Exam 2 Review

Question 1

production function

Answer 1

shows you how much output the economy can produce from K units of capital and L units of labor

• exhibits CRS
• reflects economy’s level of technology

Question 2

assumptions about production function

Answer 2

1. technology is fixed

2. economy’s supplies of capital and labor are fixed

Question 3

disposable income

Answer 3

total income minus total taxes (Y-T)

Question 4

consumption function

Answer 4

C = C ( Y - T )

-shows that (Y -T ) changes( disposable income), consumptions changes

Question 5

marginal propensity to consume

Answer 5

change in C when disposable income increases by one dollar

Question 6

investment function

Answer 6

I = I(r)

where r denotes the real interest rate (cost of borrowing)

• so as real interest rate increases, investment decreases
• spending on investment goods depends negatively on the real interest rate

Question 7

government spending

Answer 7

government spendong on goods and services

• excludes transfer payments
• assume government spending and total taxes are fixed or determined by the ole gvt

Question 8

aggregate demand formula

Answer 8

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

Question 9

aggregate supply

Answer 9

Y = F (K,L)

Question 10

equilibrium for the market for goods and services

Answer 10

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

real interest rate adjusts to equate demand withs supply

Question 11

loanable funds market

Answer 11

• simply supply-demand model for the financial system
• one asset: “loanable funds”
• -demand for funds: investment
• -supply of funds: saving
• -“price of funds”: real interest rate

Question 12

demand for funds

Answer 12

INVESTMENT

• firms borrow to finance spending on plants and equipment, new buildings
• consumers borrow to buy new houses

-depends negatively on the real interest rate (r)

Question 13

supply of funds

Answer 13

SAVINGS

• savings come from households and government
• households use thier saving to make bank deposits, purchase bonds, and other assets
• the government may also contribute to saving if it does not spend all the tax revenie it receives

Question 14

formulas for:
private saving
public saving
national saving
total saving

Answer 14

private saving = (Y-T)-C, Sp
public saving = T - G, Sg
national saving = S = Sp + Sg
=private saving + public saving
S = (Y - T) - C + T - G
S = Y - C - G

Question 15

budget surpluses and deficits

Answer 15

budget surplus if T > G

budget deficit if T < G

balanced budget if T = G

finanace deficits by issuing Treasury Bonds

Question 16

loanable funds market: axis’ and demand and supply

Answer 16

Y axis: r
X axis: S, I
supply curve: loanable funds, vertical because national saving does not depend on r
demand curve: downward sloping

Question 17

things that shift the savings curve

Answer 17

public saving: fiscal policy changing G or T
private saving:
preferences
tax laws that affect saving
-401 K
IRA
-replace income tax with consumption tax

Question 18

thigns that shift the investment curve

Answer 18

1. technological innovations
   - to take advantage of innovations, firms must buy new investment goods
2. tax laws that affect investment
   - investment tax credit

Question 19

what happens to the interest rate and the equilibrium level of investment when there is an increase in desired investment?

Answer 19

demand curve shifts right
-shows an increase in the interest rate but level of investment cannot increase because supply of loanable funds is fixed

Question 20

Reagen Deficits explanation

Answer 20

policies increased government spending while giving massive tax cuts
-both policies reduce national saving

the increase in the deficit reduces savings, which causes real interest rates to rise, which reduces the level of investment

Question 21

quantity equation of money

Answer 21

M x V = P x Y

M = money supply
Y = output
P = price of one unit of output
V = velocity of money

Question 22

assumptions of quantity equation of money

Answer 22

-V is fixed, Y is fixed

implies that any percent change in M = change in P (inflation)

Question 23

quantity theory of money for a fixed level of income

Answer 23

percentage change in money supply = the inflation rate

• a one percent increase in the money supply causes a one percent increase in inflation
• the Fed, which controls the MS, has the ultimate control over the rate of inflation

Question 24

implications of quantity theory

Answer 24

1. countries with higher money growth rates should have higher inflation rates
2. long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate

Question 25

real interest rate formula

Answer 25

r = i - pi ``` r = real interst rate i = nominal interst rate pi = inflation rate ```

Question 26

The Fisher effect

Answer 26

i = r + pi implies that a one percent increase in inflation causes a one percent increase in the nominal interest rate

Question 27

what happens when we combine the fisher effect and the quantity equation?

Answer 27

in the long run, a 1% increase in the money supply will lead to a 1% increase in the nominal interest rate this is because a 1% increase in the money supply causes a 1% increase in inflation, a 1% increase in inflation will lead to a 1% increase in nominal interest rate, and so a 1% increase int he money supply with lead to a 1% increase in the nominal interest rate

Question 28

the demand for money

Answer 28

the amount of money a person carries in her wallet or non-interest bearing accounts

Question 29

what factors determine the demand for moony?

Answer 29

1. nominal interest rate: the higher the interst rate, the lower the demand for money 2. the level of income: higher the income, the higher demand for money

Question 30

suppose the Fed announcces today that it will increse the money supply in the future, but it does not change the money supply today. how will this announcment affect the demand for money and the price level TODAY? how will this effect the demand for bonds today?

Answer 30

the demand for money decreases and the price level increases. the demand for bonds increases. announcement causes people to expect a higher growth in money supply, expect higher inflation; therefore, leads to an increase in nominal interest, reduces demand for money, increases demands for bonds, leads to higher price level

Question 31

does inflation affect output in the long run?

Answer 31

in the long run, the level of output is determined by the factors of production and the production technology

Question 32

does inflation affect real wages in the long run?

Answer 32

only in the short run, not in the long run -in the long run, the real wage is determined by labor supply and the marginal product of labor, not the price level or inflation rate

Question 33

social costs of inflation fall into what two categories?

Answer 33

1. costs when inflation is expected | 2. costs when inflation is different than people had expected

Question 34

costs of expected inflation

Answer 34

1. shoeleather cost 2. menu costs 3. relative price distortions 4. unfair tax treatment 5. general inconvenience

Question 35

shoeleather cost of inflation

Answer 35

the costs and inconveniences of reducing money balances to avoid the inflation tax -same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash

Question 36

menu costs

Answer 36

the costs of changing prices | -the higher inflation is, the more frequently firms must change their prices and incur these costs

Question 37

relative price distortions

Answer 37

firms facing menu costs change prices infrequently -ex: firm issues new catalog each January, general price levels increase throughout the year, the firm's relative price will fall

Question 38

unfair tax treatment as a cost of inflation

Answer 38

some taxes are not adjusted to account for inflation, such as capital gains tax ex: you buy 10,000 worth of IBM stock - you sell the stock for $11,000 so your nominal capital gain is 1,000 (10%) - suppose inflation is 10% that year - real capital gain is zero - but government requires you to pay taxes on your 1000 nominal gain

Question 39

general inconvenience

Answer 39

inflation makes it harder to compare nominal values form different time periods -this complicates long-range financial planning

Question 40

arbitrary redistribution of purchasing power as a cost of unexpected inflation

Answer 40

1. many long-term contracts not indexed, but based on E(pi) | - if pi turns out different from Epi, then some gain at others expense

Question 41

hyperinflation

Answer 41

inflation is greater than 50% per month - costs of inflation become HUGe under hyperinflation - money ceases to function as a store of value, and may not serve other functions - people may resort to conducting transactions with barter or a stable foreign currency

Question 42

what causes hyperinflation

Answer 42

excessive money supply growth - central bank prints money, the price level rises - if it prints money rapidly enough, the result if hyperinflation

Question 43

why do some governments in developing countries create hyperinflation

Answer 43

they dont have the means to raise taxes and their bonds arent trustworthy, so they must print money to pay off debts

Question 44

natural rate of unemployment

Answer 44

the normal unemployment rate that the economy experiences when the factors of production (labor and capital) are fully utilized - the average rate of unemployment around which the economy fluctuates - in a recession, the unemployment rate rises above the natural rate - in a boom, the unemployment rate falls below the natural rate

Question 45

the equilibrium for the labor market

Answer 45

s x E = f x U ``` s = rate of job seperation = fraction of employed workers that become separated from or lose their jobs f = fration of unemployed workers that find jobs = rate of job finding ```

Question 46

calculating the natural unemployment rate

Answer 46

``` U / L = s / (s + f) ex: each month: 1% of employed workers lose their jobs 19% of unemployed workers find jobs find natural rate of unemployment ``` .01 / (.01 + .19)

Question 47

two large categories for reasons we observe unemployment

Answer 47

frictional unemployment | structural unemployment

Question 48

3 reasons for frictional unemployment

Answer 48

1. it takes time for workers to search for a job 2. the economy experiences changes in the compositions of demand among industrtries or regions 3. unemployment insurance: UI pays part of a worker's former wages for a limited time after losing his/her job

Question 49

3 reasons for structural unemployment (wage rigidity)

Answer 49

1. minimum wage laws: cause real wages to exceed equilibrium wage 2. labor unions: unions typically secure higher wages for their members 3. efficiency wage theory: firms willingly pay above-equilibrium wages to raise productivity