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Economics Midterm
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What was the response of Classical economists to the Great Depression?
Do nothing
According to Keynes - statement about money
Money matters in determining output and employment
According to Keynes, Savings are primarily determined by
Current disposable income
How did the financial crash of 1929 spread to such an economic decline?
- Stock market suddenly crashed and spread to the banking sector (financial) and the real sector (production) - which affected everyone
Why did classical economists tell gov't to do nothing in response to the Great Depression?
Because they believed that markets have an autocorrect right after each crisis
How did Keynes respond to Classical economists viewpoint on macroeconomics?
1. There was a fallacy of composition
2. Macroeconomic theory only works when markets work
What is the fallacy of composition?
Logical flaws in parts of the whole compared to the whole itself
What proof was there for Keynes against Classical theory on autocorrecting markets?
During the 1930's people decreased in their purchasing power (as they lost jobs, demand crashed)
What is the principal of sound finance?
Not spending more than earning
What proof was there for Keynes against the principal of sound finance?
Because demand crashed in the 1930's, the government needed to spend more than it makes to correct the spiral (Deficit budgets originate)
What was the classical school's concern (supply or demand)?
Supply
What did classical economists assume for markets?
That markets always clear - where they always reach equilibrium
supply = demand
What did classical economists assume about prices?
The invisible hand: in the price system that exists, no one is a price maker
What are the three types of markets in any economy?
1. labor markets
2. output markets
3. capital markets
What did classical economists say about labor markets?
There is no involuntary unemployment
What law did classical economists follow regarding the relationship between supply and demand?
Say's law
What is say's law?
That supply always equals demand
What did Classical economists say about savings?
s=s(r)
Savings is a function of the interest rate
What is Keynes' proof towards markets not always clearing?
The labor market has involuntary unemployment in capitalist economies
How did Keynes respond to Say's law?
- the natural inefficiencies in the market will see goods that are not met with demand.
- Wasted capital can result in market losses, unemployment and market inefficiency
- general glut = aggregate demand doesn't meet supply
What did Keynes say about the capital market?
That savings can far exceed investmnet
How did Keynes respond that market determinations are separate?
That market determinations aren't separate
What gave Keynes proof towards the argument that market determinations aren't separate?
That level of unemployment is determined by the total/aggregate demand in the output market.
What is the relationship between total demand and employment
As total demand (AD) increases, unemployment decreases and employment increases.
What is Keyne's response to the third tenent, regarding what determines unemployment?
Level of unemployment (or employment) is determined by the total aggregate demand in the output market.
What is Keynes response to the third tenant, that policies are irrelevant?
Government policies are necessary to increase demand --> by creating employment in public works or redistribution.
What is the chain reaction that represents the effects of government policies to demand??
AD increases -> supply increases -> employment increases (goes in a circle)
How was keynes' view of the role of demand and supply, contrasting to classical economists?
That demand creates supply (DEMAND SIDERS)
How did Keynes view the capital market, of how savings are determined?
s = d(y)
- The more people make, the more they save
What isn't included in the GDP function?
1. doesn't account for externalities (i.e. damages to the environment)
2. illegal activities/black market/ under the table
3. household production
4. secondary markets (buying things form other people instead of a company)
5. inequality (GINI coefficient)
What resulted from the Great Depression?
Keynesian ideas
What resulted after post WWII?
Keynesian revolution - the Neoclassical synthesis
What is the Neoclassical synthesis?
Argument to split micro and macro economics/classical micro with Keynesian macro
Marginalism
What are countercyclical policies?
Policies that go against the cycle to smooth out the peaksH
How do countercyclical policies work?
- Have a business cycle at boom times, government cools down the economy a little (by raising taxes and interest rates)
- When there is a trough, gov't supports economy by lowering taxes, increasing G, and lowering interest rates
Of the post wwii period, how was labor treated?
Agreement that workers would work hard and capitalists would reward. - because of the merge of the two greatest labor unions
What happened after post 1970?
Marked the counter revolution, high inflation and stagflation of the economy
What is Stagflation?
inflation in most economies, government followed counter cyclical policies, only increased inflation, unemployment started to rise.
Why was there such stagflation in the economy during the post 1970's
OPEC crisis - profitability crisis of oil - mass movement from coal to oil caused middle east companies to create an oligopoly and increased the prices of oil)
↑oil prices, ↑ inflation (Severe)
What was the monetary policy response to the 1970's?
To increase money supply, but led to inflation!
What marked the post 1980's?
Gov't supported demand increasing policies, but attacked trade unions and welfare policies.
Welfare state policy ↓ and demand side policies were abandoned.
What were the effects of reducing worker's rights and welfare policies?
1. Wages stopped rising (went down or stagnated)
2. The top 1% increased wages - increasing inequality
3. Women were forced to go into the workforce.
With workers' wages decreasing in the 1980's how was it possible for consumer spending to increase?
Credit cards were released
What asset bubbles developed in the post 1980's?
the .com bubble and the housing bubble
What happened after the 2008 financial crisis?
Return to Keynesian ideas
- Bail out packages and increased liquidity
What happened after 2010?
Austerity policies - Post 1970's ideas are still resilient.
What are austerity policies?
Austerity are policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. ... In most macroeconomic models, austerity policies generally increase unemployment as government spending falls
What is monetarism?
The doctrine that economic systems are controlled by variations in the supply of money.
What is the overview of Keynesian ideas?
1. Markets don't always clear
2. Labor unemployment is determined by total agg demand in the output market
3. Say's law isn't always right
4. S = s(y)
5. Fiscal policy matters
What points of time was Monetary policies implemented?
1979, The chief of the federal reserve utilized the monetarist perspective to control inflation.
- created price stability
- identified that shortage of the money supply was a critical component of the recession.
What is the main difference between classical and neoclassical perspectives?
Is the introduction of marginalism
What is marginalize?
Economic participants make decisions based on marginal utility (the additional satisfaction a consumer gains from consuming one more unit of a good or service.)
What is neo-keynesian economics?
the coordination and formalization of Keynes writings
What are the two contributions from Neo-Keynesian?
IS/LM Model
Phillips Curve
What is the rational expectations theory?
Is an economic concept whereby people make choices based on their rational outlook, available information and past experiences.
- equivalent to what people think the future state of the economy will become
Which idea does rational expectations theory contrasts?
That government policy influences people's decisions
What is rational expectations theory usually used to explain?
How events are expected based on past events to predict future events
How do we measure the macroeconomy? (4)
1) Gross Domestic Product (GDP)
2) Economic growth
3) unemployment rate
4) inflation rate
What is the gdp?
total value of all final goods and services
What is the rule of the GDP & Equilibrium?
Aggregate production = aggregate income
- Everything produced is sold
What are the factors of aggregate income?
1. Labor income
2. Capital income (profit)
How do we calculate Nominal GDP?
(Same years) P*Q
How do we calculate Real Gdp?
Price of 2009 chained dollars* Q of year you are trying to calculate
Why do economists care about real gdp?
Because it provides us with how Q increases, which determines inflation.
What does the Per capita gdp tell us?
The average standard of living in the country
How do we compare the measure of GDP across time?
Nominal vs. Real
How do we compare the measure of GDP across spaces at a point of time?
Exchange nominal rates
What is the unit for comparing the growth rate between two consecutive years?
Percentage
How do we find the growth rate betwen two consecutive years?
Rate of change
How do we find the growth rate between t1 and t3 (when there is one t between two values)?
Y3 = Y1 (1+g)^2
where g = annual growth rate
How can population become divided into?
Civilian population & Non-civilian institutional population
How can civilian population become divided into?
Labor force and outside labor force
How can the labor force become divided into?
Employed and unemployed
What is considered outside the labor force?
Children, retirees, discouraged workers
What is unemployment?
The number of people who do not have a job but are looking for one.
What happens when the inflation rate increases?
The buying power of a dollar goes down & Real income goes down.
Who are the (3) groups who are most impacted?
1) minimum wage earners
2) pensioners
3) bankers
What is does the purchasing price parity measure?
Measures a common price across countries
How do we find the world price GDPppp?
PWorld * Q1 (SUM of all)
What is important to remember about comparing the prices that are in the same exchange rates to find the PPP?
That the higher priced price should be in the numerator
That the lower price should be in the denominator
Once you get the calculation of the PPP, how do you say it?
For every $1 spent in china, it takes 1.7774 to obtain the same (product) in the US
What is deflation?
sustained decrease in price levels
What is disinflation?
decrease in inflation ( a slower rate)
What is the rate of inflation?
The rate of change - the rate at which general level of prices increases over time.
How do we calculate the GDP Deflator?
GDP Deflator (for each year)---> Inflation rate
What does inflation give us?
The average price of output - the final goods produced in the economy
What are flows:
income/consumption
What is stock?
wealth
What does it mean inequality increases?
Share of total income and wealth becomes concentrated in smaller amount of hands (the top 1%)
How does inequality affects the rich vs. the poor - consumption?
The poor consume all of their small income, and the rich consumer smaller amount of their income.
What is the effect of inequality to the rest of the economy?
As inequality increases, consumption increases, total aggregate demand decreases, output decreases
How do we measure inequality?
By the gini coefficient
What is the gini coefficient measured between?
(0,1), where 0 = perfect equality and 1 = perfect inequality
What is the average range where most countries fall between?
.3-.7 inequality range
What is the average range of wealth inequality?
(0.5-.95) range
What are the axes of the proportion of the lorenz curve?
Proportion of population (Quintiles) and proportion of income (share)
How is proportion of population and proportion of income (share) shown in a table?
Btom 20%
20-40%
40-60%
60-80%
80-100%
How is cum proportion of population and cum proportion of income (share) shown in a table?
20%
40%
60%
80% 100%
If they give the proportion of income (share) but not cumulative proportion of income (share), how do you change it?
1. Leave the first measure of cum proportion of income for bottom 20%
2. Add the bottom 20% + 40-60% proportion of income share to get the 40% cum income share
3. do it for the rest
4. The 100% should have 100%
How do you find the gini from the Lorenze curve?
Area of A / Area of (A+B)
What is the equation to find the gini coefficient if calculating by hand?
(A+B) - B / (A+B)
How do you find a, the gini coefficient, without using integrals?
1. Find the area of the triangle: b*h/2
2. find the trapezoids - a + b / 2 * h
3. Find the total of area of the triangle and the trapezoids
4. Find the area under the line of perfect inequality b
h/2 = 100
100/2
5. Subtract the total area - areas found for triangle and trapezoids to find A
6. Divide A/ A+B
What is important to remember while calculating the gini coefficient
Using the actual units within the graph, instead of the proportional units (25 instead of 5 boxes)
How do you find the unemployment rate?
Unemployed/ labor force
What is the equation to find the labor force?
Labor force = unemployed + employed
What is the equation to find the labor force participation rate?
Labor force / population
What is important about graphing the lorenze curve?
1. The units should go up at the same amount (cum proportion of income = 20, cum proportion of population = 20)
2. Draw out the line of perfect inequality
How do you interpret a country's lorenz curve based on inequality levels?
The closer to perfect inequality line, then closer to inequality.
What are the assumptions of the goods market?
I is exogenous
G is exogenous
Is = 0
(x-m) = 0
What is the GDP decomposition without the assumumptions?
Y = C + I + G + (x-m) + Is
What is c in the equation?
Private consumption of goods and servces
What is I in the equation?
Expenditures of firms/investments
What is Is?
Inventory not sold (Production - sales)
What is (X-M)
Exports - Imports
What is the most basic form of the GDP decomposition?
Y= C + I + G
What is the expanded version of the GDP decomposition function?
Z = c0 + c1 (Y-T) + I (bar) + G (bar)
What is c0?
Fixed consumption
What is fixed consumption?
When you have a disposable income of 0, you still want to consume (constant)
What is c1?
MPC
What is the MPC?
With every additional dollar you make, how much would you consume?
How do you solve the expanded version of the GDP?
Y = 1 / 1-c1
c0- (c1
T) + I + G
What is shown in the equilibrium in the goods market?
Production Y is equal to demand
What are the axes of the equilibrium in the goods market?
(Output, Y) , (Demand Z or Production Y)
What happens if you increase the exogenous variables, G & T?
Shifts ZZ curve up, where equilibrium shifts up
What happens when you increase the MPC?
ZZ becomes more steep, increasing Y**
What is the slope of the ZZ line?
MPC = C1
When does equilibrium occur in the goods market?
The equilibrium output Y occurs at the intersection of the 45-degree line and the demand function
At any point on the left of the equilibrium point, what does this mean?
Demand exceeds production
At any point on the right of the equilibrium point, what does this mean?
Production exceeds demand
What are the steps to creating the Keynesian cross diagram?
1. Draw XY
2. Draw equilibrium were Y=Z (45 Degree line)
3. Write out the equation: X=(C0 - C1T + I + g) + c1Y
4. Shift the line up, showing ↑ΔG.
5. From the Y-intercept, Start at the shifted-up line to get c1↑
6. Draw (3) equilibrium points from Y
(original line), Y1
, Y2*
How does the multiplier work?
If government spending increases, AD increases, AS increases (Y, output), income increases by 100b, consumption increases by c1(100b) = 80b
AD increases, AS increases, income increases, consumption increases
Where does the multiplier fit in with the snowball effect of increase in exogenous spending?
After (Y) increases (income), multiplier shows how increase in exogenous spending effects consumption and starts the chain again to increasing AD
What happens when investment isn't exogenous anymore but becomes a function?
Investment becomes a function of Y. Therefore, when Y increases due to a change in G, the multiplicative increase in Y will be magnified, since an increase in Y increases C and I, which further increases Y
What is the equation of the multiplier?
Y = 1 / 1-c1
What equation allows us to find how the change from gov't spending affects the change in output?
Change in gov't spending * multiplier
What is the alternative equilibrium?
Total savings = total investment
What is the equation of public savings?
Taxes - government spending
What is the alternative equilibrium equation?
Investment (exogenous) = Private savings (S) + Public savings
S+ (T-G) = Total investment
What is the equilibrium of the investments?
Investment = Savings
What is the private savings equation?
S = (Y-T-C)
C--> Input the consumption function
What is the expanded private savings function once you solve for y?
S = -mpc + mps + disposable income
S = -c0 + (1-c1) (Y-T)
How do you expand the Investment function?
1. Take I = S + (T-G)
2. Input the expanded savings function
3. Solve for Y
What is MPS?
How much additional unit of income people save
(0,1)
= 1 - c1
What is the paradox of savings?
If everyone saves more in the economy, the aggregate savings should increase - the paradox - but in the short run, they end up saving the same!
Where does finance fit in between the players of the financial markets?
Savers --> Finance --> Investors
What is money?
Use for transactions, pays no interest
What are the two types of money?
Currency & checkable deposits
What are bonds?
Pays a positive interest rate, i, but cannot be used for transactions
What is the purpose of bonds?
- debt issued by an entity to raise money for a project
What is the difference between money and bonds?
1) Whether it can be used for transactions
2) Whether it pays interest
3) Bonds are assets
4) Money is a liability
What are the 3 liquidity preferences?
1) Transactions motive
2) Precautionary motive
3) Speculative motive
What is the transactions motive?
The transactions motive states that individuals have a preference for liquidity in order to guarantee having sufficient cash on hand for basic day-to-day needs.
What is the precautionary motive?
The precautionary motive relates to individuals' preference for additional liquidity in the event that an unexpected problem or cost arises that requires a substantial outlay of cash.
What is the speculative motive?
When interest rates are low, demand for cash is high as individuals prefer to use the cash or hold onto it until interest rates rise. The speculative motive refers to investors' general reluctance to commit to tying up investment capital in the present for fear of missing out on a better opportunity in the future. When higher interest rates are offered, investors will give up liquidity in exchange for the higher interest rates.
What is Money demand?
Md = sum of all the individual demands for money by the people and firms in the economy
What does money demand depend on?
All the overall level of transactions in the economy and on the interest rate.
What is the money demand equation?
Md = $Y L(i)
$Y = nominal income
L(i) = interest rates
- Nominal income is in place for overall transactions in the economy.
How do you interpret the money demand function?
The demand for money Md is equal to nominal income $Y times a decreasing function of the interest rate, i
What is the effect of the interest rate on the money demand?
Interest rate has a negative effect on money demand: An increase in the interest decreases the demand for money, as people put more of their wealth into bonds.
What is the effect of nominal income on money demand?
The demand for money increases in proportion to nominal income (i.e. if nominal income doubles, increasing from $Y to $2Y, then the demand for money also doubles, increasing from $Y L(i) to $2Y L(i)).
What does the money demand graph show?
The relation between the demand for money and the interest rate for a given level of nominal income $Y is represented by the Md curve.
What are the axes of the money demand graph?
(Money, Interest rate)
What does the curve look like?
Curve is downward sloping: the lower the interest rate, the higher the amount of money people want to hold)
How does an increase in Nominal income $Y affect Md?
Shifts the curve to the right
- at an interest rate i, an increase in nominal income from $Y to $Y1 increases the demand for money from M to M1
Why? Because at the initial interest rate with the increase in nominal income, the demand for money exceeds the supply. The increase in the interest rate decreases the mount of money people want to hold and reestablishes equilibrium.
What is equilibrium in the financial markets?
Ms = Md
Money supply = money demand
What is the interpretation of MS = MD
At the interest rate, i, given their income $Y, people are willing to hold an amount of money equal to the existing money supply M.
When does Ms shift?
If the interest rate changes?
If MS shifts to the right, how does equilibrium move? What are the happens after?
The equilibrium moves down from A to A1 and the increase rate decreases from i to i1.
- the decrease in the interest rate increases the demand for money so it equals the now larger money supply.
What is monetary open market operations?
Central banks change the supply of money by buying or selling bonds (public or private) in the bond market
Expansionary open market operations?
For the central bank wants to increase the amount of money in the economy, it buys bonds and pays for them by releasing money --> MS increases, and the interest rate decreases
What is contractionary open market operations?
If it wants to decrease the amount of money in the economy, it sells bonds and withdraws money from circulation → MS↓, i ↑
How does a bond work?
Annual coupon rate (Today) → interest every year → principal + interest (when it matures).
What is the equation for the price of a bond?
i = 100 - $PB / $PB
PB = Price bond (after maturity date)
VB = Value of bond (first price)
i = interest rate
How can we manipulate the equation if we are given the interest rate, to find the price of the bond?
$PB = 100 / 1+i
What is the relationship between bonds and the interest rate?
The higher the price of the bond, the lower the interest rate.
What is IS?
Equilibrium in the goods market where production Y is equal to the demand for goods, Z
I = S, investment = savings
What is LM?
LM: Equilibrium in the money market, L = M; Md = MS ; (M/P)d = M/P
What is the relation of I between Y and investment, i? What does this tell us?
I = I(Y, i)
- I moves with Y, but I has an inverse relationship
- Increase in production leads to an increase in investment
- Increase in the interest rate leads to a decrease in investment
What is the condition for equilibrium in the goods market?
Y= C(Y-T) + I(Y,i) + G
What does the ZZ curve represent?
represents the relationship between demand and output
When is equilibrium achieved?
Where the demand for goods equals output; at point A, the intersection of ZZ and the 45 degree line
How does the increase in the interest rate affect the ZZ curve?
The Increase in the interest rate decreases the demand for goods at any level of output (& Lower investment), leading to a decrease in the equilibrium level of output. -- Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in output
How does the IS curve shift?
Only with T and government spending
How does the increase in taxes affect the LM curve?
At the same interest rate, the economy moves along the LM curve from A to A1.
What is the explanation for the increase in taxes to the rest of the the factors in the equilibrium equation?
Increase in taxes lead to lower disposable income, which caused people to decrease their consumption. The decrease in demand leads (through the multiplier) to a decrease in output and income. The decrease in income and in taxes both contribute to the decrease in disposable income and in turn, a decrease in consumption.
What is the LM curve?
M/P = M/P d = Y * L(i)
Real money supply is equal to the real money demand, which depends on real income, Y, and interest rate, i.
What is fiscal contraction/ consolidation?
Increasing taxes while keeping government spending unchanged (Reducing the budget deficit)
What is fiscal expansion?
Increase in the deficit, either due to an increase in government spending or to a decrease in taxes.
What is monetary expansion?
The central bank decreases the interest rate, increasing the money supply.
What is monetary contraction?
Increase in the interest rate, which is achieved through a decrease in the money supply.
What is the chain reaction between an increase in the interest rate to equilibrium?
IS (investment-saving): i goes up=> investment goes down=> Z goes down=> equilibrium output goes down
What is the lm relation?
i = ī
How is the interest rate determined?
By: The Central bank chooses the interest rate and adjusts money supply to achieve it.
What are the steps to solving a IS-LM questions?
Steps: 1. Set up Equilibrium equations
ISrelation: 𝒀=𝑪 𝒀−𝑻 +𝑰 𝒀,𝒊 +𝑮
because AS = Y, AD = Z = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺, in equilibrium AS = AD LM Relation: i = ī
2. Solve for Y from the two equations (IS and LM relations)
3. Draw the graph (i in vertical axis, Y in horizontal axis)
4. Understand how changes in fiscal policy and/or monetary policy might change equilibrium output and interest rate.
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