CFA Economics Flashcards
Explain the two approaches to measuring gross domestic product and calculate GDP using each approach
One way GDP can be measured is the expenditure approach, which is derived from the total expenditures on final goods and services produced throughout the year. The expenditure approach has four components: personal consumption expenditures, gross private domestic investment, government consumption, and net export to foreigners
A second way of calculating GDP is the resource cost income approach, which is the sum of all of the income payments to the resource suppliers and the other costs of producing those goods and services. This approach tracks the flow of income payments and indirect costs and is the sum of aggregate income, non income cost items (such as indirect business taxes and depreciation) and the net income of foreigners.
Distinguish between GDP & GNP
GNP is the total market value of all final goods and services produced by the citizens of a country no matter where they are residing
GDP is a measure of the output produced domestically
Explain the difference between real and nominal GDP
Nominal GDP is expressed in current dollars, while Real GDP has been adjusted by a price index for inflation
Distinguish between the GDP deflator and the CPI
The CPI is an indicator of general price levels, as indicated by a basket of typical goods purchased by households. The GDP deflator is a broader measure of prices than the CPI and also includes prices for capital goods and other goods and services purchased by businesses and governments. CPI and GDP deflator are two different measures and are NOT interchangeable.
Discuss three self correcting mechanisms that may help to stabilise a market economy
Consumption Demand
Real Interest Rates
Resource Prices
Consumption Demand
Demand is relatively stable over the business cycle
Real Interest Rates
Changes in real interest rates will help to stabilise aggregate demand and redirect economic fluctuations
Resource Prices
Changes in real resource prices will direct economic fluctuations
Distinguish between classical economics and Keynesian Economics
Classical economists stressed the importance of aggregate supply.
Keynesian economics stresses the importance of aggregate demand in determining the overall level of output in the economy. If spending decreases due to pessimism on the part of consumers and investors, business will respond by cutting output. At this point, the argument is precisely the same as that used in the classical AD/AS model. But the classical AD/AS model depends on a subsequent reduction in resource prices to restore long run equilibrium, namely a reduction n wages, were highly inflexible in a downward direction. Hence, in Keynes’ view, the economy would languish for an extended period of time with high unemployment.
Explain the major components of the Keynesian model
Real GDP = planed expenditures = planned (C + I + G + NX)
Where:
Consumption (C): As disposable income increases, current consumption expenditures rise, but by a smaller amount. Considered the most important component of the model
Investment (I): Includes expenditures on fixed assets, as well as changes in inventories or raw materials and unsold finished goods.
Planned Govt Expenditures (G): Determined by political process, and not necessarily dependent upon tax revenues.
Planned Net Exports (NX): Level of Imports increases with income, as consumers buy more domestic and foreign goods.
Explain Keynesian macro equilibrium
Keynesian macro equilibrium is achieved when planned aggregate output expenditures equal the value of current production, and can be stated as:
Total Output = planned C + I + G + NX
Note that the left side of the equation is real GDP and the right side of the equation is planned aggregate expenditures. At the point of equilibrium, businesses are able to sell their exact output of goods and services. If the economy is out of equilibrium, for example, if supply exceeds demand (right side of the equation) output will then decrease (left side of the equation) until equilibrium is once again achieved.
Define and calculate the marginal propensity to consume and the expenditure multiplier
The marginal propensity to consume (MPC) is the proportion of additional income that households will choose to spend on consumption rather than saving. The greater the MPC, the more spent on consumption. The formula is:
MPC = additional consumption / additional income
The expenditure multiplier is the ratio of change in equilibrium output to the independent change in investment, consumption, or government spending that effects the change. The formula is:
Expenditure multiplier = 1 /( 1 - MPC)
Explain the importance of the expenditure multiplier within the framework of the Keynesian model
The expenditure multiplier states that one individual’s expenditures will become the income of another. The income recipient in turn will spend a portion on consumption, becoming the income of yet another individual and so on. It can be defined as the change in total income divided by expenditure changed caused by the larger income. According to the Keynesian model, autonomous expenditures (spending unrelated to income) will cause a shift in aggregate expenditures, which in turn will increase income
Discuss the Keynesian view of the business cycle
Keynesian economists believe that if left alone, a market economy is unstable and is subject to long periods of recession. Autonomous changes in expenditures, in conjunction with the expenditure multiplier, are major destabilising factors in the economy. Governments have the power to use tax and fiscal policies to stabilise aggregate expenditures and assure full employment
Explain the phases of the business cycle
The business cycle is a pattern over time of shifts from economic expansion to economic contraction. A business peak is when businesses are operating at capacity and real GDP is growing rapidly. As business slows, unemployment increases, and GDP grows at a slow pace or declines, it is called the contraction, or recessionary phase of the cycle. The bottom of the phase is the recessionary trough. As economic conditions begin to improve again, marked by growth in GDP and a decline in unemployment, the EXPANSION phase begins. The expansionary period will grow into a business peak, thus beginning a new business cycle.
Describe the key labour market indicators and discuss the problems in measuring unemployment
The CIVILIAN LABOUR FORCE are at least 16 years old and either currently employed or actively seeking employment
The LABOUR FORCE PARTICIPATION RATE is the number of persons 16 years or older who are either employed or actively seeking employment as a percentage of the civilian population 16n years or older
The RATE OF UNEMPLOYMENT is the percent of people in the civilian labour force who are unemployed
UNEMPLOYED WORKERS include those classified as (1). laid off, (2) re-entrants into the labour force (3) new entrants (4) left last job willingly and (5) fired or terminated.
Measurement problems include:
Workers waiting recall
Discouraged Workers
Part-time workers
Define and explain full employment and the natural rate of unemployment
FULL EMPLOYMENT is the economic condition that exists when cyclical unemployment is zero. Note however, that there is some level of unemployment that is expected when the country is at FULL employment
The NATURAL RATE OF UNEMPLOYMENT is that rate of unemployment present when the economy is at its full employment rate of production or output. The natural rate of unemployment can persist for an indefinite period of time and is typically associated with the economy’s maximum long run rate of output.
Define inflation and calculate the inflation rate
Inflation is defined as a continuing rise in the general level of prices of goods and services. Because of higher prices, a dollar will purchase less goods and services in periods of inflation.
Define the harmful consequences of inflation
Inflation will increase the risks of and slow the level of activity in long-term projects. Unanticipated inflation will negatively impact the outcome of long term capital investments, and therefore these types of projects may be postponed or cancelled
Inflation distorts the information delivered by prices. Some prices will respond to inflationary pressure more quickly than others, therefore giving a distorted picture of overall price levels until inflation stabilizes
In periods of high or variable inflation, productivity will decline. People will spend more time trying to protect themselves from inflation rather than producing goods and services.
Explain the process by which fiscal policy affects aggregate demand and aggregate supply.
Fiscal policy refers to government budgeting, ie taxing and spending. Expansionary policy means more spending or lower taxes (note that this means budget deficits). Restrictive policy means less spending or higher taxes. Keynesians believe that fluctuations in aggregate expenditures are the main source of economic disruptions. According to the Keynesian view, expansionary fiscal policy can stimulate aggregate expenditures, while restrictive policy can act as a brake on inflationary pressures. Thus fiscal policy can be used to smooth the effects of fluctuations in economic cycles. According to supply side economists, marginal tax rates can affect aggregate supply. Lower tax rates reduce purely tax motivated investments, encouraging more efficient allocation of capital resources
Explain the importance of timing of changes in fiscal policy and the difficulties in achieving proper timing.
Fiscal policy can be used to stimulate or restrain economic activity. If a stimulus is applied to an economy that is already growing or at full employment, the effects could be inflationary. Similarly, applying restrictive policies to an economy in recession could worsen economic conditions. Timing is difficult for three reasons: (1) forecasts of future macroeconomic conditions are imperfect, (2) decisions relating to changes in fiscal policy take time, (3) the policy change takes time to have an effect. If fiscal policy is implemented based on an incorrect forecast, or if conditions change during the time it takes to decide on a policy change and execute that change, then the policy change is less likely to achieve the desired goal.
Describe the impact of expansionary and restrictive fiscal policies based on the basic Keynesian model, the crowding out model, the new classical model, and the supply side model.
Basic Keynesian Model: An increase in government spending &/or reduction in taxes will be magnified by the multiplier process and lead to a substantial increase in aggregate demand. This will stimulate the economy to lead to increases in the level of employment and output.
Crowding Out Model: The potency of expansionary fiscal policy will be dampened because borrowing to finance the budget deficit will push up interest rates and crowd out private spending.
New Classical Model: The potency of expansionary fiscal policy will be dampened because households will anticipate the higher future taxes implied by the debt and reduce their spending in order to pay them. Like current taxes, this future tax debt will crowd out private spending.
Supply Side Model: A reduction in marginal tax rates will increase the incentive to earn and improve the efficiency of resource use, leading to an increase in aggregate supply (output) in the long run.
Explain how and why budget deficits and trade deficits tend to be linked.
A budget deficit occurs when total government spending exceeds total government revenues. A trade deficit is an excess of imports relative to exports. Larger budget deficits will push up interest rates, which will then attract a greater inflow of foreign capital into the economy. In turn, increased foreign exchange demand for the dollar will cause it to appreciate, which will reduce both net exports and net demand.
Identify automatic stabilisers and explain how such stabilisers work
Automatic stabilisers are built in fiscal devices that ensure deficits in a recession and surpluses during booms. Automatic stabilisers minimise the problem of proper timing.
