ECON 205 2nd Edition Final Exam Study Guide Lectures 19 23 Lecture 19 A closed economy is a model that only includes consumption investment and government expenditures An open economy however includes net exports as well The foreign trade involves imports which are goods produced abroad and consumed domestically and exports which are goods produced domestically and consumed abroad Net exports are exports minus imports Net foreign investment denotes the net U S savings abroad and is approximately equal to net exports Government annual budget The fiscal year is from September to the following September A budget surplus for the year means that tax revenues are greater than expenditure while deficit means expenditures are greater than tax revenues The fiscal clif is the ongoing problem with the US debt Even though most plans call for tax decrease and expenditure increase macroeconomic theory supports the opposite Deficit refers to one fiscal year while debt refers to the total account that is permanent An internal debt is when the American government borrows from its citizens while external is from abroad Government debt displaces private investment The actual budget records revenues public expenditures deficit or surplus in a given period Structural budget however records what the revenues expenditures deficit or surplus would be if the economy was operating at its potential output Lastly cyclical budget is the difference between actual and structural budget Income is a dynamic concept that deals with the amount of money per unit of time i e month Wealth is the total amount of money a unit has and is static Lecture 20 The savings investment relation in an open economy is It I X S T G where total national investment It consists of investment in domestic capital I plus net exports X This must equal total private saving S plus total public saving T G Net exports are determined by the difference between national saving and national investment which is determined by domestic factors and the world interest rate Moreover changes in exchange rates are the mechanism by which savings and investment adjust How net exports adjust to provide necessary investment during budget deficit if the government suddenly runs a budget deficit this will lead to an imbalance in the savings investment market which would push up domestic interest rates relative to world rates This rise will attract international funds and appreciate the foreign exchange rate causing a decrease in net exports This will continue until the savings investment gap is closed In 1999 eleven European nations linked their currencies and joined the European Monetary Union EMU They created one currency the Euro as their unit of account and medium of exchange The European Central Bank ECB conducts the European monetary policy and defines its main goal as price stability inflation rates of below 2 percent per year Inflation occurs when the general level of prices is rising We calculate it using prices indexes most commonly the consumer price index CPI The GDP deflator is the price of all of the different components of the GDP Rate of inflation in year t 100 x Pt Pt 1 Pt 1 Some economists are more pessimistic about the Euro believing that Europe is not an optimal currency area a region with high labor mobility and common aggregate supply and demand shocks Lecture 21 The Lafer curve relates tax rate and revenues If the tax rate is zero the revenue of the government will be zero Furthermore if the tax rate is one hundred percent the revenue will be zero also When you get to the point of inflection you reach the maximum amount of revenue and optimal rate of taxation A lack of aggregate demand is when the government has to interfere Keynes believed the government has to be the manager of the economy Aggregate demand is equal to consumption part of the GDP Aggregate supply is an abstract concept relating to the total production of the economy Social overhead means hospitals schools streets parks etc We have plenty of opportunities to spend money but if we don t we can create capital to stimulate employment Life cycle model of consumption consumption decisions are influenced by concern for future generation welfare Intangible capital refers to education and other forms of human capital Lecture 22 Aggregate supply describes the behavior of the production side of the economy The aggregate supply curve AS curve shows the level of total national output that will be produced at each price level The short run aggregate supply schedule is inflexible for prices and wages leading to an upward sloping AS curve higher prices mean more production Over the long term however most elements of the business cycle are perfectly flexible and output is determined by potential output only Potential output is the maximum sustainable output that can be produced without causing rising inflation The long term AS curve is determined by the same factors that cause economic growth namely quantity and quality of labor supply of capital and resources and technology level We measure the potential GDP at the unemployment rate NAIRU nonaccelerating inflation rate of unemployment An upward shift of the AS curve is caused by increases in costs of production while an outward shift is caused by increases in potential output Keynesian macroeconomics is associated with an upward sloping short run aggregate supply In it changes in aggregate demand have significant effects on output If aggregate demand falls due to monetary tightening or a falloff in spending this will lead to falling output and prices In the long term prices and wages adjust to AD The classical curve is vertical changes in AD have no effect on output Some elements of business costs are inflexible or sticky in the short run Because of that firms respond to higher demand by raising both production and prices However in the longer run costs respond fully and increased demand takes the form of higher prices Employed persons are people who perform any paid worked unemployed are persons that do not have a job have actively looked for work in the prior 4 weeks not in the labor force are the 34 of the adult population keeping house retired too ill to work or not looking for work and labor force is all employed and unemployed The unemployment rate is the number of unemployed divided by the total labor force Okun s Law relates unemployment to GDP stating that for every 2 percent that the GDP falls relative to potential GDP