ECON 0110: EXAM 1
167 Cards in this Set
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Macroeconomics
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Examines the behavior of the overall US economy
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Employment Act of 1946
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“It is the continuing policy and responsibility of the Federal Government to use all practicable means…to promote maximum employment, production, and purchasing power”
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macroeconomic goals
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1. Promote maximum production (Economic growth)
2. Promote maximum purchasing power (Stable prices)
3. Promote maximum employment
4. Smooth out business cycle fluctuations
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what is fiscal policy?
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a. Tax laws
b. Government spending
Determined by Congress and the President
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monetary policy
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a. Influence the money supply
b. Influence interest rates
Conducted by the Federal Reserve System
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descriptive statement
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economic facts or data
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positive statement
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statements or theories about how the economy works
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normative statements
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Value judgments about what is good or bad
Policy statements about what courses of action should or ought to be taken
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fallacy of false cause
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incorrect assumption that one event causes another because they tend to occur together
post hoc, ergo propter hoc
“after this, therefore because of this”
EXAMPLE: President Reagan lowered taxes during the 1980s and the economy grew rapidly. Thus, decreasing taxes caused economi…
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fallacy of composition
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What holds for one person does not necessarily hold for everybody
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Ceteris Paribus Fallacy
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the other things being equal fallacy
when observing data you dont know what caused what
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Good Sources of Economic Data
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1. Economic Report Of The President
2. Statistical Abstract Of The United States
3. Wall Street Journal
4. New York Times
5. Monthly Labor Review
6. Bureau of Labor Statistics website: www.bls.gov
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households
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Goal: Maximize their UTILITY
UTILITY = level of satisfaction, sense of welll-being, overall happiness
Households act in their own RATIONAL SELF INTEREST
People choose actions which they perceive to be in their own best interests
For a given cost, they try to maximiz…
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firms
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Goal: maximize profits
Sole proprietors
Partnerships
Corporations
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governments
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1. Protect private property (police)
2. Enforce contracts (judicial system, courts of law)
3. Promote competition
4. Regulate natural monopolies (electricity, water)
5. Provide PUBLIC GOODS
6. Deal with EXTERNALITIES
7. Promote MACROECONOMIC GOALS…
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private goods
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are RIVAL in CONSUMPTION
The amount consumed by one person is not available to others
are EXCLUSIVE in SUPPLY
The SUPPLIER can exclude people who do not pay
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public goods
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NON-RIVAL in CONSUMPTION
One person’s benefit does not diminish the amount available to others
NON-EXCLUSIONARY in SUPPLY
Suppliers cannot easily prevent consumption by those who fail to pay (FREE RIDERS)
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externality
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A cost or benefit that affects people not involved in an activity or market transaction and is therefore ignored by the individuals involved in the activity or market transaction
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negative externalities
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impose costs on third parties
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positive externalities
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confer benefits on third parties
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growth rate calculation
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= (New – Old)/Old x 100%
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nominal GDP
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Value of output calculated using prices that existed during the year when the goods and services were produced
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price index
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we first choose some year to be the base year, say, Year 0.
Next we choose a representative set of quantities of items Q0 that are purchased by consumers.
Next we determine how much those quantities cost using the prices that existed during various years.
That is, we calcu…
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real GDP
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Value of output during any year calculated using prices that existed in some base year
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calculation real GDP
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Suppose we are given a set of prices and a set of quantities sold during various years. To calculate, we pick a base year and use the prices during that year to determine the value of output during any year using the base year prices. As a result, the value of output during any year is …
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rule of 72
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If some quantity grows at an annual growth rate of g% per year, how long will it take for the quantity to double in size?
Let g = annual growth rate (expressed as an integer)
I.e.: 5.4% per year growth is expressed as 5.4
FORMULA: (Approximate)
Years Required to Double = …
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real output per capita
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= REAL GDP/POPULATION
If population grows 4%, we need a 4% increase in real GDP to maintain our standard of living
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who are the unemployed?
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NEW ENTRANTS
RE-ENTRANTS
JOB LEAVERS
JOB LOSERS
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business cycle
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EXPANSION
Period when REAL GDP is growing
PEAK:
Turning point when REAL GDP peaks and begins falling
CONTRACTION (RECESSION)
Period when REAL GDP is falling
TROUGH
Turning point when REAL GDP stops falling and begins rising
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recession
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Two consecutive quarters of declining REAL GDP
The unofficial beginning and ending dates of national recessions are defined by a nonprofit research organization known as the National Bureau of Economic Research (NBER). The NBER defines a recession as “a significant decline in econom…
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depression
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a severe recession
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classical theory
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Natural tendency to move toward full employment
No need for fiscal or monetary policy
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classical reasoning
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Unemployed workers compete against each other
Wage rates will decline
Lower wages lead to increased profits
Increased profits lead to increased employment
Full employment will be restored
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John Meynard Keynes
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The General Theory Of Employment, Interest And Money, 1936.
Most famous economist of the 20th century.
Argued that there is no automatic tendency for the economy to move toward full employment
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Keynesian Economic Theory
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Unemployment is caused by a lack of sufficient aggregate demand
Producers adjust output to satisfy the desires of customers
If demand is low, output will be low
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Keynesian Fiscal Policy
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Other things being equal, an increase in government spending will stimulate the economy
Other things being equal, a tax cut will stimulate the economy
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questions an economic system needs to ask
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WHAT types of goods will be produced?
Consumption goods
Investment goods
Government goods
HOW MUCH will be produced?
WHO will get the output?
HOW will the output be allocated?
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barter economy
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I exchange my goods or services for your goods or services
Exchange requires a double coincidence of wants
Inefficient
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laissez faire economy
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Minimal government interference in the economy
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command/planned economy
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The central government owns many of the factors of production
Government planners often decide what will be produced and who gets the output
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capitalism
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Emphasis on the free market system
Producers and consumers are free to make their own choices
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Adam Smith
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The Wealth of Nations, 1776
Emphasized how a free market economy can allocate resources efficiently, without central planning or government interference
Emphasized the virtues of “THE INVISIBLE HAND” that leads the private interests of consumers and producers toward socially des…
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socialism
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Significant amount of government interference in economic affairs
Government controls many industries.
High taxes
Limits the incentive to work
Government provides extensive health and unemployment benefits
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consumer sovreignty
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Consumers ultimately determine what gets produced
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production possibilities frontier
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A graph that shows all combinations of TWO goods or services that can be produced if all of society’s resources are used efficiently
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why is a country inside its ppf?
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Unemployment of labor
Underemployment of labor
Under use of plant & equipment
Inefficient allocation of resources
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opportunity cost
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The best alternative that we give up when we make a choice
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quota
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-a numerical limit on the quantity of a good that can be imported into a country
-can only import so much of a product
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sole proprietor
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an unincorporated business with one owner who pays personal income tax on profits from the business. With little government regulation, they are the simplest business to set up or take apart, making them popular among individual self-contractors or business owners.
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partnership
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a business organization in which two or more individuals manage and operate the business. Both owners are equally and personally liable for the debts from the business.
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corporation
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a legal entity that is separate and distinct from its owners. they enjoy most of the rights and responsibilities that an individual possesses; that is, a (?) has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes.
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limited liability
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Applies to corporate stockholders
You sue a corporation as a separate legal entity.
Personal assets of stockholders are safe.
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dividends
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Portion of after-tax profits that are distributed to stockholders
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retained earnings
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Portion of after-tax profits that are retained by the corporation for later use
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corporate tax rates
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Marginal tax rates on corporate profits
Profits Marginal tax rate
$0 to $50,000 15%
$50,000 to $75,000 25%
$75,000 to $10 million 34%
Over $10 million 35% (last incr…
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comparative advantage
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Specialization and free trade benefit all trading parties
Two producers can both gain by specializing in the production of the item in which they have a lower opportunity cost and then trading with each other
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absolute advantage
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an ability to produce a particular good or service better than anyone else
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embargo
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prohibits foreign firms or nations from
exporting a product to the US
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tariff
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requires foreign firms or countries to pay taxes on their sales of a product in the US
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ways to get money for business expansion
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Use your own income
Borrow
Sell part of the company to others by issuing stock
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capital gain
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Increase in the price of an asset
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capital loss
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Individual income taxes are paid on capital gains when the asset is sold
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short term capital gain
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Own stock for less than one year
Gain is taxed at your regular marginal tax rate (which could be as high as 35%)
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long term capital gain
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Own stock for more than one year
Maximum tax is 15%
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stock risks
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Price can fall
Protected by limited liability
Maximum loss occurs if price falls to $0
Diversify your portfolio to reduce risk
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stock mutual funds
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Investors pool their funds with an investment company
Company purchases stocks for the investors
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fidelity magellan
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Buys stock of high growth companies
Lots of buying and selling to “beat the market” = high expenses
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vangaurd 500
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Buys shares of the 500 largest corporations sold on the New York Stock Exchange (NYSE)
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NYSE Wall Street
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Location where shares of several thousand major corporations are bought and sold
No new shares of stock are being traded
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dow jones industrial average
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Adjusted average price of shares of stock in 30 major “industrial” corporations
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standard and poor's 500 index
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Adjusted average price of shares of stock in 500 major U.S. corporations
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prospectus
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Official description of a corporation for purposes of selling new shares of stock
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annual report
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Describes activities of a corporation during the last year
Provides financial information: sales revenue, profits, etc.
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bond
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IOU
Legal contract specifying the terms of a loan between a borrower and a lender
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a bond contract specifies
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1. Amount that a borrower will repay to the lender on the date of maturity: (Par Value or Principal)
2. When the Principal will be repaid (time to maturity or date of maturity)
3. Interest rate (or amount of interest) that will be paid on the Par Value
4. Date when e…
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default risk
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Risk that a borrower will not repay a loan
High risk leads to higher interest rate that must be offered to entice a lender to lend.
Alternatively, high risk means that a lender will offer a lower price to purchase the bond.
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risky borrowers
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Cities & states with falling populations
Cities & states with declining tax bases
Cities & states with rising expenditures
New corporations, small corporations
Unprofitable or failing corporations
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types of bonds
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US GOVERNMENT SECURITIES
CORPORATE BONDS
MUNICIPAL BONDS
JUNK BONDS
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US government securities
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Treasury Department writes checks to cover Federal Government SPENDING.
Treasury gets its REVENUE from TAXES.
If government SPENDING exceeds TAX REVENUE, the government has a BUDGET DEFICIT
Then, the Treasury Department must borrow to pay its bills
Thus, new Treasury sec…
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types of US government securities
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TREASURY BILLS: maturity up to 1 year
TREASURY NOTES: more than 1 year to less than 10 years
TREASURY BONDS: 10 years or more
Interest is taxable
Least risky of all bonds:
NO DANGER OF DEFAULT
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corporate bonds
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Rated by Standard & Poors or Moodys
AAA, AA, A, BAA, BA, B, etc.
Interest is taxable
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junk bonds
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High–risk, high–yield bonds issued by companies in a weak financial condition.
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municipal bonds
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Issued by cities and counties
Interest is not taxable
Big advantage for municipalities
It lowers the interest rate that municipalities must pay
Risk varies from city to city
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term of maturity
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Longer term to maturity causes lenders to demand a higher interest rate or they will offer a lower price
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taxability of interest
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Taxable interest causes lenders to demand a higher interest rate or they will offer a lower price
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real rate of interest
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= Nominal interest rate - inflation rate
= Interest rate after adjusting for inflation
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prime rate
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Interest rate charged by banks to their biggest and best corporate clients, such as Ford, GM, EXXON
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discount rate
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Interest rate charge by the Federal Reserve System for loans made to banks
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federal funds rate
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Interest rate charged by banks for overnight loans made to other banks
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calculating present value
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You could invest PV for one year at i = 10%
After one year, you would get 10% interest and would have
PV + .10 PV = PV x (1.10)
Thus, the amount PV should be the solution of
PV x (1.10) = $11,000
PV = $11,000 / (1.10) = $10,000
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for money due after n years
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Let Fn = Amount I owe you n years from today
Let i = interest rate
PV = Present value of the debt
PV x (1 + i)n = Fn
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gross income
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total about of money make in one year by a person, household, or family unit
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personal exemption
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You are permitted to subtract a specified amount from your gross income for each member of your household
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taxable income
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=gross income - exemptions - deductions
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horizontal equity
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People with equal incomes should pay approximately equal taxes
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vertical equity
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People with higher incomes should pay more in taxes
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progressive tax system
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As your income increases, the percentage of your income that you pay in taxes increases
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proportional tax income
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MARGINAL TAX RATE IS CONSTANT REGARDLESS OF LEVEL OF INCOME
EVERYONE PAYS THE SAME PROPORTION OF INCOME
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regressive tax system
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MARGINAL TAX RATE DECREASES AS LEVEL OF INCOME INCREASES
LOW INCOME EARNERS PAY A HIGHER PROPORTION OF INCOME THAN HIGH INCOME EARNERS
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benefits principle
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Those who benefit from public spending should bear the burden of the tax that pays for that spending
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ability to pay principle
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Those with greater ability to pay should pay more tax.
People with high incomes should pay more taxes than people with low incomes
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tax base
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The measure or value that determines how much tax a person pays
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examples of tax bases
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1. Income tax uses many forms of income
2. Payroll tax uses wage earnings
3. Sales tax (excise tax) uses value of purchase
4. Profits tax uses corporate profits
5. Property tax uses value of property
6. Wealt…
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social security system
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EMPLOYER PAYS 6.2% OF WAGES AND SALARY INTO SS FUND
EMPLOYEE PAYS 6.2% OF WAGE AND SALARY EARNINGS TO SS FUND
TOTAL = 12.4% OF WAGES AND SALARIES UP TO MAX EARNINGS OF $90,000
IF SELF EMPLOYED, WORKER PAYS ENTIRE 12.4% OF PROFITS
During 2011, the employee will pay 4.2%…
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why is social security called the payroll tax?
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because the tax is paid on wages, salaries, sole proprietor profits and partnership profits
SOCIAL SECURITY TAXES ARE NOT PAID ON INTEREST INCOME, DIVIDENDS, CAPITAL GAINS, ROYALTIES
THERE ARE NO DEDUCTIONS OR PERSONAL EXEMPTIONS
Thus, unlike with Federal income taxes, yo…
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flat tax
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-a tax system with a constant marginal rate, usually applied to individual or corporate income.
-under proportional tax as they allow certain deductions
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current social security benefits
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RETIREES CAN BEGIN RECEIVING REDUCED BENEFITS AT AGE 62
OR
RETIREES CAN BEGIN RECEIVING UNREDUCED BENEFITS AT AGE 66
(AGE 67 IF BORN AFTER 1960)
CURRENT CONTRIBUTIONS INTO THE FUND ARE USED TO PAY BENEFITS TO CURRENT RETIREES
CURRENTLY THERE ARE ABOUT THREE WORKERS …
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social security surplus
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ALL THE PAST SURPLUS SOCIAL SECURITY CONTRIBUTIONS HAVE BEEN SPENT BY THE FEDERAL GOVERNMENT TO PAY FOR OTHER GOVERNMENT EXPENSES
EARLY RETIREMENT BEGINS AT AGE 62
THE “BABY BOOMER” GENERATION BEGINS WITH PEOPLE BORN IN 1946 (AFTER WWII)
THE FIRST “BABY BOOMERS” BECAME …
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social security isn't sustainable because
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AFTER 2008, THE NUMBER OF RETIREES WILL EXPAND RAPIDLY AND BENEFITS BEING PAID WILL INCREASE RAPIDLY
SUPPOSEDLY, AROUND 2018, BENEFITS BEING PAID OUT OF THE SOCIAL SECURITY FUND WILL BEGIN TO EXCEED CONTRIBUTIONS INTO THE FUND
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solutions to the social security problem
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1. INCREASE THE AGE (62) AT WHICH WORKERS CAN BEGIN RECEIVING REDUCED BENEFITS
2. INCREASE THE AGE (67) AT WHICH WORKERS CAN BEGIN RECEIVING FULL BENEFITS
3. INCREASE THE TAX RATE
4. GREATLY INCREASE THE INCOME CAP
5. REDUCE YOUR STARTING ANNUAL BENEFITS
6. FORCED IRA
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gross domestic product
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The market value of all final goods and services produced in the U.S. in a given year.
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market value
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Output is valued at its selling price
If output remains constant, but prices increase, then nominal GDP will increase
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final goods and services
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Goods and services produced for final use by final users
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intermediate goods
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Goods that are produced by one firm for use in further processing by another firm
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produced in the US
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All goods and services produced inside the boundaries of the U.S count in GDP
Items produced in foreign countries by Americans or American owned firms do not count in GDP
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items not counted in GDP
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Sales of used goods
Purely financial exchanges
Government and private transfer payments
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government transfer payments
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Cash payments made by governments to people who do not provide goods or services in exchange for these payments
Social security benefits
Welfare payments
Unemployment compensation
Veterans’ benefits
Subsidies to farmers
Medicare and Medicaid payments to individuals
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private transfer payments
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Gifts, inheritances, charitable contributions are not included in GDP
Some productive activities are omitted from GDP because there was no market transaction
Homemaker activities
Do-it-yourself projects
Barter transactions
Underground economy
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nominal GDP
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GDP measured in current dollars
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current dollars
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The current prices that people pay for goods and services during any specific year
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base year and price index
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Any year can be chosen as the base year, and then prices in other years are compared to the level of prices during the base year in order to create a price index.
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interpretation of a price index
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We arbitrarily always set the level of the price index during the base year to 100, so we set the index value to 100 in 1996. Now we want to determine how much things would have cost during other years if they cost $100 (or $1.00) during 1996.
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real GDP calculation
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Real GDP = (Nominal GDP/Price index) x 100
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DEPRECIATION AND NET DOMESTIC PRODUCT (NNP)
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During the production process, firms typically use up or wear out lots of tools and equipment.
Sometimes we want to measure the value of the new ouput MINUS the amount of wear and tear on the tools and equipment.
This would give us a measure of our NET new production.
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depreciation
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The amount by which the value of an asset falls in a given period
Also called the capital consumption allowance
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net national product (NNP) calculation
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= Nominal GDP – Depreciation
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calculating GDP
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C + I + G + (X - M) = C + I + G + NX when
CONSUMPTION
C = Purchases by consumers
GROSS PRIVATE DOMESTIC INVESTMENT
I = Purchases by businesses
G = GOVERNMENT PURCHASES OF FINAL GOODS AND SERVICES
Federal, state and local
NET EXPORTS = EXPORTS – IMPORTS
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three categories of investment spending
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1. NEW plant and equipment expenditures
2. NEW home construction expenditures
3. CHANGES in business inventories
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consumption spending
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Durables
(Cars, appliances, furniture)
Non-durables
(Food, gasoline, clothing)
Services
(Clerks, secretaries, teachers, doctors, attorneys, dentists, accountants, entertainers, beauticians, pilots, etc.)
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inventory
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Items produced that have not yet been sold
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change in inventory
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= Inventory at end of year - inventory at start of year
= Total production during year - Total sales during year
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net investment calculation
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gross investment – depreciation
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government spending
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Expenditures on final goods and services by federal, state and local governments
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exports
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Purchases by foreigners of goods and services produced in the US
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imports
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Purchases in the US of goods and services produced in other countries
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CIVILIAN NONINSTITUTIONAL POPULATION (CNP)
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Monthly Labor Review
All persons age 16 and over who are not inmates of penal or mental institutions, sanitariums, or homes for the aged, infirm or needy
This is the potential labor force
It includes students, old people and retirees
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employed (E)
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1. Worked for pay any time during the week which includes the 12th day of the month
2. Worked unpaid for 15 hours or more in a family-operated business
3. Temporarily absent due to illness, vacation, etc.
A person with 2 jobs is counted only once
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unemployed (U)
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1. Did not work during the survey week
2. Available for work
3. Had looked for jobs within the preceding 4 weeks
or
4. Did not look for work because they were laid off
5. Persons who do not have a job, would like one, and are actively seeking a job
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not in the labor force (N)
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Everyone in the civilian noninstitutional population who is not classified as employed or unemployed
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civilian labor force (LF)
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= Employed + Unemployed
= All employed or unemployed persons in the Civilian Noninstitutional Population
= all individuals who have a job or are actively seeking work
= E + U
ignores people in the military
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unemployment rate
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= Number unemployed as a percentage of the labor force
= (Unemployed / Labor Force) x 100%
= U / LF x 100%
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employment rate
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= Number employed as a percentage of the labor force
= (Number employed / labor force) x 100%
= E / LF x 100%
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labor force participation rate
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= Labor force as a percentage of the civilian noninstitutional population
= (Labor force / civilian noninstitutional population) x 100%
= (LF / CNP) x 100%
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costs of unemployment
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1. Individual hardship due to loss of income
2. Loss of output at the national level (lower GDP)
3. Lower standard of living
3. Lower aggregate income
4. Lower tax revenue for government
6. Increased government spending for welfare and unem…
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problems in measuring unemployment
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1. DISCOURAGED WORKERS
People who want to work but are unable to find a job and quit looking
2. UNDEREMPLOYED WORKERS
People working in jobs far beneath their skill level
People working part time who want to work full time
3. UNDERGROUND ECONOMY
Portion of t…
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unemployment compensation
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People can get unemployment compensation for 26 weeks.
Encourages people to remain unemployed
Other things being equal, an increase in unemployment benefits will cause the unemployment rate to increase
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frictional unemployment
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The portion of unemployment due to the normal workings of the labor market
Denotes short run problems in matching people with skills to available jobs
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structural unemployment
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Unemployment caused by changes in the structure of the economy
Often leads to a significant loss of jobs in certain industries
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cyclical unemployment
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The increase in unemployment that occurs during a recession
Unemployment caused by a decline in aggregate demand for goods and services
Related to the business cycle
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policies to cure cyclical unemployment
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FISCAL POLICIES
1. Cut taxes
2. Increase government spending
MONETARY POLICIES
3. Increase the money supply
4. Lower interest rates
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seasonal unemployment
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RELATED TO SEASONS OF THE YEAR AND WEATHER
(construction, highway repair, house painting, landscaping, ski resorts, beaches)
HOLIDAYS
(Christmas, start of school)
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natural rate of unemployment
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Unemployment that occurs as a normal part of the functioning of the economy
Sum of frictional and structural unemployment
The unemployment rate that would prevail if there were no cyclical unemployment
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full employment
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The unemployment rate when there is no cyclical unemployment
There is always some frictional and structural unemployment in any economy
Unemployment rate can never reach 0%
Assumed to occur when there is about 4% to 5% unemployment
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potential GDP
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The level of output when we are at full employment
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GDP gap
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= Potential GDP - Actual GDP
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consumer price index (CPI)
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Based on prices of things consumers buy
Includes used goods
Includes imports
Does not include raw materials (steel, aluminum, oil, wheat, etc.)
Good indicator of changes in cost of living for consumers
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GDP Deflator
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Includes prices of all new goods and services produced in the U.S.
Includes prices of raw materials
Does not include prices of used goods or imports
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CPI calculation
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(Cost of market basket in current year / cost same market basket in base year) x 100
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inflation rate calculation
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= Rate of growth of price index
= [(New value - old value) / old value] x 100%
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harmful effects of variable inflation
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Uncertainty inhibits long term planning and long term investment
More uncertainty implies greater risk
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indexing
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Increasing contracted payments automatically to take into account inflation
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indexed contracts
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Union wage contracts
Social security benefits
Federal Income Tax Brackets
Capital gains are not indexed
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cost of living adjustments
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= Pay increases which are indexed
Protect the worker’s standard of living
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common uses of price indexes
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Calculate real GDP to determine if the economy is growing or contracting
Adjust wage contracts
Adjust social security benefits
Adjust tax brackets
Helps determine the need for fiscal or monetary policy
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demand full inflation (1960's)
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Caused by an increase in aggregate demand
Tends to occur when the economy is near full employment
Caused by increases in spending by consumers, business firms, government, or foreigners
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cost push inflation (1970's)
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Caused by increase in production costs
1. Increases in fuel costs (oil)
2. Increases in wage rates (near full employment)
3. Increases in interest rates and the cost of borrowing
4. Input shortages
5. Stricter environmental regulations
6. Stricter saf…
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The Phillips curve
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shows the inverse relationship between the inflation rate and the unemployment rate of an economy
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ECON 0110: Monopoly