1 of 32 © 2014 pearson education, inc. midterm review

1 of 32© 2014 Pearson Education, Inc.

Midterm Review


Three of the major concerns of macroeconomics are

Output or output growth

Unemployment

Overall price level or its increase/decrease (i.e. Inflation/deflation)

Macroeconomic Concerns


business cycle The cycle of short-term ups and downs in the economy.

aggregate output The total quantity of goods and services produced in an economy in a given period.

recession A period during which aggregate output declines. Conventionally, a period in which aggregate output declines for two consecutive quarters.

depression A prolonged and deep recession.

Output Growth

expansion or boom The period in the business cycle from a trough up to a peak during which output and employment grow.

contraction, recession, or slump The period in the business cycle from a peak down to a trough during which output and employment fall.


Typical Business Cycle

Expansion/boom The economy expands as it moves from a trough to a peak.

Recession/slump The economy moves from a peak down to a trough.

Depression Large and long recession


Unemployment

unemployment rate The percentage of the labor force that is unemployed.

Inflation and Deflation and Stagflation

inflation An increase in the overall price level.

hyperinflation A period of very rapid increases in the overall price level.

deflation A decrease in the overall price level.

stagflation A situation of both high inflation and high unemployment.


The participants in the economy can be divided into four broad groups:

(1) Households.

(2)Firms.

(3)The government.

(4)The rest of the world.

Households and firms make up the private sector, the government is the public sector, and the rest of the world is the foreign/external sector.

The Components of the Macroeconomy


The Circular Flow Diagram

transfer payments Cash payments made by the government to people who do not supply goods, services, or labor in exchange for these payments. They include Social Security benefits, veterans’ benefits, and welfare payments.


fiscal policy Government policies concerning taxes and spending.

monetary policy The tools used by the Federal Reserve to control the short-term interest rate.

The Role of the Government in the Macroeconomy


Gross Domestic Product

gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within a country.


final goods and services Goods and services produced for final use.

intermediate goods Goods that are produced by one firm for use in further processing by another firm.

value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

Final Goods and Services

Example: eggs you buy, cook and then eat at home

Example: eggs S&P buys, bakes and it sells the cakes made of eggs


Exclusion of

Used Goods and Paper Transactions

GDP is concerned only with new, or current, production.

GDP does not count transactions in which money or goods changes hands but in which no new goods and services are produced.

• Old output is not counted in current GDP because it was already counted when it was produced.


GDP is the value of output produced by factors of production located within a country.

gross national product (GNP) The total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizens (or a country’s factors of production), regardless of where the output is produced.

Exclusion of Output Produced Abroad by Domestically Owned Production Factors


expenditure approach A method of computing GDP that measures the total amount spent on all final goods and services during a given period.

income approach A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services.

Calculating GDP


Four main categories of expenditure:

Personal consumption expenditures (C): household spending on consumer goods

• Gross private domestic investment (I): spending by firms and households on new capital, that is, plant, equipment, inventory, and new residential structures

• Government consumption and gross investment (G)

Net exports (EX − IM): net spending by the rest of the world, or exports (EX) minus imports (IM)

GDP = C + I + G + (EX − IM)

The Expenditure Approach


Personal Consumption Expenditures (C)

personal consumption expenditures (C) Expenditures by consumers on goods and services.

• durable goods Goods that last a relatively long time, such as cars and household appliances.

• nondurable goods Goods that are used up fairly quickly, such as food and clothing.

• services The things we buy that do not involve the production of physical things, such as legal and medical services and education.


gross private domestic investment (I) Total investment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector.

• nonresidential investment Expenditures by firms for machines, tools, plants, and so on.

• residential investment Expenditures by households and firms on new houses and apartment buildings.

Gross Private Domestic Investment (I)

• change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to sell later.


The Income Approach

• compensation of employees Includes wages, salaries, and various supplements

• proprietors’ income The income of unincorporated businesses.

• rental income The income received by property owners in the form of rent.

• corporate profits The income of corporations.

national income The total income earned by the factors of production owned by a country’s citizens.

• net interest The interest paid by business.

• surplus of government enterprises Income of government enterprises.


• net business transfer payments Net transfer payments by businesses to others.

• indirect taxes minus subsidies Taxes such as sales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return.


disposable (personal) income Personal income minus personal income taxes.

•The amount that households have to spend or save.

personal saving The amount of disposable income that is left after total personal spending in a given period.

personal saving rate The percentage of disposable income that is saved.

personal income The total income of households.

National Income versus Personal Income


• Current dollars/prices The current prices that we pay for goods and services.

nominal GDP Gross domestic product measured in current dollars/prices.

Nominal GDP versus Real GDP

real GDP Gross domestic product measured in base-year dollars/prices.

• Base-year dollars/prices The prices that take place in the (selected) base year.


Policy makers not only need good measures of how real output is changing but also good measures of how the overall price level is changing.

The GDP deflator is one measure of the overall price level.

Calculating the GDP Deflator


employed Any person 16 years old or older (1) who works for pay, either for someone else or in his or her own business for 1 or more hours per week, (2) who works without pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been temporarily absent with or without pay (such as maternity leave).

unemployed A person 16 years old or older who is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks.

Unemployment

Measuring Unemployment


not in the labor force A person who is not looking for work because he or she does not want a job or has given up looking.

labor force The number of people employed plus the number of unemployed.

labor force = employed + unemployed

adult population = labor force + not in labor force

population = adult population + population below 16 years old


unemployment rate The ratio of the number of people unemployed to the total number of people in the labor force.

labor force participation rate The ratio of the labor force to the total population 16 years old or older.

unemployedunemployment rate =

employed + unemployed

discouraged-worker effect The decline in the measured unemployment rate that results when people who want to work but cannot find jobs grow discouraged and stop looking, thus dropping out of the ranks of the unemployed and the labor force.


frictional unemployment The portion of unemployment that is due to the normal turnover in the labor market; used to denote short-run job/skill-matching problems.

structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.

Frictional, Structural, and Cyclical Unemployment

natural rate of unemployment The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of the frictional unemployment rate and the structural unemployment rate.

cyclical unemployment Unemployment that is above frictional plus structural unemployment.


A price index computed using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer.

The Consumer Price Index


The Costs of Inflation

real interest rate The difference between the interest rate on a loan and the inflation rate.

Inflation May Change the Distribution of Income

One way of thinking about the effects of inflation on the distribution of income is to distinguish between anticipated and unanticipated inflation.

The effects of anticipated inflation on the distribution of income are likely to be fairly small, since people and institutions will adjust to the anticipated inflation.

Unanticipated inflation, on the other hand, may have large effects, depending, among other things, on how much indexing to inflation there is.


We can use the following equation to describe the curve:

C = a + bY

The Keynesian Theory of Consumption

consumption function The relationship between consumption and income.


marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent.

The triple equal sign means that this equation is an identity, or something that is always true by definition.

aggregate saving (S) The part of aggregate income that is not consumed.

S ≡ Y – C

marginal propensity to save (MPS) That fraction of a change in income that is saved.

MPC + MPS ≡ 1


Planned Investment (I) versus Actual Investment

planned investment (I) Those additions to capital stock and inventory that are planned by firms.

actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

A firm’s inventory is the stock of goods that it has awaiting sale.

If a firm overestimates how much it will sell in a period, it will end up with more in inventory than it planned to have.

We will use I to refer to planned investment, not necessarily actual investment.


equilibrium Occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output.

planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment:

AE ≡ C + I.

Because AE is, by definition, C + I, equilibrium can also be written:

Equilibrium: Y = C + I

Y > C + Iaggregate output > planned aggregate expenditure

C + I > Yplanned aggregate expenditure > aggregate output

The Determination of Equilibrium Output (Income)


There is only one value of Y for which this statement is true, and we can find it by rearranging terms:

Let us find the equilibrium level of output (income) algebraically.

The equilibrium level of output is 500, as shown in Table 8.1 and Figure 8.6.


Because aggregate income must be saved or spent, by definition, Y ≡ C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium. By substituting C + S for Y in the equilibrium condition, we can write:

C + S = C + I

Because we can subtract C from both sides of this equation, we are left with:

S = I

Thus, only when planned investment equals saving will there be equilibrium.

The Saving/Investment Approach to Equilibrium

FIGURE 8.7 The S = I Approach to Equilibrium

Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I).Saving and planned investment are equal at Y = 500.


The adjustment process will continue as long as output (income) is not equal to planned aggregate expenditure.

If an economy with planned spending greater than output (where unplanned inventory reductions occur) will adjust to equilibrium by increasing output, with Y going higher than before.

If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before.

As Figure 8.6 shows, at any level of output above Y = 500, such as Y = 800, output will fall until it reaches equilibrium at Y = 500, and at any level of output below Y = 500, such as Y = 200, output will rise until it reaches equilibrium at Y = 500.

Adjustment to Equilibrium


Investment multiplier The ratio of the change in the equilibrium level of output to a change in investment.

The Investment Multiplier

MPS

1multiplier

MPC

1

1multiplier, or


discretionary fiscal policy Changes in taxes or spending that are the result of deliberate changes in government policy.

net taxes (T) Taxes paid by firms and households to the government minus transfer payments made to households by the government.

disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T.

disposable income ≡ total income − net taxes

Yd ≡ Y − T

Government in the Economy

(1) Government Purchases (G),

(2) Net Taxes (T), and therefore Disposable Income (Yd)


budget balance The difference between what a government collects in taxes and what it spends in a given period: T − G.

budget balance ≡ T − G

budget surplus if T − G > 0

budget deficit if T − G < 0

balanced budget if T − G = 0


To modify our aggregate consumption function to incorporate disposable income instead of before-tax income, instead of C = a + bY, we write

C = a + bYd

or

C = a + b(Y − T)

Our consumption function now has consumption depending on disposable income instead of before-tax income.

Adding Taxes to the Consumption Function


Y = C + I + G

TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Output(Income)

Y

NetTaxes

T

DisposableIncomeYd ≡Y −T

ConsumptionSpending

C = 100 + .75 Yd

SavingS

Yd – C

PlannedInvestmentSpending

I

GovernmentPurchases

G

PlannedAggregate

Expenditure C + I + G

UnplannedInventoryChange

Y − (C + I + G)

Adjustmentto Disequi-

librium

300 100 200 250 − 50 100 100 450 − 150 Output ↑

500 100 400 400 0 100 100 600 − 100 Output ↑

700 100 600 550 50 100 100 750 − 50 Output ↑

900 100 800 700 100 100 100 900 0 Equilibrium

1,100 100 1,000 850 150 100 100 1,050 + 50 Output ↓

1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output ↓

1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output ↓

The Determination of Equilibrium Output (Income)


saving/investment approach to equilibrium:

S + T = I + G

To derive this, we know that in equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE).

By definition, AE equals C + I + G, and by definition, Y equals C + S + T.

Therefore, at equilibrium:

C + S + T = C + I + G

Subtracting C from both sides leaves:

S + T = I + G

The Saving/Investment Approach to Equilibrium


At this point, we are assuming that the government controls G and T. In this section, we will review three multipliers:

Government spending multiplier

Tax multiplier

Balanced-budget multiplier

Fiscal Policy at Work: Multiplier Effects

government spending multiplier The ratio of the change in the equilibrium level of output to a change in government spending.

The Government Spending Multiplier

MPCMPS

1

11multiplier spending government


tax multiplier The ratio of change in the equilibrium level of output to a change in taxes.

tax multiplier MPC

MPS

YMPS

(in itia l in crease in ag g reg a te ex p en d itu re )

1

1( )

MPCY T MPC T

MPS MPS

The Tax Multiplier

Because the initial change in aggregate expenditure caused by a tax change of ∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution:

Because a tax cut will cause an increase in consumption expenditures and output and a tax increase will cause a reduction in consumption expenditures and output, the tax multiplier is a negative multiplier:

1 of 32 © 2014 pearson education, inc. midterm review

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