Exam Revision Flashcards
Scarcity
Scarcity refers to the limited nature of society’s resources.
Economics
Economics is the study of how society manages its scarce resources.
Opportunity cost
Opportunity cost is the best alternative that must be given up to obtain some items.
Opportunity cost formula
Opp.Cost=what you give up/what you gain
Microeconomics
Microeconomics is the study of how households and firms make decisions and how they interact in markets.
For example, microeconomics focuses on individual markets, examining how incentives and trade-offs influence buyer and seller behaviour.
Macroeconomics
Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment and economic growth. Macroeconomics is a branch of economics dealing with the performance, structure, behaviour, and decision-making of an economy as a whole. This includes national, regional, and global economies.
Positive statements
Positive statements are claims that attempt to describe the world as it is.
An example of a positive statement is ‘minimum wage laws create unemployment’.
This can be tested.
Normative statements
Normative statements are claims that attempt to prescribe how the world should be.
An example of a normative statement is ‘the minimum wage should be raised’.
This is subjective and can’t be tested. There will be arguments for and against this proposition.
GDP
Gross domestic product (GDP) is a measure of the total income and expenditure of an economy.
It is the total market value of all final goods and services produced within a country in a given period of time.
GDP is the market value of all final goods and services produced within a country in a given period of time
The components of GDP
Y = C + I + G + NX
GDP (Y) is the sum of the following: consumption (C) investment (I) government purchases (G) net exports (NX)
Consumption (C):
The spending by households on goods and services, with the exception of purchases of new housing.
Investment (I):
The spending on capital equipment, inventories and structures, including household purchases of new housing.
Government purchases (G):
The spending on goods and services by local, state and federal governments.
Does not include transfer payments because they are not made in exchange for currently produced goods or services.
Net exports (NX):
Exports minus imports.
Nominal GDP
Nominal GDP values the production of goods and services at current prices.
Real GDP
Real GDP values the production of goods and services at constant prices.
Real and nominal GDP example
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The GPD deflator
The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.
The GDP deflator is calculated as follows:
Nominal GPD divided by real GPD multiplied by 100
Inflation
Inflation (CPI) refers to a situation in which the economy’s overall price level is rising.
inflation rate
The inflation rate is the percentage change in the price level from the previous period.
consumer price index (CPI)
The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.
The Australian Bureau of Statistics reports the CPI each month.
Calculating the CPI and the inflation rate: An example
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CPI =
(cost of basket current year/cost of basket base year) x 100
Inflation rate =
(CPI2 -CPI1)/CPI1 X100%
Value in year 2 dollars =
value in year 1 dollars x price level 2 / price level 1
The 2 problems of unemployment
The problem of unemployment is usually seen as two separate problems:
The long-run problem, and
the short-run problem
The long-run problem focuses on reducing the natural rate of unemployment
The short-run problem focuses on reducing the cyclical rate of unemployment
Employed
A person is considered employed if he or she has spent 1 hour of the previous week working at a paid job or family business.
3 categories of employment
A person is considered employed if he or she has spent 1 hour of the previous week working at a paid job or family business.
Labour force
The labour force is the total number of workers, i.e. the sum of the employed and the unemployed.
A person who is neither employed nor unemployed is not in the labour force
The unemployment rate
The unemployment rate is calculated as the percentage of the labour force that is unemployed.
unemployment rate = number unemployed/ labour force
multiplied by 100
Discouraged workers
Discouraged workers, people who would like to work but have given up looking for jobs after an unsuccessful search, don’t show up in unemployment statistics
3 causes of natural unemployment
Frictional
Structural
Classical
Frictional unemployment
Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs. Search for the jobs that are best suit their tastes and skills. Inevitable because the economy is always changing.
Structural unemployment
Mismatch between the skills required and offered
‘classical unemployment’ occurs due to
Minimum-wage laws.
Unions.
Efficiency wages
minimum wages
When the minimum wage is set above the level that balances supply and demand, it creates unemployment.
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Unions
A union is a worker association that bargains with employers over wages and working conditions.
In the 1970s and 1980s, when unions were at their peak, more than half of the Australian workforce was unionized. A union is a type of cartel attempting to exert its market power.
Efficiency wages
Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity.
The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level.
THE THEORY OF EFFICIENCY WAGES
A firm may prefer higher-than-equilibrium wages for the following reasons:
Worker health
Worker turnover
Worker effort
Worker quality
The production function
Y = F(L, K, H, N, A)
Y = quantity of output
F( ) is a function that shows how the inputs are combined - available production technology
L = quantity of labour K = quantity of physical capital H = quantity of (intangible) human capital N = quantity of natural resources A = (intangible) technological knowledge
Production functions basic explanation
Economists often use a production function to describe the relationship between the quantity of inputs used in production and the quantity of output from production.
The inputs used to produce goods and services are called the factors of production
Constant returns to scale
A production function has constant returns to scale if, for any positive number x,
xY = F(xL, xK, xN, H, A)
That is, a doubling of all inputs causes the amount of output to double as well
Productivity
The factors of production directly determine productivity. natural resources, N physical capital, K human capital, H technological knowledge, A
The data shows that sustained economic growth per capita is all about productivity (efficiency), A and H
While N and K are important, their effect on growth disappears over time.
The Effect of K
One way to raise productivity is to invest more current resources in the production of capital
Diminishing Returns
However, as the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns (to capital) Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while
Diminishing returns and the catch-up effect
In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these variables
The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich
It is often called ‘convergence’ across countries (as opposed to ‘divergence’ which refers to a widening gap between countries)
The Effect of H
In Australia, each year of schooling raises a person’s wage, on average, by about 8 percent. Thus, one way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them.
The effect of A
The advance of technological knowledge has led to higher standards of living.
Most technological advance comes from private research by firms and individual inventors.
Government can encourage the development of new technologies through research grants, tax breaks, and the patent system
Productivity definition
The quantity of goods and services that a worker can produce for each hour of work.
Surplus of labour
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Rule of 70
70/growth rate = no. of years it takes to double
categories of unemployment
Natural rate of unemployment (long run)
Cyclical rate of unemployment (short run)
Natural rate of unemployment (long run)
Unemployment that does not go away on its own even in the long run (always positive). The amount of unemployment that the economy normally (on average) experiences.
Cyclical rate of unemployment (short run)
Year to year fluctuations in unemployment around its natural rate. Associated with the short term ups and downs of the business cycle
Classical unemployment
The real wage in the labour market is above the market clearing level that equates supply of and demand for labour.
Although technological knowledge and human capital are closely related, there is an important difference. Which of the following statements is correct?
a. Human capital is the society’s understanding about how the world works, whereas technological knowledge is the resources spent transmitting this understanding to the labour force
b. Technological knowledge is the bridge that links physical and natural resources with human capital
c. Technological knowledge is the society’s
understanding about how the world works, whereas human capital is the resources spent transmitting this understanding to the labour force
d. Technological knowledge is the society’s understanding of human capital
C
- The production function is given as Y = F(L, K, N, H, A ), where Y is the quantity of output, A is the level of available production technology, L is the quantity of labour, H is the quantity of human capital and N is the quantity of natural resources. This equation provides:
a. a summary for the four determinants of productivity
b. a summary for the four determinants of production
c. a foundation for measuring inflation
d. a measure of the availability of natural resources
B
- The production function is given as Y = F(L, K, N, H, A ), where Y is the quantity of output, A is the level of available production technology, L is the quantity of labour, H is the quantity of human capital and N is the quantity of natural resources. This equation provides a summary for the four determinants of production
These determinants are the factors of production or inputs used in the production process and consequently a nation’s particular endowment of these “determinant” factors, does in fact determine the maximum amount of output that the economy is capable of producing.
Suppose that a firm is faced with an excess supply of workers. What would the firm do? Explain with standard economic theory and with efficiency wage theory.
a. Standard economic theory: assuming a firm maximises its profit, it should lower wages until the supply of workers is equal to the demand. This will reduce production costs and raise profits.
b. Efficiency-wage theory suggests that it might be profitable for a firm to keep wages above the equilibrium level in order to reduce worker turnover, increase worker quality, increase worker effort, and perhaps to increase worker health and therefore worker productivity.
- Explain when minimum laws are binding and result in unemployment.
When the minimum wage is set above the equilibrium level, the result is unemployment. Minimum wages are binding most often for the least skilled and least experienced members of the labour force.
Financial intermediaries: indirect borrowing
Banks
take deposits from people who want to save and use the deposits to make loans to people who want to borrow.
pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans
Recall the GDP formula
Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services:
Y = C + I + G + NX
Recall the GDP formula as a closed economy
Assume a closed economy – one that does not engage in international trade (imports and exports are zero):
Y = C + I + G
I = Y - C - G
Y - C - G
the total income in the economy after paying for consumption and government purchases.
This is referred to as National saving, or just saving (S).
Substituting S for Y - C - G, the equation can be written as:
S = I
National saving, or saving, is equal to:
S = I
S = Y – C – G
S = (Y – T – C) + (T – G)
National Saving Consists of
Private and Public Components
Private saving
Private saving is the amount of income that households have left after paying their taxes and paying for their consumption.
Private saving = (Y – T – C)
Public saving
Public saving is the amount of tax revenue that the government has left after paying for its spending.
Public saving = (T – G)
Budget Surplus and Deficit
If T > G, the government runs a budget surplus because it receives more money than it spends.
The surplus of T − G represents public saving.
If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue
The market for loanable funds
Financial markets ‘coordinate’ the economy’s saving and investment in the market for loanable funds.
The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds
Loanable funds
Loanable funds refer to all income that people have chosen to save and lend out, rather than use for their own consumption
the supply of loanable funds
The supply of loanable funds comes from people who have extra income they want to save and lend out.
The demand for loanable funds
The demand for loanable funds comes from households and firms that wish to borrow to make investments.
Interest rate
The interest rate is the price of the loan.
It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving.
Interest
Interest represents a payment in the future for a transfer of money in the past.
Nominal interest rate (i)
The nominal interest rate (i) is the interest rate usually reported and not corrected for inflation.
It is the interest rate that a bank pays or asks for
Real interest rate (r)
The real interest rate (r) is the nominal interest rate that is corrected for the effects of inflation: r = i – inflation
Supply and demand for loanable funds
Financial markets work much like other markets in the economy.
The equilibrium of the supply and demand for loanable funds determines the real interest rate.
The market for loanable funds graph
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What government policies can affect saving and investment?
taxes on saving
taxes on investment
government budgets
Pros and cons of government budget deficits
Pros:
Stimulates the economy when in recession
Cons:
Accumulation of government debt
Crowding out effect
The effect of a government budget deficit
- A budget deficit decreases the supply of loanable funds for any interest rate
Shifts the supply curve to the left.
- Which raises the equilibrium interest rate
- And reduces the equilibrium quantity of loanable funds in dollars
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Crowding out effect (occurs during government budget deficits)
Crowding out refers to the tendency for increased government deficits to reduce investment spending. Specifically, the reduction in investment stems from the fact that a decrease in public saving reduces national saving, pushing up the real interest rate in the loanable fund market.
What does a decrease in the tax rate on savings do to households’ incentive to save (at any given interest rate)?
The supply of loanable funds curve shifts to the right.
The equilibrium interest rate decreases.
The quantity demanded for loanable funds increases.
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What does an increase in the investment tax credit (i.e. a decrease in the effective corporate tax rate) do to firms’ incentive to borrow (at any given interest rate)?
Increases the demand for loanable funds.
Shifts the demand curve to the right.
Results in a higher interest rate and a greater quantity saved.
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- The demand for loanable funds is downward-sloping because:
a. as the interest rate falls, the demand for loanable funds increases
b. as the interest rate falls, the demand for loanable funds falls
c. as the interest rate rises, the quantity of loanable funds demanded rises
d. as the interest rate rises, the quantity of loanable funds demanded falls
ANS: D The demand for loanable funds comes from businesses’ willingness and ability to invest in business productive capital and ventures. As the cost of investing (the real interest rate) increases, the potential profitability of investments decreases. Thus, as the real interest rate rises, businesses are less willing and less able to proceed with investment plans, consequently the overall quantity demanded of loanable funds (for business investment) declines.
Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if the investment tax credit is abolished.
As shown in the graph below, the economy starts in equilibrium at point E0, with interest rate r0 and equilibrium quantity saved and invested at q0. If the investment tax credit is abolished, the incentive to invest is reduced, and less investment will be undertaken at each interest rate. Therefore, the demand-for-loanable-funds curve shifts from D0 to D1. The new equilibrium is at E1, with a lower interest rate, r1, and a lower level of saving and investment, q1. Hence, elimination of the investment tax credit reduces interest rates and reduces investment.
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Money
The set of assets in an economy that people regularly use to buy goods and services from other people. Money includes cash, deposits and other types of assets, but not credit card (or cheques). In fact, if people use cheques instead of cash, money supply will increase as people no longer carry extra cash.
The 3 functions of money
Medium of exchange
Unit of account
Store of value
Medium of exchange
An item that buyers give to sellers when they want to purchase goods and services. Money is the most liquid asset available
Unit of account
The yardstick people use to post prices and record debts.
Store of value
An item that people can use to transfer purchasing power from the present to the future.
Money is not the best store of value (shares, bonds, real estate…). Value of money deteriorates when there are inflationary expectations.
Liquidity
The ease with which an asset can be converted into the economy’s medium of exchange.
Kinds of money
When money takes the form of a commodity with intrinsic value, it is called commodity money (e.g. gold.)
Flat money: Money without intrinsic value that is used as money because of government decree.
Monetary policy in Australia today
The RBA uses the cash rate to influence the level of economic activity rather than attempting to control the money supply. The RBA uses open-market operations to guarantee that its target rate is the equilibrium interest rate in the short-term money.
Cash rate
The interest that financial institutions can earn on overnight loans of their currency or reserves.
Open-market operations
The purchase and sale of Australian government securities by the RBA
Problems in controlling the money supply
Can not control the amount that bankers chose to lend.
Trade-off between inflation and unemployment in short-run
Bank runs
Can not control the amount of money that households choose to hold as deposits in banks.
