Chapter 6 An Introduction to Macroeconomics

Question 1

What are the two main areas of focus in macroeconomics?

Answer 1

1. Long-run economic growth
2. Short-run fluctuations (business cycle)

Question 2

What are the three key economic statistics that macroeconomists focus on?

Answer 2

Real GDP
Unemployment
Inflation

Question 3

What is Real GDP and why is it important?

Answer 3

Real GDP measures the value of final goods and services produced within a country over a specific period (typically a year).

It helps determine if an economy’s output is growing and reflects changes in the quantity of output, not just price increases.

Question 4

What is Nominal GDP and what is its main issue?

Answer 4

Nominal GDP is the total value of goods and services produced using current prices.

Issue: It can increase even if the quantity of output doesn’t change, simply due to price increases.

Question 5

Why is Real GDP a better measure of economic growth than Nominal GDP?

Answer 5

Real GDP adjusts for price changes, allowing a more accurate comparison of output growth between different years.

Question 6

How does Real GDP impact people’s standard of living?

Answer 6

Increased Real GDP leads to more consumption possibilities, such as better healthcare and safer infrastructure, thus improving the standard of living.

Decreased does the opposite

Question 7

What is unemployment and why is it a concern for economists?

Answer 7

Unemployment occurs when individuals are willing and actively seeking work but cannot find a job.

High unemployment is undesirable because it means a significant portion of a nation’s talent and resources is unused

Question 8

What are the social consequences of high unemployment?

Answer 8

Higher crime rates

Political unrest

Increased rates of depression and health issues

Question 9

What is inflation and what does it affect?

Answer 9

Inflation is the increase in the overall level of prices.

It reduces purchasing power, making it more expensive to buy goods and services, and erodes the value of savings.

Question 10

Why is inflation problematic for consumers?

Answer 10

If inflation outpaces income growth, consumers cannot maintain the same standard of living.

It reduces the value of savings, as money buys less than expected.

Question 11

What is the purpose of macroeconomic models?

Answer 11

Macroeconomic models help policymakers understand how to maximize economic growth while minimizing unemployment and inflation.

Question 12

What is the effect of a 2% annual growth rate in output per person over time?

Answer 12

An annual growth rate of 2% means income will double every 35 years. from 70/2

Question 13

Why do some countries have higher living standards than others today?

Answer 13

Countries that began modern economic growth earlier have accumulated more wealth, leading to higher living standards.

Question 14

What defines modern economic growth?

Answer 14

Modern economic growth occurs when output grows faster than population, leading to increases in living standards over time.

Question 15

What is required for an economy to raise living standards over time?

Answer 15

An economy must devote part of its current output to increasing future output, which requires saving and investment.

Question 16

What is saving in economic terms?

Answer 16

Saving occurs when current consumption is less than current income, and the difference is saved for future use.

Question 17

What is investment in an economic context?

Answer 17

Investment is the allocation of resources to increase future output, including paying for new technologies and producing capital goods like machinery and infrastructure.

Question 18

Why is saving important for investment?

Answer 18

The amount of investment is limited by the amount of saving. More saving allows for more investment, which increases future output.

Question 19

What is the trade-off between current and future consumption?

Answer 19

To increase future consumption through investment, society must reduce current consumption by saving more, which involves a trade-off between present and future consumption.

Question 20

What is the difference between economic and financial investment?

Answer 20

Economic investment refers to expanding productive capacity (e.g., creating new capital goods, research), while financial investment involves purchasing assets like stocks or bonds, which do not increase productive capacity.

Question 21

Why is economic investment important?

Answer 21

Economic investment increases future output by expanding the economy’s productive capacity through capital goods and technological development.

Question 22

What is the role of financial institutions in an economy?

Answer 22

Financial institutions, such as banks, collect savings from households and lend them to businesses for investment in capital goods and research, R & D, facilitating economic growth.

Question 23

How does a well-functioning financial system impact the economy?

Answer 23

A well-functioning financial system promotes economic growth and stability by encouraging saving and directing funds to productive investments.

Question 24

What is the relationship between saving and investment?

Answer 24

Saving is crucial for investment. An economy can only invest if it saves some of its current output, which leads to higher future output.

Question 25

What complicates decisions about savings and investment?

Answer 25

Uncertainty about the future, as investments sometimes fail or produce disappointing results.

Question 26

Why are expectations important in economics?

Answer 26

Expectations affect current behavior, such as investment levels, and can also influence how firms respond to unexpected outcomes (shocks).

Question 27

What is the role of shocks in economics?

Answer 27

Shocks are unexpected situations that force firms to respond to conditions different from what they expected, affecting output and employment.

Question 28

What are the two types of shocks in economics?

Answer 28

Demand shocks (unexpected changes in demand) and supply shocks (unexpected changes in supply).

Question 29

Why are demand shocks a problem for firms?

Answer 29

Many prices are “sticky” (inflexible) in the short run, meaning the economy responds to demand shocks through changes in output and employment rather than prices.

Question 30

What happens if a firm has sticky prices and faces a demand shock?

Answer 30

The firm adjusts its output and employment to match the new demand, since it can’t quickly change prices to restore equilibrium.

Question 31

What the relationship bw sticky prices and short fluctuations?

Answer 31

Sticky prices cause short-run fluctuations in output and employment, as firms cannot adjust prices quickly to match changes in demand.

Question 32

What happens when demand unexpectedly falls for a firm with sticky prices?

Answer 32

The firm experiences a drop in sales, leading to increased inventory, and may cut production, resulting in higher unemployment.

Question 33

How do firms deal with demand fluctuations when prices are sticky?

Answer 33

Firms maintain inventories, adjusting inventory levels instead of production levels to cope with demand shifts.

Question 34

How does the economy respond to a prolonged demand shock?

Answer 34

Firms cut production, GDP falls, and unemployment rises.

Question 35

How does the economy respond to a prolonged demand boom?

Answer 35

Firms increase production, GDP rises, and unemployment falls as more workers are needed.

Question 36

What was the “double whammy” of the COVID-19 recession?

Answer 36

The COVID-19 recession involved both a demand shock (reduced demand for goods and services) and a supply shock (reduced supply due to business closures and worker inactivity).

Question 37

How does sticky pricing affect the response to a demand shock?

Answer 37

With sticky prices, the economy adjusts to demand shocks primarily by changing output and employment, not prices.

Question 38

What happens when prices are flexible in response to a demand shock?

Answer 38

If prices are flexible, the market adjusts to the new demand level by changing the price, ensuring that supply meets demand without affecting output or employment.

Question 39

What are sticky prices?

Answer 39

Sticky prices are prices that do not adjust quickly to changes in supply and demand, leading to fluctuations in GDP and employment, especially during unexpected changes in demand.

Question 40

How do prices for commodities and raw materials differ from prices for consumer products?

Answer 40

Prices for commodities and raw materials (e.g., corn, oil, natural gas) are extremely flexible, changing quickly. In contrast, prices for most consumer products are stickier, with an average of 4.3 months between price changes.

Question 41

Why do firms keep prices sticky in consumer goods markets?

Answer 41

Consumers prefer stable, predictable prices, and rapidly fluctuating prices can lead to dissatisfaction and difficulties in planning. Firms aim to avoid customer frustration and maintain stability in pricing.

Question 42

What is a price war, and how does it affect price stickiness?

Answer 42

A price war occurs when firms retaliate against each other’s price cuts, making it harder for any company to gain a competitive advantage. This fear of price wars leads firms to maintain sticky prices, especially in markets with few competitors.

Question 43

Why might firms hesitate to cut prices in competitive markets like Coca-Cola and Pepsi?

Answer 43

Firms fear that if they cut prices, their competitors will retaliate by matching the price cut, resulting in no real market share gain but lower profits for both companies.

Question 44

How does price stickiness affect consumer behavior?

Answer 44

Unstable prices may make consumers feel they are being taken advantage of, especially if prices vary significantly from day to day. Firms avoid this by maintaining stable prices, occasionally offering sales but generally avoiding frequent price fluctuations.

Question 45

How do prices adjust in the long run?

Answer 45

In the long run, prices become fully flexible, allowing the economy to adjust to demand shocks through both price changes and output changes.

Question 46

What is the main difference between short-run and long-run economic models?

Answer 46

Short-run models, like the aggregate expenditures model, assume fixed prices and focus on changes in output and employment. Long-run models, like the aggregate demand–aggregate supply model, assume flexible prices and focus on price adjustments.

Question 47

Why do economists use different models for different time horizons?

Answer 47

Economists use different models because the economy behaves differently in the short run (with sticky prices) and the long run (with flexible prices), and each model helps analyze those differences.

Question 48

What are the key implications of short-run vs. long-run models?

Answer 48

In the short run, price stickiness leads to changes in output and employment, while in the long run, flexible prices allow for adjustments through price changes instead of just output changes.

Question 49

How does price flexibility change over time?

Answer 49

Prices become more flexible as time passes, enabling both price and output changes in response to demand shocks in the long run.

Question 50

What are sticky wages, and how do they contribute to price stickiness?

Answer 50

Sticky wages refer to the resistance of wages to decrease during recessions, making it difficult for firms to cut prices, as labor costs represent a large portion of total costs.

Question 51

Why do firms avoid cutting wages during recessions?

Answer 51

Firms avoid cutting wages because workers tend to retaliate, leading to lower productivity, absenteeism, and other negative consequences.

Question 52

What strategy do firms often use to reduce labor costs during recessions?

Answer 52

Firms often lay off workers rather than cut wages to avoid negative employee reactions, but this doesn’t change per-unit labor costs and contributes to price stickiness.

Question 53

How do layoffs affect a firm’s per-unit labor costs?

Answer 53

Layoffs reduce total employment, but per-unit labor costs remain unchanged because less output is produced with fewer workers, making it difficult for firms to lower prices.

Question 54

How do layoffs help firms maintain stable prices during recessions?

Answer 54

Layoffs reduce total labor costs without reducing per-unit labor costs, allowing firms to maintain stable prices even when demand drops.