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Flexible exchange rate
An exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market
Foreign exchange market
the market on which currencies of various nations are traded for one another
Fixed exchange rate
e rate whose value is set by government policy
Nominal exchange rate
Number of units of foreign currency that can be bought for one unit of the domestic currency
Factors that increase supply of dollars in foreign exchange market...
Increased preference for Jap goods increase in U.S. real GDP increase in real interest rate on Jap assets or decrease in real interest rate on U.S. Assets
Factors that increase demand for dollars...
Increased preference for U.S. goods by foreign customers increase in real GDP abroad increase in the real interest rate on U.S. Assets"
Real exchange rate
The price of the average domestic good relative to the price of the average foreign good, when prices are expressed in terms of a common currency real exchange rate = price of domestic good/ price of foreign good, in dollars real exchange rate = (exP)/Pf"
Law of one price
If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations
Purchasing power parity
The theory that nominal exchange rate are determined as necessary for the law of one price to hold good in long run bad in short run"
Net capital inflows
capital inflows minus capital outflows foreign purchases of domestic assets minus domestic purchases of foreign assets nothing to do with exports or imports NX + KI = 0
National saving and capital inflows
S+KI=I the sum of national saving and net capital inflows from abroad must equal domestic investment in new captial goods
Reason for trade deficits
Low rate of national saving
Capital inflows
When a person, firm, or government borrows from abroad
Scarcity principle
Although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another
The Cost-Benefit Principle
An individual should take an action, if and only if, the extra benefits from taking the action are at least as great as the extra costs
Economic surplus
The economic surplus from taking any action is the benefit of taking the action minus its cost
Opportunity cost
The value of what must be forgone to undertake the activity
The Incentive Principle
A person is more likely to tak an action if its benefit rises, and less likely to take it if its cost rises. Incentives matter
Normative economic principle
One that says how people should behave
Positive economic principle
One that predicts how people will actually behave
Comparative advantage
One person has a comparative advantage over another if his or her opportunity cost of performing a task is lower than the other person's opportunity cost everyone does best when each person concentrates on the activities for which his or her opportunity cost is lowest
Opportunity cost equation
OC nuts = loss in coffee/gain in nuts OC coffee = loss of nuts/gain in coffee
The Principle of Increasing Opportunity Cost ("Low-Hanging-Fruit Principle)
In expanding production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs.
The demand curve
Schedule or graph showing the quantity of a good that buyers wish to buy at each price price on y-axis quantity on x-axis
Substitution effect
The change in the quantity demanded of a good that results because buyers switch to or from substitutes when the price of the good changes
Income effect
the change in the quantity demanded of a good that results because a change in the price of a good changes the buyer's purchasing power
Buyer's reservation price
The largest dollar amount the buyer would be willing to pay for a good
The supply curve
Graph or schedule showing the quantity of a good that sellers wish to sell at each price
seller's reservation price
The smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost
Market equilibrium
Occurs in a market when all buyers and sellers are satisfied with their respective quantities at the market price
Change in the quantity demanded
A movement along the demand curve that occurs in response to a change in price
Change in demand
A shift of the entire demand curve
Two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other
Two goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other
Normal good
A good whose demand curve shifts rightward when the incomes of the buyers increase and leftward when the incomes of the buyers decrease
Inferior good
A good whose demand curve shifts leftward when the incomes of buyers increase and rightward when the incomes of buyers decrease
Increases in demand are caused by...
decrease in price of comp. increase in price of subs. increase in income for a normal good increase in the population of potential buyers expectations of higher prices in the future
Increases in supply are caused by...
Decrease in the cost of materials, labor, or other inputs used in production improvement i technology that reduces the cost of producing the product improvement in the weather increase in number of suppliers expectation of lower prices in the future"
Seller's surplus
Difference between the price received by the seller and his or her reservation price
Buyer's surplus
Difference between the buyer's res. price and the price he or she actually pays
Total surplus
The difference between the buyer's res. price and the seller's res price
Cash on the table
Unexploited gains from exchange
The Efficiency Principle
Efficiency is an important social goal because when the economic pie grows larger, everyone can have a larger slice
The Equilibrium Principle
A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action
The market value of the final goods and services produced in a country during a given period
Capital good
Long-lived good that is used in the production of other goods and services
Value added
For any firm, the market value of its product of service minus cost of inputs purchased from other firms
spending by household on goods and services such as food, clothing, etc. Consumer durable goods- long-lived such as cars and furniture consumer nondurable goods- such as food and clothing services- largest component/such as haircuts, legal, financial
Spending by firms on final goods and services, primarily capital goods 1. business fixed= machinery/office buildings 2. residential= construction of new homes and apartments 3. inventory= addition of unsold goods to company inventories
Government purchases
Purchases by federal, state, and local governments of final goods and services; do not include transfer payments
GDP Equation
Y = C + I + G + NX
Real GDP
A measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices; real GDP measures actual physical volume of production
Nominal GDP
Measure of GDP in which the quantities produced are valued at current-year prices; measures current dollar value of production
Consumer price index
For any period a measure of the cost in that period of a standard basket of goods relative to the cost of the same basket of goods and services in the base year. CPI = cost of base year basket of goods in current year/cost of base year basket of goods in base year"
Price index
A measure of the average price of a given class of goods or services relative to the price of the same goods or services in a base year
Rate of inflation
Annual percentage rate of change in the price level, as measured, for example, by the CPI Inflation rate = (CPI2 - CPI 1)/ CPI1
Income approach
GDP = labor income + capital income labor income is 2/3 of total
Prices of most goods and services are falling over time so that inflation is negative
Core rate of inflation
Rate of increase of all prices except energy and food
Nominal quantity
A quantity that is measured in terms of its current dollar value
Deflating a nominal quantity
Dividing nominal quantity by price index (CPI) to express quantity in real terms Real = Nominal/ CPI Real x CPI = Nominal
Real wage
The wage paid to workers measured in terms of purchasing power; the real wage for any given period is calculated by dividing the nominal wage by the CPI for that period
The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index. prevents nominal quantity from being eroded by inflation
Substitution bias
True cost of living and inflation may be exaggerated by CPI because substitution is being ignored overstates inflation
Price level
A measure of the overall prices at a particular time as measured by a price index such as CPI
Relative price
The price of a specific good or service in comparison to the prices of otheer goods and services
CPI adjustment bias
Does not measure quality change overstates inflation
High inflation leads to...
decrease in plant/equipment investment cash loses value over time benefits borrowers not lenders higher interest rates
Real interest rate
annual % increase in purchasing power r = i - pi i- nominal pi- inflation"
Nominal interest rate
The annual percentage increase in the nominal value of a financial asset
Fisher Effect
The tendency for nominal interest rates to be high when inflation is high and low when inflation is low
Labor market trends part 1
Over a long period of time, average real wages have risen in U.S. and other indust. countries Despite long-term upward trend of real wages, real wage growth has slowed significantly in the U.S. since the early 1970s"
Labor market trends part 2-
In U.S. wage inequality has increased in recent decades. Real wages of unskilled workers have declined while real wages of skilled and educated have continued to rise Until downturn in 2008, employment had been growing much faster than working age pop.
diminishing returns to labor
if the amount of capital and other inputs in use is held constant, then the greater the quantity of labor already employed, the less each additional worker adds to production
marginal product
"extra production gained by adding one more worker value of marginal product = worker's m.p. x price of firm's output"
increases in labor demand due to....
increase in the price of worker's output or increase in productivity
worked full or part time during past week
did not work during past week but looked for work in the past 4 weeks
out of the labor force
"did not work in past week or look for work in past 4 weeks. students/homemakers/retirees"
labor force
employed + unemployed
unemployment rate
unemployed people/ labor force
participation rate
labor force/16+ population
long-term unemployment
unemployed over 6 months
chronically unemployed
brief employment with unemployment spells
discourage worker
wants a job but didn't look in the past 4 weeks
involuntary part-time
wants to work full-time
frictional unemployment
"short term/ matching workers with jobs costs are low"
structural unemployment
long-term and chronic that exists in good economy due to language and discrimination very costly long term mismatch union and minimum wage laws ex. migrant farm workers
cyclical unemployment
occur during recessions and are costly
diminishing returns to capital
if the amount of labor and other inputs employed is held constant, then the greater the amount of capital already in use, the less an additional unit of capital adds to production
business cycle
short term fluctuations in GDP and other variables
"period in which the economy is growing at a rate significantly below normal usually where real GDP falls for at least two consecutive quarters unemployment and fall in sales of durable goods help indicate recession often followed by decline in inflation"
severe or protracted recession
beginning of the recession; high point of economic activity before downturn
end of recession; low point in economic activity prior to recovery
not a government agency but treated as the official arbitrator of beaks and troughs
"opposite of recession period in which economy is growing at a rate way above normall"
particularly strong and protracted expansion
coincident indicators
"industrial production total sales in manufacturing nonfarm employment real after-tax income (coincide with overall movements in economy)"
recesssionary gap
"negative output gap where potential output exceeds actual output Y<Y*"
expansionary gap
"Y>Y* often leads to inflation"
Okun's Law
one percentage increase in cyclical unemployment leads to a two percentage increase in the output gap
causes of output gaps
"changes in economy wide spending (government can change this easily by changing its own spending)"
Keynesian Model
"decline in aggregate spending may cause output to fall below potential output in the short run, firms meet demand for their products at a preset price"
income-expenditure multiplier
effect of a one-unit increase in autonomous expenditure on short-run equilibrium output
contractionary policies
government policy actions designed to reduce planned spending and output
Board of Governors
leaders of the Fed consisting of 14 members appointed by the president to staggered 14 year terms
Federal Open Market Committee
FOMC makes decisions regarding monetary policy
banking panic
situation in which news or rumors of the imminent bankruptcy of one or more banks leads bank depositors to rush to withdraw their funds
deposit insurance
"instituted by Congress after the depression system in which the government guarantees that depositors will not lose any money even if their bank goes bankrupt (under 100,000)"
federal funds rate
the interest rate that commercial banks charge each other for very short-term loans
increased interest rates lead to...
"decline in consumptions spending decline in planned investment spending decline in PAE increase in saving"
things that affect the benefits of holding money
"increases in real income or output (higher income=higher demand for money) the price level (higher price level=higher demand for money)"
discount window lending
the lending of reserves by the Fed to commercial banks
discount rate (or primary credit rate)
the interest rate that the Fed charges commercial banks to borrow reserves
reserve requirements
set by the Fed, the minimum values of the ratio of bank deposits that commercial banks are allowed to maintain
ways in which Fed can increase money supply and lower ew. nominal interest rate...
"open market purchases increase in discount window lending decrease in interest rate paid on required reserves reduction in reserve requirements"
long-run equilibrium
situation in which the AD and AS curves intersect at potential output Y*
short run equilibrium
situation where AD and AS curves intersect at a level of real GDP that is above or below potential
AD curve
"shows the amount of output consumers, firms, government, and customers abroad want to purchase at each price level, holding all other factors constant increase in P (price level) eventually leads to decrease in PAE and decrease in output Y"
Wealth Effect
An increase in price level causes real household wealth to fall, which reduces planned consumption
The Interest Rate Effect
An increase in the price level results in higher money demand and a higher interest rate, causing both planned consumption and planned investment to fall
The Exchange Rate Effect
an increase in the price level causes the dollar to appreciate, which reduces net exports
demand shocks
"changes in planned spending that are not caused by changes in output or the price level primary cause of aggregate demand shifts"
to increase aggregate demand, government can...
"increase government spending cut taxes increase money supply"
aggregate supply curve (AS curve)
a curve that shows the relationship between the amount of output firms want to produce and the price level
why does the price level increase?
an increase in the aggregate demand for goods and services will result in an increase in the amount of real GDP firms are willing to supply, and this increase in real GDP will be accompanied by an increase in the price level
expected price level
the price level expected when the economy is at potential output
price shocks
"changes in input prices that are not caused by changes in output or the price level primary cause of aggregate supply shifts"
AD-AS model for studying business cycle (5 steps)
"show economy in long-run equilibrium identify how AD and or AS curves are affected Shift curves appropriately Find economy's new short-run equilibrium compare the new short-run equilibrium with initial long-run equilibrium to show how output and price level were affec…
self-correcting property
the fact that output gaps will not last indefinitely but will be closed by falling or rising prices
Stabilization policy is helpful when...
"recession is caused by negative demand shocks and costly when caused by negative price shocks negative demand shocks caused Great Recession"

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