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USC ECON 205 - Exam 2 Study Guide

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ECON 205 2nd EditionExam 2 Study Guide: Lectures 6-10Lecture 6Gross domestic product (GDP) refers to the combined total of consumption (C), investments (I), government expenditures (G), and net exports (X)—total exports minus total imports.- GDP = C + I + G + XThe consumption function is the relationship between consumption and income. Consumption is for the most part a stable percentage of the GDP. The Y-axis of the graph measures consumption, while the X-axis measures income.Marginal propensity to consume is percent of income used on consumption. For instance, if themarginal propensity to consume (MPC) equals 0.8, that means that for every dollar of income earned, eighty cents (eighty percent of a dollar) is spent on consumption. It is the slope of the consumption function.- With income, you either consume it or save it. Therefore, income is equal to consumption plus savings. Savings goes into investment, which is still part of GDP.- Poor people have a higher marginal propensity to consume. Rich people tend to put a higher percentage of their income into savings. - Marginal propensity to consume and the marginal propensity to save equals 1.Progressive taxation is the tax model used by the United States government; one’s tax rate goesup according to one’s income level (i.e. rich pay a higher percentage, poor a smaller percentage). It was first proposed by Karl Marx.Lecture 7The savings function shows the relationship between the level of saving and disposable income.The break-even point is where the consumption function intersects the 45-degree line of level of disposable income—it is the point in which households break even. The slope of the savings function is the marginal propensity to save.- Investment happens for many reasons, including: revenues, cost, expectations, and the role of interest rate on investment (which shifts the investment function).Consumption is made up of durable goods, nondurable goods, and services. It makes up approximately 70% of a country (like the US)’s GDP.Disposable income is equal to personal income minus personal taxes. Furthermore, disposable income minus consumption and interest equals personal savings. Disposable income is after-taxes income, and is spent on either consumption or savings.GDP growth in market economics is not smooth – it occurs in cycles. The cycles have four phases: expansion of the economy, peak economic conditions, contraction of the economy, and trough (or revival).- The duration of a business cycle is between two to ten years.Lecture 8Macroeconomic Equilibrium is when different forces at work are in balance—there is no furthertendency for change, all variables are satisfied. At equilibrium level of output, spending and output are in balance. To create assets and build the economy, deficit financing—spending out of debt—is often employed by all sectors. It changes the equilibrium value by increasing both output and spending.The economist Keynes developed the multiplier model, which calculates that certain investments and government expenditures increase the gross domestic product (GDP) more than the amount originally invested or spent. The multiplier effect is when the change in investment is equal to change in GDP times the multiplier (M). The change in GDP equals the reciprocal of marginal propensity to save multiplied by change in investment. - This is equivalent to 1/(1 – marginal propensity to consume) multiplied by change in GDP- The change in income is equal to the reciprocal of the marginal propensity to save multiplied by change in investment.Governments often use the multiplier model to influence fiscal policy: government spending increases growth, while government taxation will contract and slow the economy. This often influences the duration and progression of the business cycle.Lastly, aggregate demand in the economy determines unemployment. Keynes determined that aggregate demand is dependent on consumption, investment, government expenditures, and net export (the GDP). Aggregate demand slopes downward to the right due to the money supply effect.Lecture 9Capital goods are tangible and intangible durable products that are used for further production,such as machinery, buildings, and manufacturing equipment. - Capital can be both inputs and outputs.Capital is bought and sold in capital market. Rentals are payments for temporary usage of durable capital or land.Financial assets are monetary claims, such as loans and investments. Interest rate affects the rate of return on fixed interest and financial assets, leading to changes in financial asset patterns.- The rate of return on an asset depends on the asset’s maturity, what risk is involved, the cost of the asset, taxes levied by the government upon it, and the credit of parties involved.- Present value is the value of assets at the current time. The present value formula is PV (present value) equals total revenue over time. For instance, given present revenue R0 and future revenue a year from now R1, two years R2, etc. PV = R0 + R1/(1 + interest rate) + R2/(1 + interest rate)^2 + R3/(1 + interest rate)^3- Present value applies for both costs and asset values.ROI is the rate of return on investment, and determines allocation of capital into alternative investments. - Despite the law of diminishing returns affecting capital (the return on capital has a downward slope graphically), the rate of return on it has not fallen due to technological innovation.  When interest rate rises, bond and stock prices fall. Asset prices move inversely with interest.  Real versus nominal interest rate: Nominal means current price and current interest rate, while real means pegging it to a previous year and removing inflation. - Real interest rate = nominal interest rate – inflationRevenues minus costs equal profits. Profits are also defined as residuals left over from operatingcosts. However, economic profit is equal to revenues minus all costs—including implicit costs or opportunity costs.Lecture 10Investment is not done by consumers, but done by businesses. Additionally, investment is the ability to create something new; for instance, buying a new computer or new factory. However, buying something existing is not an investment, like an old computer. Investment can be an input or an output, but is always used for further production. Do not call a financial investment (stocks, bonds, equities) an investment. It has to


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