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ECON 2305:Study Guide
Classical Model
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1770s- explain determinants of price level and levels of real GDP, employment, consumption, saving, investment.
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Classical economists
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adam smith, jb say, david ricardo, john stuatrt mill, thomas malthus, AC pigou. 1170s-1930s
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What did classical economists assume about wages and prices?
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all prices and wages were flexible and competititive markets existed throughout economy
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Say's law
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supply creates its own demand; it follows that desired expenditures will equal actual expenditures.
-process of producing specific goods (supply) is proof that other goods are desires (demand)
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actual aggregate output always equals...
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actual aggregate income
Say's law. Act of supplying a certain level of goods and services necessarily quals the level of goods and services demanded.
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4 assumptions of Classical model
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pure competition exists
wages and prices are fexible
people are motivated by self-interest.
People cannot be fooled by money illusions
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4 assumptions of Classical model- Pure competition exists:
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no single buyer or seleler of a commodity or an input can affects its price
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4 assumptions of Classical model- wages and prices are felxible:
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prices wages and interest rate are free to move to whatever level suuply and demand dictate.
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4 assumptions of Classical model- People are motivated by self-interest:
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businesses want to maximize their profits and hosuefholds want to maximize their economic well-being.
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4 assumptions of Classical model- Poeple cannot be fooled by money illusiion:
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buyers and sellers reach to changes in relative prices. they do not suffer from money illusions.
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Money illusion
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reacting to changes in money prices rather than relative prices. a woerker whose wages double when price level also doubles thinks he or she is better off is suffering from Money illusion.
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classical economists on role of government, prices/wages, and self-interest
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role of government should be minimal, prices/wages are felxible, people are self-interested and DO NOT experience money illusion. market will correct itself
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classical econ [relationship between saving and investment]
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saving was not a problem
each dollar saved will be invested by businesses and leakage of saving will be matched by injection of business investment.
Investment: refers to additions to national capital stock.
businesses invest as much as households want to save
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equilibirum in the labor market
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if excess labor is supplied at a particular wage elvel, the wage level must be above equiliibirum.
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relationship between employment and real GDP
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increase in quantity of labor input increases real GDP.
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LRAS
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Long-run aggregate supply curve. the real GDP that would be produced in an economy with full information and full adjustment of wages and prices year in and year out. Corresponds to long-run rate of unemployment
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natural rate of employment
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structural and frictional
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Classical theory on Vertical aggregate supply and price level
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unemployment > natural unemployment is impossible
Aggregate supply curve is vertical at real GDP
LRAS the only aggregate supply curve
labor market adjusts rapidly and real GDP is always full employment.
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Classical model: increase in aggregate demand
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cause a change in price level
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In the classical model, equilibirum leve l of real GDP per year is completely _________
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Supply determined: change in aggregate demand affect only the prive level, not real GDP.
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classical model: decrase in aggregate demand
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1. full employment and agg. demand decreases
2. real GDP falls belows long-run level
3. unemployment increases
4. wage rates and input prices goes down,
5. economy again on vertical LRAS
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Say's law states that _______creates its own _______and therefore desires expenditures will equal actual expenditures
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supply, demand,
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the classical model assumes that (1)___ ___ exists, (2) ____ and ___ are completely flexible, (3) individuals are motivated by ____-____, and (4) they cannot be fooled by ____ ____.
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pure competition, wages, prices, self-interest, money illusions
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when saving is introduced into the model, equilibirum occurs in the credit market thorugh changes in the interest rates such that desired ____equals desired ____at the equilibirum rate of interest
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saving, investment
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in the labor market, full employment occurs at a __ __ at which quanity demanded equals quanitty supplied. that particular level of employment is asociated with the full-employement level of real GDP per year.
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wage rate
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In the classical model, because LRAS is ____, the equilibirum level of real GDP is supply determined. Any changes in agg. demand simply change the _____ ______.
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vertical, price level
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keynesian model
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1930s economic decline.
jhon maynard keynes
prices, labor(wages) are inflexible downward due to the existence of unions and long-term contracts between businesses and workers.
prices are "sticky"
increase in agg. demand will not raise price level, decrease in agg demand will not cause firms to lower prices
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keynesian: equilibirum level of real GDP per year is
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demand determined
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Keynesian short-run aggregate supply curve
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horizontal portion of the aggregate supply curve in which there is excessive unemployment and unused capacity in the economy
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short-run aggregate supply curve
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relationship between total planned economywide production and the prive level in the short run, all other things held constant. if prices adjust incompletely in the fhort run, the curve in positibey sloped.
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10 Fundamental Principles of Economic
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1)Scarcity is inescapable
2)Risk is unavoidable
3)Therefore, all persons must make choices
4)Incentives matter
5)People generally act in their own self interest
6)Things can often be produced in multiple ways
7)It's wealth, not poverty, which has causes
8)Voluntary exchange is mutually advantageous
9)Public policies have primary and secondary effects
10)In the end, economic laws tend to prevail
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Fundamental Definition of Economics
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W(∞/↑)
---------------
Ṝ
w = wants
R = resources
numerator = unlimited wants
denominator = limited resources
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Opportunity Cost
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The best forgone alternative
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Wealth of Nations
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Wealth of Nations
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Cobb-Douglas Production Function
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Q= f(K,L)
Q=quantity
f=function of
K=capital (goods that produce other goods)
L=labor
*Labor intensive goods cost >capital intensive goods cost
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Economics (def):
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a social science which attempts to explain how individuals, firms, and nations allocate scarce resources among competing interests.
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Positive Economics
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-fact related
-what IS
-uncontroversial
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Normative Economics
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-value judgement related
-what SHOULD be
-controversial
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Microeconomics
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-small picture
-individuals
-entrepreneurs
-firms
-industries
*foundation for building blocks of macro
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Macroeconomics
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-big picture
-aggregates (collection/summation)
-business sectors
-private sectors
-public sectors
-international sectors
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4 Factors of Production
(Inputs or Resources)
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1) Land
2) Labor
3) Capital
4) Entrepreneurship
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"Payments" or goods that produce other goods for the for Factors of Production
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1) Land --> Rent
2) Labor -->Wage
3) Capital --> Interest
4) Entrepreneurship --> Profit
*Adding all these payments up gives you National Income/N.I. (2nd Test)
*Wages makes up largest % of N.I.
*Rent makes up smallest % of N.I.
*Karl Marx predicted exact opposite (Das Kapital)
|
Circular Flow Diagram
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Household:
-supplies inputs
-demands outputs
Business:
-demands inputs
-supplies outputs
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3 Questions all economic systems must answer
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1) What? (Allocation of Inputs)
2) How? (Production)
3) For Whom? (Allocation of Outputs)
*Price Dictates the results and actions
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4 Types of economic systems
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1) capitalism "laissez-faire"
2) command and control
3) compromise
4) customary
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6 Economic Warnings
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1) "Post hoc ergo propter hoc" fallacy
-A happened and then B, therefore A caused B
2) Fallacy of composition
-What holds true for 1 individual, must hold true for group as whole
3) Correlation does not necessarily mean causation
*related to cross-sectional data
4) Violation of "ceteris paribus"
*comparing apples to oranges
5) Inclusion of an irrelevant variable
6) Exclusion of an relevant variable
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Production Possibilities Frontiers (PPF)
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-Outward arch means increasing opportunity cost
-No curve means the goods can convert with no extra cost
*ex) Right handed paint rollers to left handed paint rollers
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Elements of PPF's
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-Always ask "what are we measuring on the axes?"
-Extremes are negative
-Consumer sovereignty: buyers control the market
-Inside curve: inefficient production
-Outside curve: unattainable production
-Any point along PPF curve are productive methods
-Perfect point along PPF curve: Allocative Efficiency
-When you devote resources to capital goods, in the long run the PPF curve will shift out further and faster
-Technology improvement causes production increase resulting in outward shift in PPF curve
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Demand (def):
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1)the various quanities
2)of a good or service
3)which a consumer
4)is BOTH willing and able
5)to purchase
6)at various prices
7)per unit of time
8)ceteris paribus
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Law of Demand
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Qᵈ = f(P)|
*negative relationship
*Price = independent variable
*Quantity = dependent variable
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Non-price parameters of Demand
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-income
-price of other goods
-advertising
-expectations of buyers
-# of buyers
-tastes/preferences
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Supply (def.):
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1)the various quanities
2)of a good or service
3)which a producer/seller
4)is BOTH willing and able
5)to produce/sell
6)at various prices
7)per unit of time
8)ceteris paribus
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Law of Supply
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Qˢ = f(P)|
*Direct relationship
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Non-price parameters of supply
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-price of inputs
-expectations of sellers
-# of sellers
-technology
-taxes & subsidies
-weather
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Shift in the demand curve are caused by:
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-changes in non price parameters
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Movement Along a Demand Curve
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Change in price causes change in quantity demanded
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Normal Good
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-increase in income leads to increase in demand
-decrease in income leads to decrease in demand
* positive relationship
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Inferior Good
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-increase in income leads to decrease in demand
-decrease in income leads to increase in demand
*Negative relationship
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Complementary Goods
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Inverse/negative relationship
*Oreos and milk
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Substituting Goods
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Direct/positive relationship
*Pepsi and Dr. Thunder
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Movement Along a Supply Curve
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Change in price causes change in quantity supplied
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Shift in supply curve
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Change in non-price parameter causes change in supply
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Equilibrium
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Qᵈ=Qˢ
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Surplus
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Qˢ>Qᵈ
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Shortage
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Qᵈ>Qˢ
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Comparative Statics
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1) Identify the initial P* & Q* (Equilibrium)
2) Identify the shift
-Supply right
-Supply left
-Demand right
-Demand left
3)Identify the new P1* & Q1*
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Price Floor
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Gov. says you must charge AT LEAST ____.
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Price Ceiling
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Gov. says you must charge NO MORE THAN ____.
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Price Floor Elements
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-Gov has sided with sellers
-Minimum (ex: wages)
-Effective Price Floor must be set ABOVE the P* and must result in a surplus
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Price Ceiling Elements
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- Gov has sided with buyers
-Maximum (ex: Rent Control)
-Effective Price Ceiling must be set BELOW the P* and must result in a shortage
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Demand shifts right
Supply shifts right
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-Price can go up, down, or stay the same
-Quantity will go up
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Demand shifts left
Supply shifts left
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-Price can go up, down, or stay the same
-Quantity will go down
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Demand shifts right
Supply shifts left
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-Quantity can go up, down, or stay the same
-Price will go up
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3 Main Measures in Macroeconomics
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1) Output
2) Price/Money
3) Employment
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6 Main Measures of 3 Main Variables
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1) Output:
-Gross National Product (GNP)
-Gross Domestic Product (GDP)
2)Price/Money:
-Producer Price Index (PPI)
-Consumer Price Index (CPI)
-GDP Deflator
-*BONUS: Employment Cost Index (ECI)
3)Employment:
-Unemployment Rate
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Why is GDP used today instead of GNP?
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The switch over is due to the Gulf War in 1991 where the GDP was a more accurate reflection of the home economy
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Unemployment Rate Equation
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U U
---- = -----
L E+U
U: unemployed population
L: labor force = employed + unemployed
*NOT UNEMPLOYED DIVIDED BY TOTAL POPULATION
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Why is CPI controversial?
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Controversial because it overstates inflation by 1 - 1.5%, effecting politically sensitive topics such as welfare and social security
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Phillips Curve
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negative relationship between the inflation rate and the unemployment rate
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Okun's Law
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Negative relationship b/w output and unemployment
*%ΔOutput = 3% - 2% * %ΔUnemployment
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Fair's Model
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relationship b/w Output and Price
*Predicts presidential elections
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Full Employment Act of 1946
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Brought about by WWII. Goals in Plan:
-output increases
-price remains stable
-employment increases
flaw in plan is that in pursuit of one goal, it may put another at risk, making them incompatible
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GDP
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1) The total dollar value
2) of ALL FINAL goods and services
*3) produced by anyone
*4) within U.S. borders
5) in a given calendar year
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GNP
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1)The total dollar value
2) of ALL FINAL goods and services
*3)produced by U.S. citizens/firms
*4) ANYWHERE in the world
5)in a given calendar year
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How to calculate GDP Deflator
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Use the Nominal GDP and divide it by the Real GDP calculated.
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Nominal GDP
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P(current) X Q(current)
(GDP Deflator)x(Real GDP)
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Real GDP
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P(base)xQ(current)
(Nominal GDP)/(GDP Deflator)
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CPI
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-fixed market basket of goods
-consumer goods and services
-may include foreign products
(Current Basket)/(Base Basket) x 100
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GDP Deflator
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-changing market of goods
-all good and services
-produced within U.S. Borders
(Nominal GDP)/(Real GDP)
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Inflation Rate
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(CPI new - CPI old)/(CPI old)
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Magnitude
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(CPI new)/(CPI old)
*converts old dollars to new dollars
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Labor Force
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-people b/w 16 & 65 yrs old
-noninstitutionalized (no prisons, hospitals, etc.)
-actively seeking employment if out of work
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Types of Unemployment
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-cyclical: due to changes in the business cycle (aka seasonal)
-frictional: related to job skills matching
-structural: structural change to economy due to technology and/or regulation
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Business Cycle
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Types of fluctuations:
Expansions (boom) - until it reaches a peak
Contractions (recessiong) - until it reahes a trough
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VER
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Voluntary Export Restraint
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VIE
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Voluntary Import Expansion
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MITI
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Ministry of International Trade Industry
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GATT
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General Agreement on Tariffs and Trade
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WTO
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World Trade Organization
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FTAA
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Free Trade Area of the Americas
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Rational Expectations
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the theory that people understand how the economy works and learns quickly from their mistakes so that even though random errors may be made, systematic and persistent errors are not
|
Real Business Cycle Theory
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1)Only real variables can affect real variables; a nominal variable cannot affect a real variable (Classical Dichotomy)
2)Money - a nominal variable - cannot affect output - real variable (Money Neutrality)
3)Expansions in the Business Cycle can be explained in terms of technology
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Hysteresis
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Associated with New Keynesian Branch of economics (occurred in 1970's because of stagflation). Short run shocks can have long term consequences
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Real variables
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capital, labor, and technology
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Beige book
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the summary of commentary on current economic conditions (what's happening in districts)
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The Fed
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the Federal Reserve System (economic gate keeper of the US)
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BUBBA
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Bundesbank (Germany)
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EMU
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European Monetary Union
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BOJ
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Bank of Japan
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Hume's Gold Theory
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1. Gold represents wealth
2. export more, import less
3. domestic price begins to rise
4. Pdom > Pfor X(decreses) M(increases) = NX(decreases)
5. As NX decreases gold flows out of country
6. Foolish pursuit
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economist closely associated with the concept of absolute advantage
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Adam smith
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economist closely associated with comparative advantage
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David Ricardo
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G-2,5,7,8,10,20, and 67
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G-2 – United States and Japan
G-5 – Germany, France, and Great Britain + (G-2)
G-7 – Canada and Italy (G-5) + (G-2)
G-8 – Russia in minor role(G-7) + (G-5) + (G-2)
G-10 – Belgium, the Netherlands, Sweden, andSwitzerland playing minor role (G-7) + (G-5) + (G-2)
G-20 – Everyone in G-10 with some more majorcountries including China, India, Brazil and Saudi Arabia
Everyone in G-20 with third worldcountries
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3 ways international trade differs from trade at any other level
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1) currency
-exchange rate
-US style domination
2)Distance
-limits products shipped
3)Laws
-trade treaties
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Purchasing Power Parity Theory
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The law of one price/prices will vary throughout the country but is a good indication of a currency's worth. Predicts the exchange rate b/w 2 currencies and will adjust in the long run to reflect price difference b/w the regions
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Nike Index
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It Looks at the prices of shoes in different countries, by determining weather a currency is undervalued of overvalued, the index should give a guide to the direction in which currencies should move.
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current account
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difference of nations exports of goods, services, and transfers of their imports of them
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capital account
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the overall result of public and private international investments flowing in and out of a country
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closed economy
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no imports/exports
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open economy
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receives imports/exports
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tariff
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tax on imports
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quota
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trade restriction on imports/exports
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best type of economy for domestic consumers?
|
open economy
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open economy
best option for foreign producers?
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quota
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Arbitrage
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making a profit when there is a difference in price of a certain good
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Triangular arbitrage
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exchanging currency from one country to another, then again and then exchanging it back to the original country to make a profit
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exchange rate
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one's country's currency express in another country's currency
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Implicit exchange rate
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One's country's currency 1st expressed in another and then expressed in yet another currency besides the 1st country's
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slope of PPF
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magnitude of two items' tradeoff
aka opportunity costs
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what causes PPF curve to shift right
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increase/improvement in capital, labor, technology, or investment
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seiniorage
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Producing money when cost of producing it is low. International trade would be benefitting the person producing said currency. They give less dollars' worth to the people they are trading with.
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stock
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amount accumulated (amount of $ in pocket right now)
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flow
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amount accumulated over time (spending per week)
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laffer curve
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representation between tax rates and government revenue (fiscal policy)
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Functions of the Fed
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1)promote bank stability
2)regulatory function
3)bankers bank
4)bank of US Gov
5)Lender of Last Resorts
6)Monetary Policy
7)Check clearing
|
J curve
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predicts that a country will eventually move into a trade surplus after its currency declines in value. As a result the country will eventually see positive net income from trade
|
how many district banks
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12
|
how many branch banks
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25
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Bretton Woods Agreement
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allowed foreign countries to change currency back into gold, and maid dollar main currency (fiat currency), causing a fixed rate in 1944, which was referred to as the Nixon Shock and was changed in 1971.
|
3 types of exchange rates
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1) fixed (gold standard)
2) flexible
3) managed floating (current)
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factors that cause demand for dollars to shift right in the international money market
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increase in:
-foreign tourism
-US goods and services
-purchases in stocks and bonds
-interest
decrease in:
-inflation
-growth rates
|
dovish
|
looking for recession(lower interest rates)
|
hawkish
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looking for signs of inflation(raise interest rates)
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Riccardian equivalence
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budget deficits do not matter b/c they are offset by increase in savings
|
Crowding out
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Government spending increases and private investment decreases
|
Twin Deficits Anomaly
|
Trade deficit is equal to a budget deficit
|
Protectionism (pros and cons)
|
pros: national defense, helps keep jobs, keeps infant industries, keeps senile industries, diversification, fall back plan, macro econ, increase GDP
cons: expensive to protect jobs and industries, doesn't give into better opporunities (Shumpter creative destruction theory), not needed, may cause retaliation
|
2 creations of Bretton Woods Agreement that exist today
|
1) World Bank
2) IMF (International Monetary Fund)
|
4 C's of Banking
|
1. capacity/cash flow: ability to pay back loan
2. character: past history of paying back loans
3. collateral: what the bank receives if a loan is not paid back
4. conditions: reason for taking out loan
|
4 tools of the Fed
|
1. Moral suasion
2. Reserve Requirements (L/R RR > L/R MS) [most powerful. rarely used]
3. Discount Rate used for signaling purposes (L/R DR > L/R MS) [used for signaling purposes]
4. Open Market Operations (B/S goods >L/R MS) [best tool]
L/R = lower(s)/raise(s)
B/S= buying/selling
MS=Money Supply
|
11th district
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Dallas
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states represented by dallas bank
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TX, north LA, south NM
|
How T-bills, T-notes, and T-bonds differ
|
length of maturity:
T-Bill: <1yr
T-Note: 1yr-10yrs
T-Bond:10yrs-30yrs
|
What cities in 11th district have Fed Branch banks
|
El Paso
Houston
San Antonio
|
Economist that represented England at Brenton Woods Agreement
|
John Maynard Keynes
|
Advocated 100% Reserve Requirement for commercial banks
|
Milton Friedman
|
Keynesian Economics
|
-John M Keynes
"money does not matter as much as fiscal policy does"
-Velocity: fluctuates
-Indirect Transmission Mechanism:
MS(up)i(down)I(up)Y(up)
-Great Depression: Inadequate Aggregate Demand
-Interest Rates during GD: Low (nominal)
|
Monetarism
|
-Milton Friedman
"money matters and effects GDP"
-Velocity: is constant or predictable
-Direct Transmission Mechanism: M(up)*V= (P*Y)(up)
-Great Depression: Bad Monetary Policy
-Interest Rates during GD: High (real)
|
Is it possible for Real interest rates to be greater than nominal interest rates?
|
Yes. if πe is negative (aka expectation of deflation)
|
New Keynesian
|
Alan Bunder
|
Classical School of Econ
|
Adam Smith
|
New Classical
|
Robert Lucas
|