Basic Economic Concepts

Question 1

Quantity Supplied

Answer 1

Quantity supplied is the amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period. There is a direct relationship between the quantity of a good supplied and its price.

Question 2

Law of Supply

Answer 2

An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied. Changes in the quantity of a good or service supplied by the producers result in a move along the supply curve.

Question 3

Factors that can lead to a supply curve shift

Answer 3

New Technology

Market Expectations or Conditions

Changes to the Number of Producers

Changes in Input Prices

Changes in Prices of Related Goods or Services

Question 4

Quantity Demanded

Answer 4

Quantity demanded is the amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price. The relationship between quantity demanded and price is either negative, or inverse.

Question 5

Law of Demand

Answer 5

When price rises, quantity demanded falls, and when price falls, quantity demanded rises. This negative relationship between price and quantity demanded is referred to as the law of demand.

Question 6

Factors that can shift the demand curve

Answer 6

Changes in income levels

Changes in consumer preferences

Change in expectations

Changes to number of consumers in the market

Changes in prices of related goods and services

Question 7

Equilibrium Price

Answer 7

Equilibrium price is the point where the supply curve intersects the demand curve of a good or service. It is the price where there is no tendency for change.

Question 8

Excess Demand

Answer 8

The quantity demanded exceeds the quantity supplied at the current price. This would result in an increase in price (for example, the price people are willing to pay for a ticket to a sold out sporting event or our previous discussion on the hot holiday toy).

Question 9

Excess Supply

Answer 9

The quantity supplied exceeds the quantity demanded at the current price. This will result in a decrease in price (for example, a liquidation sale of the excess inventory of current-year car models in anticipation of the arrival of next year’s model).

Question 10

Equilibrium

Answer 10

The quantity supplied equals the quantity demanded at the current price.

Question 11

Price Elasticity of Demand (PED)

Answer 11

A measure of a buyer’s responsiveness or sensitivity to changes in price.

Question 12

Three things that determine price elasticity of demand

Answer 12

Availability of substitutes

Relevance to budget

Time

Question 13

Availability of Substitutes

Answer 13

Availability of substitutes: If more substitutes are available, then an increase in price will cause a drop in quantity demanded. Consumers simply buy a competitor’s lower priced product instead.

Question 14

Relevance to Budget

Answer 14

Relevance to budget: If the product is a small part of consumer budgets, a small increase in price will not cause a change in quantity demanded.

Question 15

Time

Answer 15

Time: In the short run, a change in price for a product without substitute can be effective because it is price inelastic. Consumers who want or need the product would still buy it, regardless of the price, so they are insensitive to the price change. An example would be the price of food, fuel, water and other consumer staples. In the long run, consumers may be able to find or develop substitute products to bring down prices.

Question 16

Gross Domestic Product

Answer 16

In order to understand the government’s influence on the economy, it is helpful to understand how the economy is measured. In macroeconomics, one measure of the economy is to look at the aggregate output or income (Y). Aggregate output is the sum total of consumption, corporate capital investments, net exports, and government spending. Another term for aggregate output is real Gross Domestic Product (GDP).

Question 17

Fiscal Policy

Answer 17

Fiscal policy refers to the government’s tax and spending policies and how these interventions influence the economy. Only the federal government, not state government, has the power and flexibility to run budget deficits or surpluses large enough to influence total consumer demand.

Question 18

How does the government use spending policy to increase the equilibrium level of national output?

Answer 18

The government uses spending policy to increase the equilibrium level of national output. To increase spending without raising taxes (which provides the government with revenue to spend), the government must borrow. When government spending (G) exceeds taxes collected (T), the government runs a deficit. The difference between G and T must be borrowed.

Question 19

What are then effects of increased government spending?

Answer 19

Increased government spending will throw the economy out of equilibrium. As output rises, the economy generates more income. An increase in government spending has the same impact on the equilibrium level of output and income as an increase in planned investment (I). A dollar of extra spending from either G or I is identical with respect to its impact on equilibrium output. There is an immediate and direct impact on the economy’s total spending when the government increases spending.

Question 20

Monetizing the Debt

Answer 20

If government expenditures exceed the revenue collected, then the government runs a budget deficit. The US Treasury borrows by issuing bonds that are bought by banks and investors. Banks pay for bonds by crediting the checking account of the Treasury, which increases the money supply. This process is known as monetizing the debt.

Question 21

Monetary Policy

Answer 21

Monetary policy controls the supply of money and influences bank lending and interest rates. It can be used to slow down inflation or stimulate the economy.

Question 22

M1 Money Supply

Answer 22

Currency

Demand Deposits

Travelers Cheques

Question 23

M2 Money Supply

Answer 23

M1

Savings

Money Market

Question 24

Tree ways the Fed influences economic activity

Answer 24

Setting short-term interest rates (discount rates and fed funds targets for inter-bank loans).

Buying and or selling treasury securities to increase/decrease money supply.

Setting member bank reserve requirements to increase/decrease funds available for loans.

Question 25

Three ways the Fed regulates the money supply

Answer 25

Manipulating the Reserve Requirements.

Manipulating the Discount Rate.

Engaging in open market operations.

Question 26

Reserve Requirement

Answer 26

The reserve requirement is the amount of total deposits that the Fed requires its members to keep with the Federal Reserve at the end of the business day.

Question 27

Discount Rate

Answer 27

Banks sometimes borrow money from the Federal Reserve. The discount rate is the interest rate banks pay the Fed. The Fed periodically sets the discount rate which regulates the flow of money into the economy. The interest rate that banks charge firms and individuals for borrowing will adjust as the discount rate changes. When banks borrow from the Fed, there is an increase in the money supply. The discount rate is the only rate controlled directly by the Fed.

Question 28

Impact of a higher discount rate

Answer 28

The higher the discount rate, the higher the cost of borrowing, therefore, the less borrowing banks will do. When the Fed increases the discount rate, the cost of borrowing (for example, mortgage rates, coupon rates and others) will ultimately increase for consumers, which discourages borrowing in general.

Question 29

Impact of a lower discount rate

Answer 29

If the Fed decreases the discount rate, the cost of borrowing will be cheaper. Firms and individuals will take advantage of lower rates by purchasing new homes or by financing the construction of new plants. If the Fed sets the discount rate too low, then banks may be tempted to borrow more.

Question 30

Fed Funds Rate

Answer 30

Rates will be lower if the banks, in turn, lower the interest rate they charge other banks on overnight loans. This is known as the federal funds rate. The Fed sets a targeted range for the federal funds rate which is currently 0 - 0.25% (June 2020), due to uncertainty associated with the US economic recovery from the coronavirus pandemic. If banks are unwilling to lend to one another given various uncertainties, or are charging their clients and other banks much higher interest rates, then a credit crunch will ensue. The federal funds rate is only targeted, or, indirectly influenced by the Fed.

Question 31

Prime Rate

Answer 31

The prime rate is another lending rate which banks extend to their most favored customers. This rate is also based upon the discount rate. Therefore, the Fed indirectly influnces the prime rate.

Question 32

Open Market Operations

Answer 32

Open market operations describe the Fed’s buying and selling of government securities in the open market. It is a tool used to expand or contract the amount of reserves in the system and, thus, the money supply.

Question 33

The Primary job of the Federal Reserve

Answer 33

The primary job of the Federal Reserve is to control inflation while avoiding a recession.

Question 34

Gross Domestic Product

Answer 34

Gross Domestic Product (GDP) is a statistic used to measure the economy on a quarterly basis. GDP measures the total market value of a country’s income and output of goods and services produced by all the people and companies in the U.S. Since nominal GDP includes inflation, it is higher than real GDP.

Question 35

Components of Real GDP

Answer 35

Market value of all final goods and services produced within a country. For example, if a U.S. company makes shoelaces that are used to make shoes in the U.S. then only the value of the shoe is counted.

Income of foreigners working in the United States.

Profits that foreign companies earn in the United States.

Question 36

GDP Excludes

Answer 36

Imports, to avoid the impact of exchange rates and trade policies.

The effects of inflation.

Intermediate goods (goods that could be counted, both when they are purchased as inputs and when they are sold as final products).

All transactions in which money or goods change hands but in which no new goods and services are produced.

The income of U.S. citizens working abroad.

Profits earned by U.S. companies in foreign countries.

Question 37

Unemployment Rate

Answer 37

The unemployment rate measures the number of people unemployed as a percentage of the labor force. To be counted as unemployed, a person must be out of a job and actively looking for work. When someone stops looking for work, they are considered out of the labor force and no longer counted as unemployed.

Question 38

Inflation

Answer 38

Inflation is the general rise in prices of goods and services. Too much inflation can erode the purchasing power of your savings. In order for you to increase your wealth, your investments must earn a higher return than your tax rate and the inflation rate.

Question 39

Deflation

Answer 39

Deflation is a decrease in the overall price level. It occurs when many prices decrease simultaneously. The last time the U.S. experienced deflation was in the era of the Great Depression. The consensus for economists is that modest inflation, with rates between 1% and 3%, is a more likely long-term scenario.

Question 40

Disinflation

Answer 40

Disinflation occurs when the rate of inflation decreases and prices are still rising, but at a slower rate.

Question 41

Hyperinflation

Answer 41

Hyperinflation is a period of rapid increase in the overall price level. Most Americans are unaware of what life is like under hyperinflation. In some countries, people were accustomed to prices rising by the day, hour, or even minute. During 1984 and 1985, the people of Bolivia experienced hyperinflation. By 1985, three bottles of aspirin sold for the same price a luxury car had sold for in 1982. When inflation approaches rates of 2,000% per year, the economy and structure of a country begin to break down. Workers may go on strike to demand wage increases and firms may find it hard to secure credit.

Question 42

Stagnation

Answer 42

Stagnation results in declining prices, slow economic growth, and high unemployment. In business cycles, the economy generally alternates between stagnation and inflation.

Question 43

Stagflation

Answer 43

Stagflation is a term coined in 1965 which signifies a period of high inflation combined with slow or stagnant economic growth (i.e. high unemployment.) When stagflation occurs, the economy is contracting, yet prices continue to rise. Stagflation occurred in the early 1970s when oil prices and unemployment rates sky-rocketed, triggering inflation during an economic recession.

Question 44

Types of Inflation

Answer 44

Sustained inflation

Demand-pull inflation

Cost-push or supply-side inflation

Expected inflation

Question 45

Sustained Inflation

Answer 45

Sustained inflation occurs when the overall price level continues to rise over a fairly long period of time. Most economists believe that sustained inflation can occur only if the Fed continuously increases the money supply.

Question 46

Demand Pull Inflation

Answer 46

Demand-pull inflation is initiated by an increase in aggregate demand. As demand shifts higher while supply remains the same, the equilibrium price will increase.

Question 47

Cost Push or supply side inflation

Answer 47

Cost-push or supply-side inflation is initiated by an increase in costs. An increase in costs may also lead to stagflation - when the economy is experiencing inflation during a time of contraction.

Question 48

Expected Inflation

Answer 48

Expected inflation is “built into the system” as a result of expectations. If prices have been rising and people form their expectations from this past behavior, firms may continue raising prices even if demand is slowing.

Question 49

Consumer Price index

Answer 49

This represents a measure of the average change in prices of goods and services over a period of time.

Question 50

Yield Curve

Answer 50

A yield curve gives an indication of the market’s expectation of the future direction of interest rates. It is a graph that shows the yields-to-maturity (on the vertical axis) for Treasury securities of various maturities (on the horizontal axis) as of a particular date. This provides an estimate of the current term structure of interest rates and changes daily as yields-to-maturity fluctuate. The slope of the curve indicates the relationship between short-term and long-term interest rates.

Question 51

Three types of yield curves

Answer 51

Upward-sloping

Flat

Downward-sloping

Question 52

Three yield curve theories

Answer 52

Horizon premium theory

Market segmentation theory

Expectations theory

Question 53

Horizon Premium Theory

Answer 53

The horizon premium theory, or liquidity premium theory, asserts that on average, investors pay a price premium for bonds with short-term maturities. This is to avoid the greater interest rate and price risks of bonds with longer maturities. Due to this premium, long-term bond yields are typically higher than short-term bond yields. Thus, an upward sloping yield curve is considered normal.

Question 54

Market Segmentation Theory

Answer 54

The market segmentation theory, or segmented market hypothesis, asserts that the yield curve is composed of a series of independent maturity segments.

Question 55

Expectations Theory

Answer 55

The expectations theory asserts that long-term yields are the average of the short-term yields expected to prevail during the period before a bond matures.