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Macro Econ

Terms in this set (132)

Gross Domestic Product (GDP)
total market value of the goods and services produced in a country within a certain time period; includes purchases of NEWLY produced goods & services

values used: market values of FINAL goods; won't be resold or used in the production of other goods
GDP: expenditure approach
calc by summing amounts spent on goods and services produced during the period

value-of-final-output-method
GDP = C + I + G + (X - M)
GDP: income approach
calc by summing amounts earned by households and companies during the period, including wage income, interest income, business profits

GDP = national income + capital consumption allowance + statistical discrepancy
Sum-of-Value-Added-Method
GDP calculated by summing additions to values created at each stage of production & distribution

prices of final goods & services include, and are equal to, the additions to value at each stage of production
Nominal GDP
GDP valued at current market prices
Real GDP
output of the economy using prices from a base year, removing the effect of changes in prices so that inflation is not counted as economic growth

inflation in nominal GDP increases the GDP
GDP Deflator
price index that can be used to convert nominal GDP into real GDP, taking out the effects in changes to overall price level
Per-Capita Real GDP
GDP divided by population; often used as a measure of economic well-being of a country's residents
Capital Consumption Allowance (CCA): income approach
measures depreciation of physical capital from the production of goods & services over a period; amount needed to be reinvested to maintain productivity of physical capital from one period to the next
Statistical Discrepancy: income approach
adjustment for difference btw GDP measured under income approach & expenditure approach bc use different data
National Income
sum of the income received by all factors of production that go into the creation of final output

= compensation to employees (wages & benefits) + transfer payments to households - indirect business taxes - corporate income taxes - undistributed corporate profits
Personal Disposable Income
personal income after taxes; amount have to save or spend, important econ indicator of ability to save/spend
Fiscal Balance
government spending - tax receipts, (G - T)
if (G - T) > 0, deficit, financed by combo of trade deficit or excess of saving over private investment
Trade Balance
net exports, exports - imports (X - M)
Consumption (C)
function of disposable income
increase personal income or decrease in taxes will increasing consumption & saving

Marginal Propensity to Consume (MPC) + Marginal Propensity to Save (MPS) = 100%
Investment (I)
function of expected profitability and the cost of financing; financing costs reflected in real interest rates (~ nominal rate - expected inflation rate)
IS Curve
income-savings
negative relationship between real interest rates & real income for equilibrium in goods market
- lower interest rates decrease savings/increase investment
LM Curve
liquidity-money
positive relationship between real interest rates and income consistent with equilibrium in the money market


higher real interest rates decrease quantity of real money balances individual want to hold - for given real money supply (M/P constant), equilibrium in mkt requires real interest rate increase accompanied by increase in income
**greater real money supply reduces equilibrium real interest rates and shifts LM curve
Aggregate Demand Curve
relationship between quantity of real output demanded (real income) & price level
hold nominal money supply constant, change in price level changes real money supply (M/P where M is constant)

slopes downward because higher price levels reduce real wealth, increase real interest rates and make domestic produced goods and services more expensive compared to abroad
- LM curve shifts up with increase in price/down with decrease in price
Aggregate Supply Curve
relationship between price level and quantity of real GDP supplied when all other factors are kept constant
- amount of output firms will produce at different price levels

very short run: adjust output without changing price by adjusting labor hours/intensity of plant/equipment in response to change in demand

short run: curve upward sloping, some input prices will change as production increases/decreases
- assume output prices will change proportionally to price level but input prices are sticky
- output price increase, price level increase, no change in input price so increase output bc anticipate greater profit from greater output price
Sticky Prices
do not adjust to changes in the price level in the short run
Shifts in Aggregate Demand Curve
note: change in price level is a movement along the AD curve NOT a shift in the curve

GDP = C + I + G + (X-M)

Increase AD Curve (shift right), opposite for decrease
1. increase consumer's wealth: (C increases)
2. business expectations: more optimistic, increase investments (I increases)
3. consumer expectations of future income: expect higher incomes, save less for future & increase spending now (C increases)
4. high capacity utilization: produce at higher capacity, invest more in plant & equipment (I increases)
5. expansionary monetary policy: lower rates, more funds to lend, increase investment, greater availability of credit (I and C increase)
6. expansionary fiscal policy: tax cut (C increases), gov't spending (G increases)
7. exchange rates: decrease in rel value increases exports & decreases imports (net X increases)
8. global economic growth: increase domestic export demand (net X increases)
Shifts in SR Aggregate Supply Curve
relationship between output & price level when wages & other input prices are held constant

Shifts to the right (opposite for left)
1. labor productivity: increase labor increase output
2. input prices: decrease in NOMINAL wages or other productive inputs will decrease production costs
3. expectations of future output prices: expect price to increase, expand production
4. taxes & government subsidies: decrease tax/increase subsidy
5. exchange rates: appreciation of currency decreases cost of imports, to extent purchases inputs from foreign country, decrease price increases output
Shifts in LR Aggregate Supply Curve
curve is vertical (perfectly inelastic) at potential full-employment level of GDP

Shifts to the right (increases):
1. increase supply & quality of labor: increase potential real output
2. increase supply of natural resources: increase potential real GDP/output
3. increase in the stock of physical capital: increase potential output
4. technology
Recessionary Gap
real GDP is less than full employment
SRAS & AD equilibrium to left of LRAS curve
recession period: declining GDP & rising unemployment

options: expansionary fiscal policy or monetary policy increase AD & return GDP to full output
Inflationary Gap
increase in AD from previous level causes upward pressure on price level
real GDP is greater than full employment, can't be maintained in long run

options: contract fiscal policy (decr govt spending, increase tax) or monetary policy (slowing growth rate of money)
Stagflation
stagnant economy with inflation; combination of declining econ output & higher prices

SR-equilibrium at lower GDP & higher overall price level, caused by decrease in SRAS from increase in prices of raw material or energy

increasing AD using expansionary policy returns econ to full employment but at higher level than original eq, increases price level even more
Sources of Econ Growth
1. Labor Supply: labor force
2. Human Capital: education/skill level of workforce
3. Physical Capital Stock: high rate of investment increases country's stock of physical capital
4. Technology: increase productivity & potential GDP
5. Natural Resources: large amounts of productive natural resources can achieve greater rates of econ growth
Labor Force
number of people over age of 16 who are either working or available for work and are currently unemployed
effected by population growth, net immigration, labor force participation rate
Sustainable Rate of Econ Growth
rate of increase in economy's productive capacity (potential GDP), important for long-term equity returns
Production Function
relationship between output & labor, capital stock, and productivity
Total Factor Productivity
multiplier that quantifies amount of output growth that cannot be explained by the increases in labor and capital; closely related to tech advances
Diminishing Marginal Productivity
amount of additional output produced by each additional unit of input declines, holding other inputs constant; assume for each individual input
Capital Deepening Investment
increasing physical capital per worker over time; alone will not achieve sustainable long-term growth
Solow Model
measures contributions of technology, labor and capital to economic growth

higher levels of capital per worker, economy will experience diminishing marginal productivity of capital and must look to advances in technology for strong econ growth
Business Cycle
characterized by fluctuations in economic activity; key variables are GDP & unemployment rate
Expansionary Phase
1. real GDP increasing
2. unemployment rate decreases, hiring accelerates
3. investment increases in producer's equipment and home construction
4. inflation may increase
5. imports increase as domestic inocme growth accelerates

two consecutive quarters of growth in real GDP = beginning of expansion
Peak
1. real GDP stops increasing & begins decreasing
2. unemployment rate decreases, hiring slows
3. consumer spending & business investment grow at slower rates
4. inflation rate increases

approaches peak: rates of increase in spending, investment & employment slow but remain positive; inflation accelerates
- unsold inventories accumulate, increase inventory sales ratio above normal level
Contraction Phase/Recession
1. real GDP decreasing
2. hours worked decrease, unemployment rate increase
3. consumer spending, home construction, business investment decrease
4. inflation rate decreases with lag
5. imports decrease as domestic growth slows

declines in most sectors, inflation typically decreases

two consecutive quarters of declining real GDP = beginning of contraction
Trough
1. real GDP stops decreasing & begins increasing
2. high unemployment rate, increase use of overtime & temporary workers
3. spending on consumer durable goods & housing may increase
4. moderate or increasing inflation

when contraction reaches trough, firms find inventories being depleted more quickly once sales begin to increase, inventory-sales ratio decrease below normal level
Recovery
economic growth becomes positive again and inflation typically moderate, employment growth may not start to increase until the expansion has taken hold convincingly
Determinants of Level of Econ Activity in Housing Sector
1. Mortgage Rates: low rates tend to increase home buying and construction
2. Housing Costs Relative to Income: incomes cyclically high relative to home costs (including mortgage financing costs), home buying/construction tend to increase
3. Speculative Activity: rising home prices lead to purchases based on future expectations, lead to more construction/excess building, then dramatic drop
4. Demographic Factors
Neoclassical School
1. shifts in AD & AS primarily driven by changes in technology over time
2. economy has strong tendency toward full-employment equilibrium

conclude: business cycles result from temporary deviations from long-run equilibrium
Keynesian School
shifts in AD due to changes in expectations are primary causes of business cycles; fluctuations due to swings in level of optimism of those who run businesses

wages are "downward sticky", reduce ability of decrease in money wages to increase SRAS
policy: increase AD through monetary or fiscal policy
New Keynesian School
adds assertion prices of productive inputs rather than labor are also "downward sticky", additional barrier to full employment
Monetarist School
variations in AD that cause business cycles are due to variations in the rate of growth in the money supply, likely from inappropriate decisions by monetary authorities
central bank should follow steady & predictable changes in money supply
Austrian School
business cycles caused by government intervention in the economy; influences investor decisions
New Classical School: Real Business Cycle Theory
emphasizes effect of real econ variables like change in tech and external shocks as opposed to monetary variables as cause of business cycles

argue: policymakers should not try to counteract business cycles because expansions/contractions are efficient market responses to real external shocks
Frictional Unemployment
time lag necessary to match employees who seek work with employers needing their skill

always with us: expand/contract businesses, workers moves, fired or quit
Structural Unemployment
caused by long-run changes in economy that eliminate jobs while generating others from which unemployed are not qualified
Cyclical Unemployment
changes in general level of econ activity, positive when economy is operating at less than full capacity/negative when over capacity
Unemployed
activity seeking work
Unemployment Rate
percentage of people in the workforce who are unemployed
does not include people who are voluntarily unemployed
Labor Force
all people who are either employed or unemployed
Underemployed
employed part-time and want full time; or employed in low-paying job & qualified for higher-paying one
Participation Ratio
activity ratio, labor force participation rate
percentage of working population who are either employed or actively seeking employment
Discouraged Workers
available for work but not employed or seeking employment; causes short-term flux in participation ratio
causes rate to be a lagging indicator
Inflation
persistent increase in price level over time; erodes purchasing power of a currency

favors borrowers at expense of lenders because when principle is returned, worth less in terms of goods and services (in real terms)
Hyperinflaiton
inflation that accelerates out of control, can destroy a monetary system
Inflation Rate
percentage increase in price level, typically compared to the prior year
Disinflation
inflation rate that is decreasing over time but remains greater than zero
Deflation
persistently decreasing price level; results in decreasing revenue and increasing real fixed costs
Price Index
proxy for the price level; measures average price for defined basket of goods and services
Consumer Price Index (CPI)
CPI basket represents purchasing patterns for a typical urban household; compare cost today with cost in base period

weights assigned to each good & service reflect typical consumer's purchasing patterns, likely to be significantly different across regions

alternative: price index for personal consumption expenditure (in US created by surveying businesses) or GDP inflator
Producer Price Index (PPI)
also wholesale price index; price increases may be passed along to consumers

can identify changes in relative prices of producer inputs which may indicate shifts in demand among industries
Headline Inflation
price indexes for all goods
Core Inflation
price indexes that exclude food & energy (those two goods are typically more volatile than most other goods)
Laspeyres Index
price index that uses constant basket of goods and services

biased upwards as a measure of cost of living:
1. new goods: older goods often replaced by newer but initially more expensive goods, new goods periodically added to index/older goods replaced
2. quality changes: if price change due to quality, not due to inflation and still increases index
3. substitution: consumers can substitute lower good for more expensive good, changes make index less accurate
Hedonic Pricing
used to adjust price index for product quality
Fisher Index
address bias of substitution, chain/chain-weighted index

geometric mean of a Laspeyres Index & Paasche Index
Paasche Index
uses current consumption weights, prices from base period, and prices in current period
Cost-Push Inflation
decrease in AS caused by an increase in the real price of an important factor of production like wages or energy
(shift in curve, higher EQ on LRAS)

upward wage pressure more likely to emerge when cyclical unemployment is low but can occur even when present
Non-Accelerating Inflation Rate of Unemployment (natural rate of unemployment)
can be higher than the rate associated with the absence of cyclical employment because some segments of economy might have trouble finding enough qualified workers even during a contraction
Unit Labor Costs
indicator of wages and benefits in terms of productivity
ratio of total labor compensation per hour to output units per hour
Expected Inflation
source of wage pressure, if workers expect inflation to increase will increase their wages accordingly
Demand-Pull Inflation
increase in AD from increase in money supply, increase government spending or other changes that increase AD
increases GDP above full-employment
Leading Indicators
change direction before peaks or troughs in business cycle
Coincident Indicators
change direction roughly at same time as peak or trough
Lagging Indicators
don't tend to change until after expansion or contractions already underway
Fiscal Policy
government's use of spending and taxation to influence economic activity, balanced when tax rev = gov't expenditures
Budget Surplus
tax rev > gov't expenditures
Budget Deficit
tax rev < gov't expenditures
Monetary Policy
central bank's actions that affect the quantity of money and credit in an economy in order to influence econ acitivity
Objectives of Monetary Policy
1. stable prices: keeping inflation low, unexpected inflation is most costly
2. maximum unemployment: real GDP close to potential GDP, (natural rate)
3. moderate long-term interest rates: keeping long-term nominal rates close to the term real interest rates
Expansionary
accommodative, easy
increase money supply and credit
Contractionary
restrictive, tight
decrease money supply and credit
Money
generally accepted medium of exchange

functions
1. medium of exchange or means of payment
2. unit of account: prices of goods/services expressed in terms of money
3. store of value: money received for work or goods can be saved to purchase goods later
Narrow Money
amount of currency and coins in circulation in an economy plus balances in checkable deposits
Broad Money
narrow money + amount available in liquid assets that can be used to make purchases
M1 & M2
M1: currency, overnight deposits
M2: M1 + deposits < 2 yars, deposits redeemable up to 3 months, repo agreements
Promissory Notes
deposited gold, got promissory note stating banker will return that gold on demand, started becoming medium of exchange and didn't redeem the physical gold
Fractional Reserve Banking
lending portion of deposits to earn interest
Excess Reserves
cash not needed in required reserves & can be lent out, creates money

RR% decreased, money multiplier increases & quantity of money that can be created increases
Quantity Theory of Money
quantity of money is some proportion of the total spending in an economy and implies the quantity equation of exchange:
money supply x velocity = price x real output
MV = PY
Velocity
average number of times per year each unit of money is used to buy goods or services
assuming constant, any increase in money supply will lead to proportionate increase in price level
Money Neutrality
belief that real variables (real GDP & velocity) are not affected by monetary variables (money supply & prices)
Demand for Money
1. Transaction Demand: money held to meet need for undertaking transactions, as GDP increases demand increases
2. Precautionary Demand: money held for unforeseen future needs, increases with size of economy
3. Speculative Demand: money available to take advantage of investment opportunities that arise in the future, inversely related to returns available int eh market; risk higher people choose to hold money rather than invest it

at higher interest rates, opportunity cost of holding money is higher and will desire to hold less money and more interest-bearing financial assets
Supply of Money
determined by central bank
ST interest rates determine equilibrium between supply & demand of money
- high i, excess supply of money, purchase securities
- low i, excess demand, sale of securities
Fischer Effect
nominal interest rate is simply sum of real interest rate and expected inflation

real rates relatively stable and changes in interest rates are driven by changes in expected inflation: consistent with money neutrality
investors require risk premium for bearing risk
Roles of Central Banks
1. supplier of currency
2. banker to government and other banks
3. regulator and supervisor of payments system
4. lender of last resort
5. holder of gold and foreign exchange reserves
6. conductor of monetary policy
Fiat Money
money not backed by any tangible value, can be a medium of exchange if hold value/acceptable for transactions
Objective of Central Bank
control inflation as to promote price stability

high inflation, menu costs: cost to businesses of constantly having to change prices & shoe costs: cost to individuals of making frequent trips to the bank as to minimize their holdings of cash that are depreciating in value
Pegging
country chooses a target level for exchange rate of their currency with that of another country
- currency appreciates, sell domestic currency reserves for dollars (if pegging dollars) to reduce exchange rate
- can lead to increased vol of money supply and interest rates
Effect of High Inflation
cost of holding money rather than interest bearing securities is higher because its purchasing power decreases steadily
Costs of Unanticipated Inflation
higher than expected: borrowers gain at expense of lenders as loan payments in future are made with currency that has less value in real terms
lower than expected: benefit lenders at expense of borrowers

Information about supply and demand from changes in prices become less reliable
Monetary Policy Tools
1. policy rate: rate at which banks can borrow funds from fed, discount rate (ECB is refinancing rate)
- can use REPO agreements
- fed funds rate: rate banks charge each other on overnight loans of reserves, fed sets target & open market operations move it

2. reserve requirements

3. open market operations
Monetary Transmission Mechanism
ways in which a change in monetary policy, specifically central bank's policy rate, affects price level and inflation

4 channels through which a change in policy rates the monetary policy authorities control directly are transmitted
1. effect on other short-term rates: increase with policy rate, reduce credit purchases
2. asset values: decrease with lower discount rate for future cash flows
3. currency exchange rates: increase in rate attracts foreign investment
4. expectations: decrease expenditures because future expectations of growth decrease

decrease AD and pull downward pressure on price level
Qualities of Central Bank to be Effective
1. Independence: free from political interference
- operational: allowed to determine policy rate
- target: also can define how inflation is computed, set the target level and determine horizon to achieve it

2. Credibility: follow through, credible bank's targets can also be self-fulfilling prophecy

3. Transparency: disclose state of economic environment by issuing inflation reports, makes policy changes easier to anticipate and implement
Interest Rate Targeting
increasing the money supply when specific interest rates rose above target band
Inflation Targeting
most widely used tool, usually target 2%
Exchange Rate Targeting
used more in developing, target rate between their currency & another
Real Trend Rate
economy's long term sustainable growth rate, not directly observable, must be estimated, changes over time as structural conditions change
Neutral Rate of Interest
growth rate of money supply that neither increases nor decreases econ growth rate
= real trend rate + inflation target
Bond Market Vigilantes
limitation of monetary policy:

monetary tightening seems too extreme, increased probability of recession, LT bonds attractive & reduce LT rates, vice versa
Liquidity Trap
limitation of monetary policy

demand for money very elastic, individuals willing to hold on to more even without a decrease in short-term rates, increasing growth of money supply will not decrease rate because individuals won't invest
Other Limitations of Monetary Policy
increasing excess reserves, banks still not willing to lend
monetary policy rate floor is zero
Discretionary Fiscal Policy
spending & taxation decisions of a national government that are intended to stabilize the economy
Automatic Stabilizers
built-in fiscal devices triggered by the state of the economy
Spending Tools: Fiscal Policy
1. transfer payments: entitlement programs, redistribute wealth by taxing some and making payments to others
2. current spending: gov't purchases
3. capital spending: gov't spending on infrastructure
Justification for Spending Tools
1. provide services that benefit all residents (ex/ national defense)
2. invest in infrastructure
3. support country's growth and unemployment targets by directly affecting agg demand
4. provide min standard of living
5. subsidize investment in research and development for certain high-risk ventures
Direct Taxes
levied on income or wealth
Indirect Taxes
levied on goods and services
Desirable Attributes
1. simplicity to use and enforce
2. efficiency
3. fairness
- horizontal equality: people in similar situations should pay similar taxes
- vertical equality: richer people pay more in taxes
4. sufficiency to meet spending needs of gov
Advantages of Fiscal Tools
1. social policies can be implemented quickly with indirect taxes
2. quick implementation means gov't rev can be increased without sig costs
Disadvantages of Fiscal Tools
1. direct taxes/transfer payments take time to implement, delaying impact
2. capital spending also takes time to implement

econ forecasts may be wrong, incorrect policy decision
complications in practice that delay implementation and impact on economy
1. recognition lag: many policymakers have to recognize nature and extent of problems
2. action lag: time gov't takes to discuss, vote on, and enact fiscal policy
3. impact lag: time between change and impact
lags can make policy counterproductive
Additional Microecon Issues
1. misreading econ statistics
2. crowding-out effect: crowd out private investment
3. supply shortages: expansionary will fail to achieve goal, inflation may be higher
4. limits to deficits: if already too high, funding will be difficult
5. multiple targets: fiscal policy can't address high unemployment and high inflation
Fiscal Multiplier
changes in gov't spending have magnified effects on AD, those who incomes increase will increase their spending
multiplier determines potential increase in aggregate demand resulting from increase in gov't spending

multiplier effect depends on tax rate and marginal propensity to consume
Balanced Budget Multiplier
to balance budget, gov't should increase taxes by x amount to offset x increase in spending, changes in taxes have magnified effect on AD: increase taxes decrease disposable income and consumption, decreasing AD
Ricardian Equivalence
maintain preferred pattern of consumption over time, taxpayers may increase current savings in order to offset expected cost of higher future taxes

if underestimate future liability, AS increased by equal spending and tax increase, equivalence does not hold
Debt Ratio
ratio of aggregate debt to GDP; taxes linked to GDP so when econ grows in real terms, tax rev also grows in real terms

if real interest rate on gov't debt higher than real growth of econ, debt ratio will increase
Expansionary or Contractionary
focus on CHANGES in surplus or deficit to determine
increase surplus: contractionary
decrease surplus: expansionary
Structural (cyclically adjusted) Budget Deficit
deficit that would occur based on current policies if at full employment, used to gauge fiscal policy
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