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BSc Economics > EC108 Test 1 > Flashcards

EC108 Test 1 Flashcards

1
Q

What is the measure of aggregate output called?

A

Gross Domestic Product

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2
Q

3 ways of defining GDP

A

GDP is the value of final goods and services produced in the economy during a given period.

GDP is the sum of value added (value of production minus the value of the intermediate goods used) in the economy during a given period.

GDP is the sum of incomes in the economy during a given period.

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3
Q

What is Nominal GDP?

A

The sum of quantities of final goods produced times their current price.

Also called dollar GDP or GDP in current dollars.

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4
Q

What is Real GDP?

A

The sum of quantities of final goods times constant prices.

Also called GDP in terms of goods, GDP in constant dollars, GDP adjusted for inflation, or GDP in 2009 dollars.

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5
Q

4 reasons why measuring GDP is Difficult

A

The quality of products is changing over time. Use hedonic pricing to solve this, valuing different parts of computers in a given year.

Many new services are given for free

Measuring illegal production is difficult

Home production is normally excluded from GDP (only housing services are included)

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6
Q

Employment

A

The number of people who have a job

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7
Q

Unemployment

A

The number of people who do not have a job but are looking for one

A person is unemployed if they don’t have a job and have been looking for one in the last 4 weeks

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8
Q

Labour force

A

The sum of employment and unemployment

Those not looking for a job are not in the labour force

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9
Q

Unemployment rate

A

The ratio of the number of people who are unemployed to the number of people in the labour force

Unemployment rate = Unemployment/Labour force

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10
Q

Discouraged workers

A

Those who give up looking for a job and so are no longer counted as unemployed

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11
Q

Participation rate

A

Ratio of the labour force to the total population of working age

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12
Q

Inflation

A

A sustained rise the general price level

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13
Q

Inflation rate

A

The rate at which the general price level increases

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14
Q

Deflation

A

Sustained decline in the general price level (negative inflation rate)

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15
Q

GDP deflator

A

Nominal GDP / Real GDP

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16
Q

Consumer Price Index (CPI)

A

A measure of the cost of living (the cost of the consumption basket of a typical consumer)

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17
Q

What is GDP composed of?

A

Consumption, Investment, Govt Spending, Net exports, Inventory investment

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18
Q

What is inventory investment?

A

Difference between production and sales

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19
Q

Demand for goods equation

A

Z = C + I + G + X - IM

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20
Q

Endogenous variables

A

Variables depend on other variables in the model

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21
Q

Exogenous variables

A

Variables not explained within the model but are instead taken as given

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22
Q

If a bar is drawn above a symbol or letter, what does it represent?

A

Investment is taken as given

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23
Q

Are G and T exogenous or endogenous? Why?

A

Exogenous

Governments do not behave with the same regularity as consumers or firms.

We typically treat G and T as variables chosen by the govt and will not try to explain them with the model.

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24
Q

How to calculate equilibrium output?

A

Assume X = IM = 0 (Closed economy)

Replace C with C0 + C1(Y-T), Replace I with bar I.

Equilibrium in the goods markets requires Y=Z. This is an equilibrium condition. Replace Z with Y.

Rearrange for Y.

You’re done.

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25
Q

What is autonomous spending?

A

Part of the demand for goods that does not depend on output.

C0 + BarI + G - C1T

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26
Q

Is autonomous spending positive or negative? Why?

A

If T=G and c1 is between 0 and 1, then (G - c1T) is positive, and so is autonomous spending

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27
Q

Steps to characterise the equilibrium graphically

A

Plot production as a function of income. Because production equals income, their relation is the 45-degree line.

Plot demand as a function of income.
Z = (c0 + barI + G - c1T) + c1Y

In equilbrium, production equals demand

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28
Q

Private saving equation

A

S ≡ Yd - C
S ≡ Y - T - C

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29
Q

The IS relation

A

S = I + G - T
or
I = S + (T - G)

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30
Q

Money demand equation

A

Md = $YL(i)

$Y is nominal income
L(i) is decreasing function of the interest rate

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31
Q

An increase in the interest rate ______ the demand for money? Why?

A

Decreases.

This is because people put more of their wealth into bonds (opportunity cost of holding money)

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32
Q

Equilibrium in financial markets

A

Ms = Md = M

so

M = $YL(i)

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33
Q

What are open market operations?

A

Central banks typically change the supply of money by buying or selling bonds in the bond market

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34
Q

What is an expansionary open market operation?

A

The central bank expands the supply of money by buying bonds

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35
Q

What is a contractionary open market operation

A

The central bank contracts the supply of money by selling bonds

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36
Q

Liquidity trap

A

People are willing to hold more money (more liquidity) at the same interest rate. Expansionary monetary is powerless.

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37
Q

Zero lower bound

A

The belief that nominal interest rates cannot go below zero

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38
Q

What are financial intermediaries

A

Institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.

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39
Q

Assets of the banks are equal to…

A

The sum of bonds, loans and total reserves

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40
Q

Why do banks hold reserves? 3 reasons.

A

For everyday people who deposit/withdraw cash in their accounts.

For people at banks to write checks to people with accounts at other banks, and people at other banks write checks to people with accounts at the bank.

Banks are subject to reserve requirements. The actual reserve ratio - the ratio of bank reserves to bank checkable deposits - is about 10% in the US today

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41
Q

Demands for currency and checkable deposits equations

A

CUd = cMd
Dd = (1 - c)Md

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42
Q

Demand for reserves equation

A

R = θD (relationship between reserves and deposits)

R = θ(1 - c)Md (actual demand for reserves by banks)

θ is reserve ratio

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43
Q

The process of deriving the equation for the determination of the interest rate

A

Hd = CUd + Rd (Demand for central bank money)

Hd = cMd + θ(1-c)Md (Sub in demand for reserves in banks)

Hd = [c + θ(1-c)]Md

Hd = [c + θ(1 - c)]$YL(i) (Sub in money demand equation)

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44
Q

Determination of interest rate

A

H = [c + θ(1-c)]$YL(i)

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45
Q

Nominal interest rate

A

Interest rate in terms of dollars

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46
Q

Real interest rate

A

Interest rate in terms of a basket of goods

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47
Q

Write out the Fisher rule

A

Check Lecture 3, pg38

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48
Q

The realized real interest rate written in terms of i

A

i - pi^e

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49
Q

Openness in goods markets

A

The ability of consumers and firms to choose between domestic goods and foreign goods. Even countries most committed to free trade have tariffs (taxes on imported goods) and quotas (restrictions on the quantity of goods that can be imported)

50
Q

Openness in financial markets

A

The ability of financial investors to choose between domestic assets and foreign assets. Until recently, even some rich countries had capital controls (restrictions on the foreign assets their domestic residents could hold)

51
Q

Openness in factor markets

A

The ability of firms to choose where to locate production, and of workers to choose where to work, e.g. the North American Free Trade Agreement (NAFTA) signed in 1993 by the US, Canada and Mexico affected the relocation of US firms to Mexico.

52
Q

Nominal exchange rate

A

The price of domestic currency in terms of foreign currency

53
Q

Fixed exchange rates

A

A system in which two or more countries maintain a constant exchange rate between their currencies

54
Q

The real exchange rate equation

A

ε = EP/P*

P is the price of domestic goods in domestic currency
P* is the price of foreign goods in a foreign currency
E is the nominal exchange rate

55
Q

Real exchange rate

A

The price of domestic goods relative to foreign goods

56
Q

Balance of payments

A

A set of accounts that summarise a country’s transactions with the rest of the world

57
Q

Current account

A

Record of payments to and from the rest of the world

58
Q

Net income balance

A

Difference between income received from the rest of the world and income paid to foreigners

59
Q

Net transfer received

A

Difference in foreign aid given and received

60
Q

Capital account

A

Records net foreign holdings of domestic assets

61
Q

Net capital flows/Capital account balance

A

An increase in net foreign indebtness (holdings of domestic assets by foreigners minus the increase in domestic holdings of foreign assets)

62
Q

Gross National Product (GNP)

A

Measures the value added by domestic factors of production

GNP = GDP + NI

NI is net income payments received from the rest of the world minus income paid to the rest of the world

63
Q

Average propensity to consume

A

APC
= C/Y
= C0/Y + c1

64
Q

Irving Fisher’s Intertemporal Choice

A

Assumes consumer is forward-looking and chooses consumption for the present and future to maximise lifetime satisfaction

Consumer’s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption

65
Q

The Intertemporal Budget Constraint equation

A

C1 + (C2 / 1 + r) = Y1 + (Y2 / 1 + r)

Present value of lifetime consumption = Present value of lifetime income

66
Q

Present value of lifetime consumption equation

A

C1 + C2/1+r

67
Q

Present value of lifetime income equation

A

Y1 + Y2/1+r

68
Q

Marginal rate of substitution (MRS)

A

The amount of C2 the consumer would be willing to substitute for one unit of C1

69
Q

Graphically, where is the optimal (C1, C2) ?

A

Where the budget line just touches the highest indifference curve

70
Q

Difference between Keynes and Fisher consumption theory

A

Keynes: current consumption depends only on current income

Fisher: current consumption depends only on the present value of lifetime income. The timing of income is irrelevant because the consumer can borrow or lend between periods

71
Q

Income effect

A

If the consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods

72
Q

Substitution effect

A

The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2

73
Q

Why would Fisher’s consumption theory end up like Keynesian theory?

A

If the consumer faces borrowing constraints (i.e. “liquidity constraints”), then he may not be able to increase current consumption, and his consumption may behave as in the Keynesian theory even though he is rational and forward-looking

74
Q

Draw the diagram for constraints on borrowing

A

Check lecture 5 pg24-26

75
Q

Life-Cycle Hypothesis assumptions

A

Zero real interest rate (for simplicity)
Consumption-smoothing is optimal

76
Q

What is the Life-Cycle Hypothesis?

A

Unlike the Fisher model, the LCH says that income varies systematically over the phases of the consumer’s “life cycle”

And because of that, saving allows the consumer to achieve smooth consumption

77
Q

Smooth consumption equation

A

C = (W + RY) / T

W = Initial wealth
Y = annual income until retirement (assumed constant)
R = number of years until retirement
T = lifetime in years
W + RY = Lifetime resources

78
Q

Life-cycle consumption function for APC

A

APC = C/Y = α(W/Y ) + β

α - marginal propensity to consume out of wealth - 1/T

β - marginal propensity to consume out of income - R/T

Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households

Over time, aggregate wealth and income grow together, causing APC to remain stable

79
Q

Permenant Income Hypothesis equation

A

Y = Yp + Yt

so

C = αY^P

Y = current income

Yp = permenant income (average income, which people expect to persist into the future)

Yt = transitory income (temporary deviations from average income)

α is a fraction of permenant income that people consume per year

80
Q

Permenant Income Hypothesis solving the consumption puzzle APC

A

APC = C/Y = C = αY^P/Y

If high-income households have higher transitory income than low-income households, APC is lower in high-income households

Over the long run, income variation is due mainly (if not solely) to variation in permenant income, which implies a stable APC

81
Q

Difference between Permenant Income Hypothesis and Life-Cycle Hypothesis

A

Both: people try to smooth their consumption in the face of changing current income

LCH: current income changes systematically as people move through their life cycle

PIH: current income is subject to random, transitory fluctuations

Both can explain the consumption puzzle

82
Q

Business fixed investment

A

Business’ spending on equipment and structures for use in production

83
Q

Residential investment

A

Purchases of new housing units (either by occupants or landlords)

84
Q

Inventory investment

A

The value of the change in inventories of finished goods, materials and supplies, and work in progress

85
Q

Marginal productivity of capital (MPK)

A

Amount of extra output that can be obtained when an additional unit of capital is installed (return from an additional unit of capital)

Slope of the production function

Assume labour input is constant

86
Q

Opportunity cost of investment

A

1 + r

With the resources that could instead be invested in financial assets - opportunity cost of the investment

By borrowing - marginal cost of investment

87
Q

Firm’s profits after making investment equation

A

Profit = F(K,L) - (1+r)K

It is captured by the vertical distance between the production function Y = F(K,L) and the total cost (1+r)K

88
Q

Marginal productivity of capital

A

MPK = r + 𝛿

𝛿 is the depreciation as an additional cost of capital and r + 𝛿 is the user cost of capital

89
Q

What is the purpose of investment?

A

To bring the capital stock to its desired level
To make up for capital lost through depreciation

90
Q

Present value of income/profit received in the future equation

This is related to income expectations for investment.

A

Check lecture 6, pg20

91
Q

Tobin’s q Theory of Investment

A

Forward looking - firms choose the amount to invest with a view to maximising expected discounted profits over the lifetime of the project

92
Q

Investment demand equation

A

Kt+1 = It + (1-𝛿)Kt

93
Q

What does the value of q indicate

A

q > 1 = managers can raise the market value of their firm’s stock by buying more capital

q < 1 = managers will not replace capital as it wears out

94
Q

2 factors that investment relies on

A

Production/sales and interest rates

95
Q

IS relation equation

A

Y = C(Y-T) + I(Y,i) + G

96
Q

What does pi and i equal in the short run analysis of the IS relation?

A

pi = 0
i = r

97
Q

Why is ZZ (demand for goods) upward-sloping?

A

For a given value of the interest rate, an increase in output leads to an increase in the demand for goods through its effects on consumption

98
Q

Why is ZZ (demand for goods) a curve rather than a line?

A

We have not assumed that the consumption and investment relations are linear

99
Q

Why is ZZ (demand for goods) flatter than the 45-degree line?

A

Because we have assumed that an increase in output leads to a less than one-for-one increase in demand

100
Q

Why is the IS curve downward sloping?

A

An increase in the interest rate decreases the demand for goods at any level of output, 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

101
Q

An increase in taxes have what effect on the IS curve?

A

Inwards, left shift

102
Q

What is the LM relation?

A

M/P = YL(i)

103
Q

If there is an increase in income, at a given interest rate, what happens to the demand for money?

A

There is an increase in the demand for money

104
Q

Why is the LM curve upwards sloping?

A

Equilibrium in the financial markets implies that an increase in real income leads to an increase in the interest rate.

105
Q

A decrease in G-T means what?

A

Fiscal contraction -> fiscal consolidation

106
Q

An increase in G-T means what?

A

Fiscal expansion

107
Q

Fiscal policy affects the IS or the LM curve?

A

IS

108
Q

Monetary policy affects the IS or LM curve?

A

LM

109
Q

Domestic domand in an open economy

A

C + I + G = C(Y-T) + I(Y,r) + G

110
Q

Demand for domestic goods in an open economy

A

Z = C + I + G + X - IM/ε

111
Q

What is DD, AA and ZZ?

A

DD = C + I + G (Domestic demand)
AA = C + I + G - M/ε (Domestic demand for domestic goods)
ZZ = C + I + G + X - M/ε (Demand for domestic goods)

The distance between ZZ and AA is constant because exports do not depend on domestic income but they depend on foreign income

112
Q

The equilibrium condition for output can be expressed as….

A

Y = C(Y-T) + I(Y,r) + G + X(Y*,ε) - IM/ε (Y,ε)

113
Q

An increase in government spending affecting the trade balance?

A

It can lead to an increase in output, and to a trade deficit

114
Q

Net exports relationship with exchange rate equation

A

NX = X(Y*,ε) - IM/ε (Y,ε)

115
Q

Marshall-Lerner condition

A

A real depreciation leads to an increase in net exports

116
Q

Marshall-Lerner condition equation

A

(ΔNX)/X = (Δε)/ε + (ΔX)/X - ΔIM/IM

The proportional change in the real exchange rate
The proportional change in exports
The proportional change in imports

If the Marshall-Lerner condition holds, the sum of the three terms is positive (in which case a real depreciation improves the trade balance)

117
Q

2 ways for the govt to eliminate trade deficit without changing output?

A

Achieve a depreciation sufficient to eliminate the trade deficit
Reduce govt spending so as to shift ZZ back

118
Q

Import compression

A

A decrease in imports (improved current account balance) triggered by a decrease in output

119
Q

The J curve

A

A depreciation initially increases the trade deficit, and over time, exports increase and imports decrease, reducing the trade defict

120
Q

Current account balance equation

A

CA = S - I + (T-G)

121
Q

What is Tobin’s equation for q?

A

q = market value of the firm / cost of capital

= value of the firm’s capital as determined by the stock market / price of that capital if it were purchased today

BSc Economics (8 decks)

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