Exam 2 Review Flashcards
production function
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
assumptions about production function
- technology is fixed
2. economy’s supplies of capital and labor are fixed
disposable income
total income minus total taxes (Y-T)
consumption function
C = C ( Y - T )
-shows that (Y -T ) changes( disposable income), consumptions changes
marginal propensity to consume
change in C when disposable income increases by one dollar
investment function
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
government spending
government spendong on goods and services
- excludes transfer payments
- assume government spending and total taxes are fixed or determined by the ole gvt
aggregate demand formula
C(Y-T) + I(r) + G
aggregate supply
Y = F (K,L)
equilibrium for the market for goods and services
Y = C(Y-T) + I(r) + G
real interest rate adjusts to equate demand withs supply
loanable funds market
- 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
demand for funds
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)
supply of funds
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
formulas for: private saving public saving national saving total saving
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
budget surpluses and deficits
budget surplus if T > G
budget deficit if T < G
balanced budget if T = G
finanace deficits by issuing Treasury Bonds
loanable funds market: axis’ and demand and supply
Y axis: r
X axis: S, I
supply curve: loanable funds, vertical because national saving does not depend on r
demand curve: downward sloping
things that shift the savings curve
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
thigns that shift the investment curve
- technological innovations
- to take advantage of innovations, firms must buy new investment goods - tax laws that affect investment
- investment tax credit
what happens to the interest rate and the equilibrium level of investment when there is an increase in desired investment?
demand curve shifts right
-shows an increase in the interest rate but level of investment cannot increase because supply of loanable funds is fixed
Reagen Deficits explanation
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
quantity equation of money
M x V = P x Y
M = money supply Y = output P = price of one unit of output V = velocity of money
assumptions of quantity equation of money
-V is fixed, Y is fixed
implies that any percent change in M = change in P (inflation)
quantity theory of money for a fixed level of income
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
implications of quantity theory
- countries with higher money growth rates should have higher inflation rates
- long-run trend behavior of a country’s inflation should be similar to the long-run trend in the country’s money growth rate
real interest rate formula
r = i - pi
r = real interst rate i = nominal interst rate pi = inflation rate
The Fisher effect
i = r + pi
implies that a one percent increase in inflation causes a one percent increase in the nominal interest rate
what happens when we combine the fisher effect and the quantity equation?
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
the demand for money
the amount of money a person carries in her wallet or non-interest bearing accounts
what factors determine the demand for moony?
- nominal interest rate: the higher the interst rate, the lower the demand for money
- the level of income: higher the income, the higher demand for money
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?
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
does inflation affect output in the long run?
in the long run, the level of output is determined by the factors of production and the production technology
does inflation affect real wages in the long run?
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
social costs of inflation fall into what two categories?
- costs when inflation is expected
2. costs when inflation is different than people had expected
costs of expected inflation
- shoeleather cost
- menu costs
- relative price distortions
- unfair tax treatment
- general inconvenience
shoeleather cost of inflation
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
menu costs
the costs of changing prices
-the higher inflation is, the more frequently firms must change their prices and incur these costs
relative price distortions
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
unfair tax treatment as a cost of inflation
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
general inconvenience
inflation makes it harder to compare nominal values form different time periods
-this complicates long-range financial planning
arbitrary redistribution of purchasing power as a cost of unexpected inflation
- many long-term contracts not indexed, but based on E(pi)
- if pi turns out different from Epi, then some gain at others expense
hyperinflation
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
what causes hyperinflation
excessive money supply growth
- central bank prints money, the price level rises
- if it prints money rapidly enough, the result if hyperinflation
why do some governments in developing countries create hyperinflation
they dont have the means to raise taxes and their bonds arent trustworthy, so they must print money to pay off debts
natural rate of unemployment
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
the equilibrium for the labor market
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
calculating the natural unemployment rate
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)
two large categories for reasons we observe unemployment
frictional unemployment
structural unemployment
3 reasons for frictional unemployment
- it takes time for workers to search for a job
- the economy experiences changes in the compositions of demand among industrtries or regions
- unemployment insurance: UI pays part of a worker’s former wages for a limited time after losing his/her job
3 reasons for structural unemployment (wage rigidity)
- minimum wage laws: cause real wages to exceed equilibrium wage
- labor unions: unions typically secure higher wages for their members
- efficiency wage theory: firms willingly pay above-equilibrium wages to raise productivity
