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USC ECON 205 - Exam 4 Study Guide

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ECON 205 2nd EditionExam 4 Study Guide: Lectures 15-19Lecture 15When we talk about the macroeconomic model, we can classify countries into two categories: open economics and closed economics. Closed economies mean economies withoutany international trade or investment. In a closed economy, GDP is equal to consumption, investments, and government expenditures only. However, in the real world, there are no closedeconomies. Open economies have GDPs equal to consumption, investment, government expenditures, and net exports (exports minus imports). In traditional accounting of open economies, the GDP would actually go down if there were a trade deficit (imports are greater than exports). The balance of trade simply looks at exports and imports. When exports are greater thanimports, we have a favorable trade balance, and vice versa. This balance of trade is part of the balance of payment account, which includes current account—merchandise, trade, services between nations, the investment account—investments both domestic and abroad—and the government—which can send money abroad as aid or borrow money. A second form of accountis the financial account, which is largely buying bonds, stocks, and other financial instruments between countries. The financial account added to the current account always equals zero.Inflation rate can shift the trade balance in unexpected ways. For instance, if the inflationrate of country A is lower than country B, it will create a favorable balance of trade for country Abecause production costs will be lower.Three ways for determining exchange rates are: the market exchange rate, also called floating exchange rate, which is determined by supply and demand for said currency and appreciates and depreciates; the second way is the fixed rate, which is set by government; and lastly, countries can use PPP (Purchasing Power Parity), which is how much a currency unit buys in a certain nation.However, many countries try to target the exchange rate. If it deviates from the central bank’s expectations, they manipulate the market to bring it back to the target rate. After World War II, two organizations were created to manage the world economy: the IMF (International Monetary fund) and the World Bank. Every country participating on the global market is part of the IMF, and it is owned by the member nations. Likewise, the World Bank is in charge of helping low and middle-income economies grow, and provide loans to help create infrastructureand other necessities. - The IMF stabilizes a country’s currency by going to the market and buying inflated currencies, lowering the exchange rate. When the currency rate stabilizes, it then sells itslowly. Likewise, if there is a shortage of currency, the IMF pumps money into the economy.The World Bank however operates by sending a “mission” to endangered nations to look over the entire country’s economy. By doing so, they determine what issues the economy faces, and how to fix the problems.Lecture 16Without changing the current US Healthcare spending, our whole GDP will be consumed by it by 2027. The government needs to remove medical cartels and regulate the insurance and pharmaceutical industries. Healthcare spending is grossly excessive, topping almost three trillion in 2012. - The major reasons for this are high physician and health administrator salaries, and pharmaceutical costs.48.6 million people still are without any health insurance. The CPI average versus CPI medical components show that by approximately 1990 there is a huge divergence, especially forprescription drugs and medical care services. Because Medicare has low administrative costs (3%), it is the most efficient system. International trade and finance contribute to efficient employment of the productive forces of the world. Trade and finance are the prime engines of economic growth and income convergence of nations. This point is clearly illustrated during the interwar period and the post-World War II era of rapid economic growth. If you recall, the multiplier is equal to one over the marginal propensity to save. If you add international trade (in an open economy), the multiplier becomes equal to 1/(MPS + MPI). That means the value of the multiplier becomes smaller. Marginal propensity to import (MPI) is the amount of imports added per dollar of income added. Some countries however engage in import substitution, replacing imports with domestic product. The idea of that is that by doing that, it will contribute to the economic growth of the nation. Through international trade nations specialize in exporting goods and services in which they have comparative advantage and are efficient and importing goods and services in which they are relatively inefficient. Countries trade due to differences in resources, tastes and fads, and production costs. Lecture 17The conventional macroeconomic model states that investment is very important for a country’s growth, and investment is domestic savings. GDP in basic form is equivalent to aggregate consumption added to aggregate savings. The savings goes into investment, making GDP equal to consumption plus investment.Investment is a function of both domestic savings and international finance, meaning that it will seek the highest yield anywhere in the world regardless of nationality. Comparative advantage is when it is possible for country A and country B to trade (Ricardo comparative advantage) when country A can specialize in one good while country B can specialize in the other. Conversely, absolute advantage is when country A can produce a good for cheaper than country B. The theory of international trade states that all countries can benefit from international trade. The value of currency is determined by appreciation, when the currency’s value increases, and depreciation, when it decreases. Both are decided by market forces in the exchange rate market, based on the demand and supply of currencies. Countries that do not allow their currency to float can announce the rate they are willing to exchange at. The government in a fixed rate system can devalue currency, announcing the exchange rate to be pegged at a lower rate. Depreciation takes place by market forces of demand and supply, while devaluation takes place by governmental action. Lecture 18The fiscal clif is the current ongoing problem since 2007 that the US government, without changing current policy, will fall into increasing debt and higher


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