Final

Question 1

When the domestic price (Pd) is below the world price (Pw), what happens under free trade?

Answer 1

Country exports! Ex. Pw = $6, Pd = $4

Question 2

Where is the gains from trade found on a graph?

Answer 2

Trade always leads to a gain, even if the country is importing.

Question 3

What are three benefits of trade?

Answer 3

1. Economy of scale: Producers sell to larger mkt. –> lower costs.
2. Competition: Reduces mkt. power of domestic firms, but increases total welfare of society.
3. Enhances the flow of ideas.

Question 4

What are the three arguments for restricting trade?

Answer 4

1. The jobs argument: Trade destroys jobs in industries that compete with imports. RESP = creates FRICTIONAL unemployment, jobs move to industries with comparative advantage.
2. National security argument: Prevent dependence on imports that could be disrupted during wartime.
3. A new industry argues for temporary protection until it is mature and can compete with foreign firms. RESP = difficult to predict which industries will succeed.
4. Competitors have an unfair advantage (ex. due to gov. subsidies). RESP = we sould welcome this, they can do it cheaper!

Question 5

What’s the equation for GDP?

Answer 5

Y = C + I + G + NX

Question 6

When is housing under consumption? When under investment?

Answer 6

C: Rent payments for renters, the approximate rental payments for homeowners.

I: Price of the house.

Question 7

Debbie spends $300 to buy her husband dinner at the finest restaurant in Boston. How do GDP and its components change?

Answer 7

Consumption & GDP rise by $300.

Question 8

Sarah spends $1200 on a new laptop to use in her publishing business. The laptop was built in China.

Answer 8

Investment rises by $1200, NX falls by $1200. GDP is unchanged.

Question 9

Nominal GDP vs. Real GDP?

Answer 9

Nominal: Values output w/ current prices, not corrected for inflation.

Real: Values output using base year prices, corrected for inflation.

Question 10

GDP deflator equation

Answer 10

GDP deflator = 100(nomial GDP/real GDP)

Inflation = % change of GDP deflator from one year to the next

Question 11

CPI equation

Answer 11

CPI = 100(cost of basket in current year/cost of basket in base year)

Inflation = (CPI this year - CPI last year)/CPI last year

Question 12

Calculating real interest rate (remember from finance?)

Answer 12

Real interest rate = nominal interest rate - inflation (premium)

Question 13

Financial system

Answer 13

The group of institutions that helps match the saving of one person with the investment of another.

Question 14

Financial markets

Answer 14

Institutions through which savers can DIRECTLY provide funds to borrowers.

Question 15

Private saving equation

Answer 15

=Y - T - C

Question 16

Public saving equation

Answer 16

= T - G

Question 17

What will an increase in the budget deficit have on the economy?

Answer 17

1. It will shift the supply of loanable funds to the left, reducing the supply for other people (the crowding out effect).
2. It will reduce investment –> reduction of long-run economic growth.

Question 18

What are the three functions of money?

Answer 18

1. Medium of exchange
2. Store of value
3. Unit of account

Question 19

What are the two kinds of money and what are their differences?

Answer 19

1. Commodity money: Takes the form of a commodity with intrinsic value. Ex. Gold coins, cigarettes in POW camps, drugs in college.
2. Fiat money: Money without intrinsic value, used as money bc gov. decree. Ex. US dollar (has no backing, simply backed by our faith in it).

Question 20

Money supply

Answer 20

The quantity of mnoey available in the economy.

Question 21

What are the two parts of the money supply?

Answer 21

Currency: Paper bills and coins in the hands of the PUBLIC.

Demand deposits: Bank account balances that depositors can access on demand by writing a check or using a debit card.

Question 22

What is part of the M1 money supply?

Answer 22

Currency, demand deposits, traveler’s checks, and other checkable deposits.

Question 23

What is part of the M2 money supply?

Answer 23

M1 (Currency, demand deposits, traveler’s checks, and other checkable deposits) + savings deposits, small time deposits, money market mutual funds, and a few minor categories.

Question 24

What is the leverage ratio?

Answer 24

= Assets/bank capital

Question 25

What does a bank’s T account look like? What’s recorded as assets and what as liabilities?

Answer 25

Note: T accounts must be equal on both sides.

Question 26

What is the formula for the money supply as determined by a bank’s reserves?

Answer 26

= money multiplier * bank reserves

Question 27

How does the Fed make loans to banks? Traditional and new method.

Answer 27

Traditional: Adjusting the discount rate, the rate on lans the Fed makes to banks.

New: The Fed chooses the quantity of reserves it will lend, and then banks bid against each other for these loans. More free market style.

Question 28

Inflation tax

Answer 28

Printing money causes inflation, which is similar to a tax on everyone holding that currency.

Question 29

Quantity function (SR and LR)

Answer 29

MV = PY in the short run. Changes in nominal variables (like M) can affect real variables.

MV = PY in the long run. Changes in MS doesn’t affect real variables.

Based around the Money Supply (M).

Question 30

If interest rates go up but neither of the curves change, what is the explanation for the demand?

Answer 30

Demand goes down for loanable funds. People want to put it into bonds to capitalize on the high interest rates!

Question 31

What is the main point of the quantity theory of money?

Answer 31

Assuming V and Y remain constant (we can’t just create a new factory or whip up a new machine in the short-term), an increase in the money supply will –> a proportional increase in the price level. Ex. A 50% increase in the MS, which could occur by printing money, will lead to a 50% increase in the price level.

Question 32

Fisher equation

Answer 32

nominal interest rate (required return) = real interest rate + inflation rate.

rs = r* + IP

Question 33

What are the three main costs of expected inflation?

Answer 33

1. Shoeleather costs: The resources wasted when inflation encourages people to reduce their money holdings. Ex. More monthly trips to the bank to take out cash can be quantified!
2. Menu costs: The costs of changing prices, such as printing new menus, mailing new catalogs, paying workers to do so.
3. Misallocation of resources from relative price variability. Some firms are slower to adjust, so the allocation of resources in the country will change bc of it.

Question 34

Explain tax distortions

Answer 34

Taxes are based on nominal income (not adjusted for inflation).

Ex. Jan 1: You buy $10,000 worth of SBUX

Dec 31: You sell the stock for $11,000, a $1000 nominal gain (i = $1000)

But what if π = 10%? Your real capital gain = i - π (10% - 10%), so your real capital gain is $0. BUT the government will still require you to pay taxes on the $1000

Question 35

What are the costs of unexpected inflation?

Answer 35

Arbitrary redistributions of wealth: Many long-term contracts base interest on expected inflation. If nominal inflation is different than expected, one party gains and another party loses!

Higher-than-expected inflation transfers purchasing power from the creditors to debtors. Bank made the loan based on inflation, now that it’s higher the debtor is paying on that lower rate!

Lower-than-expected inflation transfers purchasing power from the debtors to creditors. Bank made the loan and now gets to reap the reward of more valuable payments.

Question 36

Seignorage (benefit of inflation)

Answer 36

This is a tax on who holds money. Who holds money? Data suggests criminals hold cash (because they can’t invest), so it’s basically a tax on criminals.

Question 37

Why might the AD curve shift?

Answer 37

Anything that changes C, I, G, or NX (except P) will shift AD curve.

Question 38

How does a fall in prices shift the AD curve?

Answer 38

IT DOESN’T! Change in prices shifts ALONG the AD curve, but doesn’t actually shift the whole curve.