, net exports increases and aggregate demand increases

2. The identity where the turn the Closed Economy GDP into I=S. Private Saving and Public Savings = national savings which is equal to investment.

National saving to total income in the economy that is left over after paying for consumption and purchases. In a closed economy, subtracting consumption and purchases from GDP also yields investment spending so National Savings (S) = Investments (I) Private Saving = Y - C -T and Public Saving = T - G = National savings Private saving is income that remains after household pays taxes and consumption expenditures Public saving is amount of tax revenue that the government has left over after paying for its spending

11. Nominal variable versus Real variable.

Nominal variable is how much it is (how many dollar bills), Real variable is how much it can buy (how many goods and services)

14. Identify main sources of growth- productivity (factors of production-physical capital, human capital, etc).

Physical capital- capital, stock of equipment and structures used to produces G and S's. Human capital- knowledge and skills workers acquire w education, training, experience. Natural resources- inputs into production that are provided by nature (land, rivers, deposits) Technological knowledge- understanding of best ways to produce goods and services.

4. Calculate Real GDP, Nominal GDP and a GDP deflator using simple hypothetical data.

Real GDP measures the value of output in the current year using prices from a base year Nominal GDP measures the value of current output using current prices GDP deflator is a measure of the price level calculated by dividing nominal by real GDP x 100. *********See sheet Real GDP is more accurate to measure production because its not influenced by price changes

16. Policies to encourage growth in productivity

Reducing taxes on income from saving, Protecting property rights of firms acquiring new capital, Encouraging foreign investment in the domestic economy, Encouraging research and development, provide incentives for education and health (cash payments)

1. Describe the functions of Money and the difference between commodity money and flat.

Store of value- provides a mean of transferring purchasing power from the present to the future. Ex: keepings money in a checking account Medium of exchange- provides an accepted method of payment for goods and services. Ex: writes a check Unit of account- provides buyer and sellers a common reference point for valuing goods and services. Ex: you can easily tell the price difference between a computer and a vacation because they use the same units (dollars) Commodity money: takes form of commodity with intrinsic (item would have value even if it were not used as money) value. Ex: gold Flat money: money without intrinsic value that is used as money because of government decree. Ex: you can use a regular dollar but not a monopoly dollar because the government declares the first is valid.

5. Compute the size of the monetary multiplier and the money creating potential of the banking system when provided with appropriate data

The amount of money the banking system generates with dollar of reserves. The size is determined because the money multiplier is the reciprocal of the reserve ratio. Ex: if a bank as a whole holds $100 in reserve, it can only have $1,000 in doposits (1/R) 1/10 Creating potential ex: a commercial bank has $30,000 in reserves and $100,000 in checking deposits. Legal reserve of 20%. The excess reserve would be $10,000 (.20*100,000=20,000, 30,000-20,000=10,000) and then 10,000*.2=50,000 money creating potential

2. The ideas of the coincidence of wants/ barter.

The first difficulty is to find two persons whose possessions mutually suit each other's wants and there may be many people wanting and many possessing those things wanted but to allow an act of barter there must be a double coincidence. Money gives us a more flexible approach to trade than barter

6. Changes in real GDP per person (% change formulas are used to calculate GROWTH in variables (new-old/old *100)

The problem will present the real GPD per person in a certain year prior and then a new one in a more recent year. The most current GDP - The old GDP / old GDP * 100

2. Able to explain the expression Y = C + I + G + NX

equation is an identity- equation must be true because of how the variables in the equations are defined. GDP (Y), Consumption (C), Investment (I), government purchases (G), and net exports (NX)—because each dollar of expenditure included in GDP is placed within 4 components, they must equal "Y".

Definition of GDP (Gross Domestic Product)

market value of all final goods and services produced by resources within us, but does not include transactions involving items produced in the past (includes both tangible & intangible) measures value of production within the country that takes place within a specific amount of time (usually 1 year or a quarter), measures flow of income and flow of expenditures