ECO 2013 - 01

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					ECO 2013 Spring 2002                  Some Review Tips for the Final

Your final is in Ruby Diamond Auditorium [downstairs] on Tuesday 23 April at 3 p.m.

It will be a multiple-choice exam of 75 questions. There will be more stress on the last two chapters,
19 and 20, that were not tested earlier, than on other material [of the order of say 7 or so questions
directly relevant to those chapters, as opposed to at most 3 or 4 (in some cases much fewer) directly
relevant to other chapters]. Remember, the material is cumulative, so if you are comfortable with the
later material you are probably OK with most of the earlier. Don‟t panic or be overly nervous; most of
you will do better than you expect, you know more than you think you do.

I will do a review on Sunday 21 April 3.30 p.m. in room BEL 180.

The best preparation for the exam is the practice multiple choice tests in the Study Guide and the website.

Things you should know:

Key points from the first four chapters:

   -   Difference between MACRO and MICRO economics and examples
   -   Concept of scarcity and how economics is about scarcity and its implications
   -   The business cycle and its parts, what is happening to output and employment in the different
   -   Positive versus Normative statements
   -   Graphs and the slope of a line in a graph
   -   GDP as C + I + G + (X – M), definitions of each and relative sizes
   -   The circular flow and the components of it, what the flows are
   -   PPF, Production Possibility Frontier: idea of attainable and non-attainable, increasing
       opportunity cost on curved PPF‟s, opportunity cost as slope of the PPF, how economic growth
       shows in the diagram; how international trade allows consumption at a point outside the PPF
   -   Opportunity cost; comparative advantage means low opportunity cost producer [you have
       comparative advantage in an activity if your opportunity cost of it – what you have to give up of
       the other thing -- is lower than others‟ opportunity cost of it]
   -   Supply and Demand, reason for slopes, shifts in them, idea of equilibrium
   -   Distinction between a change in Supply or Demand [shift of the curve, because something other
       than the own-price of the good changed] and movement on a curve [change in quantity
       supplied/demanded, because the price changed]
   -   How to take a change in something other than the own-price and quantity of a good and
       interpret it as a shift in either Supply or Demand and make a prediction about what will happen
       to price and/or quantity [direction of change, if any, only]
   -   Complements and substitutes in consumption and production, implications
   -   Normal goods and inferior goods; how income change affects demand
   -   Final goods versus intermediates

Chapter 5: GDP; output = income = expenditure. Gross includes depreciation, Net subtracts
depreciation. GDP = C + I + G + (X – M). Measuring by expenditure and by income. Value added
equals sum of factor incomes plus depreciation and net indirect taxes; equals value of output less value
of intermediate inputs. Nominal [money] GDP [at prices of the time] and „real‟ GDP [corrected for
price changes]. Connection between real GDP per person and average „standard of living.‟ Real GDP
times GDP deflator [price index for GDP] equals Nominal GDP times 100 [GDP deflator in base year].
GDP deflator is derived from that equation and data for real and nominal; real GDP growth is obtained
by „chain index‟ method: find growth between adjacent years at both first and second year‟s prices, and
take the average.

Chapter 6: Employed, unemployed, and not in the labor force. Part time workers; aggregate hours.
Unemployment rate and labor force participation rate. „Discouraged workers‟ – persons who leave the
labor force because they cannot find work [stop looking]. Kinds of unemployment [frictional,
structural, cyclical]. Full employment equals natural rate of unemployment equals zero cyclical

Chapter 7: Consumer Price Index: cost of fixed basket of goods and services divided by cost of same
basket in base year times 100. Rate of change is inflation. Bias from quality change, commodity
substitution as relative prices change, outlet substitution, new goods. Real and nominal values – „real‟
equals (nominal times 100) divided by CPI

Chapter 8. What Aggregate Demand [how demand for real GDP varies with the output price level and
why] and Aggregate Supply [how supply of real GDP varies with the output price level in the short run
while input prices are unchanged, and why] mean, and what shifts them. AD slopes down because of
wealth effect [money assets buy less real output if the price level goes up] and substitution effect [our
goods are relatively more expensive compared to foreign goods if our output price level goes up, so the
quantity of them people want to buy goes down]. AD increases [shifts right] if any of its components,
C + I + G + (X – M), increase. AS slopes up because if output prices increase, input prices fixed, real
wages have gone down and it is more profitable to produce so more will be produced and offered for
sale. AS shifts [left or right] if potential GDP shifts [left or right], or shifts [vertically up or down] if
input prices change [up or down]. Output of real GDP in the short run depends on employment; the
production function relates labor input to real GDP output, and shows diminishing returns. Classical
dichotomy means real factors determine real output and growth in the long run, money growth
determines price level and inflation.

Chapter 9. Investment and Saving. Definitions of gross and net investment, depreciation [gross
investment equals net investment plus depreciation]. Saving supply, quantity of finance supplied
increases with real interest rate; shifts right if income increases, left if wealth increases. Government
surplus adds to finance available for investment, i.e. shifts saving supply curve rightward. Investment
demand slopes down; at lower interest rate, more investment projects will have returns greater than the
opportunity cost of investment [the real interest rate], so quantity of investment demanded is larger.
Investment demand shifts with expected profits; if expected profits increase, investment demand shifts
right. Intersection of saving supply and investment demand gives the equilibrium real interest rate. For
world as a whole, [X - M] is zero, so because uses of income equals income equals output equals
expenditure on output, C + S + T = C + I + G. Rearranging, I = S + [T – G]. [T – G] is government
budget surplus, government saving, which shifts private saving supply right to give overall saving
supply for world. So government budget surplus world-wide would lower real interest rate, finance
more investment; deficit would raise real interest rate, „crowd-out‟ some private investment. Because
of international flows of finance in response to small interest rate differentials [after risk adjustment], in
any one country this relationship does not have to hold. In a single country, I = S + (T – G) + (M – X)
– investment is financed by private saving, the government budget surplus, and the trade deficit
[foreign saving].

Chapter 10. Growth. Growth rates of GDP and GDP per person – latter growth of GDP minus growth
of population. Rule of 70; divide percentage annual growth rate into 70 to get approximate years to
double. Labor productivity as real GDP per worker or hour of labor. Productivity curve is relation
between output per hour of labor and aggregate hours of labor input, with fixed technology and capital.
Diminishing returns again. Growth theories: Classical [Malthusian], output per person always falls
back to subsistence level; neoclassical, long run growth depends on technical progress and eventually
all countries will converge to same growth rates and income levels; „New Growth Theory,‟ no need for
convergence, growth depends on investment in human capital and technical change, and search for
profit via innovation.

Chapter 11. Money. What it is – liquid, a means of payment, store of value, unit of account. Money is
money because people will accept it in payment, i.e. based on trust. M1 defined as currency outside
banks, balances in checkable accounts, and travelers‟ checks. M2 adds savings accounts and some time
deposits. What is not money [credit cards, checks, etc – means of ordering payment or acknowledging
debt, not actual means of payment in themselves]. Definition of bank reserves – currency in the bank
plus deposits with the Fed or borrowed reserves [Federal Funds]. What financial institutions do –
facilitate payments [checks], create liquidity, pool risks, lower costs of borrowing. The required
reserve ratio – the percentage of checkable deposits a bank must keep as reserves. Excess reserves –
any excess over required reserves. Loans and securities earn income for banks, therefore are preferred
assets to reserves for banks. Excess reserves can be loaned out, thereby will be deposited elsewhere,
and money is created. Each dollar of reserves can „support‟ one divided by the required reserve ratio of
deposits; that is the „money [or deposit] multiplier‟.

Chapter 12. Banks and the Federal Reserve and monetary policy mechanics. A bank‟s assets are
reserves, loans, securities, and other; its liabilities are deposits of customers, owners‟ equity, other.
Total assets must equal total liabilities. The Federal Reserve Banks [the „Fed‟] have liabilities of
currency issued and deposits of commercial banks; assets of [a little] gold and foreign exchange,
government securities, and other. If the Fed buys securities, it pays with a check drawn on itself, and
commercial banks‟ deposits with it increase, so reserves have increased, the banks have excess
reserves, the money supply can expand by more than the original purchase [up to one over the required
reserve ratio times the initial purchase]; this is an „open market operation‟ because the Fed buys the
securities on the „open market.‟ The Fed selling securities works in reverse, it reduces bank deposits
and thus reserves, and reduces the money supply [the commercial banks when they pay for the
securities that are bought from the Fed reduce their deposits with the Fed]. The maximum change in
the money supply from an open market operation is [one divided by the required reserve ratio] times
the initial change in reserves; known as the „deposit multiplier.‟ Open market operations are how
monetary policy actually is „done;‟ the other theoretical tools are changes in the discount rate [but
banks don‟t borrow from the Fed] and changes in the required reserve ratio [too discontinuous for use].
Chapter 13. Classical dichotomy again. How nominal and real interest rates relate to inflation – the
nominal interest rate equals the real rate plus inflation. When the money supply is expanded, the
federal funds rate goes down – supply of reserves increases so the short term interest rate goes down.
Demand for money as transactions, precautionary, and speculative. Opportunity cost of holding money
is the nominal interest rate you give up; supply is determined by the Fed and institutions, is fixed in the
short run [a vertical supply curve, downward sloping to the right demand curve]. „Demand for money‟
means how much wealth people want to hold as money at different nominal interest rates, given
everything else: increased wealth or real GDP will shift it to the right. In the short run, as money
supply changes the short term interest rate adjusts [expanding money supply decreases short term
interest rates]; in the long run, real interest rates tend to be constant, so the growth of the price level and
the long term nominal interest rate adjust to the growth of the money supply: rate of growth of the
money supply equals the growth rate of real GDP plus the inflation rate. So long term interest rates do
not have to change equally with short term interest rates, because the long term interest rate equals the
real interest rate plus the expected inflation rate over the term of the loan. Velocity of money equals
money GDP divided by the money supply, tends to change only very slowly. Very rapid inflation
[hyperinflation] induces velocity to increase, people to try to hold very little money [because it loses
purchasing power rapidly if inflation is very rapid]. Inflation increases the effective income tax on
interest income, lowers the after-tax real interest rate; inflation reduces the purchasing power of money
holdings. Key points:
        - MxV=PxQ
        - If V constant, growth rate of M = inflation rate + real GDP growth rate
        - Real interest rate + inflation rate = Nominal interest rate
        - If money supply grows, nominal interest rate falls

Chapter 14: Keynesian model: fixed price level, output depends on aggregate expenditure on output.
Aggregate expenditure [AE] is planned expenditure; actual expenditures as measured always equal
GDP equals output, unplanned inventory accumulation [part of investment] is adjustment that provides
the equality. Unplanned inventory change is signal to change output plans, mechanism for economy to
adjust to equilibrium with aggregate planned expenditure equal to output – not necessarily at potential
GDP, full employment. Some expenditures [consumption, imports] are induced, i.e. they vary with
income/GDP; others are autonomous or exogenous, i.e. they do not depend on income or GDP [I, G,
X]. Marginal Propensity to Consume, fraction of an extra $ of disposable income spent on
consumption. Expenditure multiplier, 1/(1 – MPC), what you multiply an initial change in expenditure
by to get the change in equilibrium GDP; because change in income induces consumption expenditure
change which results in further income change. Imports and taxation that varies with
income/expenditure reduces size of multiplier because it reduces fraction of GDP change respent on
US-produced output. Key points:
        - Multiplier = 1/(1 – MPC) [if no taxes or international trade]
                       = 1/(1 - MP to spend on US-produced output)
                       = 1/(1 – slope of the AE curve)
        - Equilibrium is when Real GDP equals Aggregate Planned Expenditure
        - MPC = change in consumption divided by change in disposable income
        - Adjustment to equilibrium; how unplanned inventory change leads to output change

Chapter 15: Business cycle: peak – recession – trough – expansion. Explained as AS/AD fluctuations.
AS slopes up to right because it reflects supply of output as output prices change, input prices [and
every thing else] fixed; more profitable to produce, real wages are lower so more workers employed, if
output prices rise and input prices [wages] fixed. If wages go up, AS shifts vertically up. Things that
shift potential GDP [vertical line, capacity] left or right also shift AS left or right [technical change,
larger labor force, larger capital stock]. AD slopes down to right because (1) wealth effect [higher
output prices mean money stock worth less real goods and services] (2) real interest rate effect [higher
output price implies higher real interest rate in SR as holders of money require higher interest rate to
induce them to hold only the smaller real quantity of money] (3) substitution effect [foreign prices have
not changed, so higher output prices in US induce substitution of foreign goods for US ones. Key
        - AS moves up/down as money input prices [wages] move up/down
        - If AD intersects AS to the right of potential GDP, output is greater than potential and full
            employment, we have an „inflationary gap‟
        - If AD intersects AS to the left of potential GDP, output is less than potential and full
            employment, we have a „deflationary gap‟
        - Changes in C, I, G, or (X – M) change AD
        - Multiplier effects mean the shift in AD is greater than the initial change in autonomous
        - If potential GDP changes, it moves the AS curve with it left [decrease] or right [increase]
Chapter 16: Fiscal policy: changing government spending and taxing policy. Discretionary fiscal
policy to counter the business cycle would imply larger deficit during recession, larger surplus in an
inflationary boom. Rarely if ever tried in US because of inherent delays in Congressional decisions
[more often used under parliamentary systems]. But, automatic stabilizers – aspects of tax and
expenditure structure that automatically change (T – G) when GDP changes, like income and sales
taxes – have important impact in smoothing business cycle [smaller depth of recession etc].
Discretionary monetary policy can involve much faster decisions, but still faces problems in terms of
difficulty of forecasting and uncertainty/variability of time lag before impact, and sensitivity of interest
rates to money supply and investment demand to interest rates. Key points:
        - Nature of automatic stabilizers – they reduce the size of business cycle fluctuations by
            reducing the size of the multiplier
        - Expansionary fiscal policy means G up or T down, i.e. (T – G) smaller or more negative
        - Contractionary fiscal policy means G down or T up, i.e. (T – G) larger or a smaller negative
        - The tax multiplier is smaller than the government expenditure multiplier [because tax
            changes affect disposable income initially, not AD directly like G does]
        - The balanced budget multiplier is therefore not zero but likely close to one
        - The interest rate effects of monetary policy work on AD via C and I directly, and on (X –
            M) via the effect on the exchange rate [higher interest rate means (ceteris paribus) higher
            foreign value of $, less exports; (in reality, ceteris usually not paribus)]
        - Expansionary monetary policy is expand money supply, interest rate falls
        - Contractionary monetary policy is reduce the growth of money supply, interest rate rises
        - In the long run, monetary policy affects the inflation rate, not the level of activity

Chapter 17: Short Run Phillips Curve – for given level of inflation expectation, higher inflation rate
implies lower unemployment, higher unemployment implies lower inflation rate. Long run Phillips
Curve is vertical – i.e. there is a natural rate of unemployment [corresponding to potential GDP] to
which the economy will tend to revert, consistent with any level of inflation. Expectations tend to
adjust to experience, or perhaps to „rational expectations‟ – using all available information. Issue of
credibility: because of „stickiness‟ down of wages and prices [people resist wage reductions], reducing
inflation by restrictive monetary or fiscal policy may be very expensive in terms of prolonged
unemployment higher than the natural rate [i.e. AS and AD may need to intersect to the left of potential
GDP for a long time to shift AS down as wages fall because of the high unemployment]. But if people
believe inflation will be reduced, and their expectations reflect that, the Phillips Curve shifts down right
away and the cost in terms of unemployment may be much smaller. Key points:
        - The Short Run Phillips Curve [SRPC] slopes down to the right, shows lower inflation
            associated with higher unemployment [and vice versa]
        - The SRPC is „anchored‟ on the expected inflation rate and the natural rate of unemployment
            [full employment unemployment rate]
        - The Long Run Phillips Curve [LRPC] is the natural rate of unemployment, i.e. a vertical
        - As expected inflation changes, the SRPC shifts up or down on the LRPC
        - If natural unemployment rate changes, the LRPC and SRPC move left [lower natural rate]
            or right [higher natural rate] with it
        - Existence of long-run wage contracts makes the SRPC shift more slowly in response to
            changes in expected inflation

Chapter 18: Key issue is notion of fixed rule versus discretionary policies: a fixed rule policy is just
that, adoption of a fixed policy rule such as “money supply growth should be x% a year.”
Discretionary policy is adapting policy to conditions in attempt to smooth the business cycle, what
actually happens with the Fed adjusting open market operations and the target federal funds rate to
counter perceived problems in terms of the business cycle and inflation. Zero inflation may not be a
good policy target because (a) measured inflation overstates „true‟ inflation [the upward bias of the
CPI] (b) some inflation helps adjustment to structural change, particularly in labor markets [attitudes to
money wage increases and decreases are asymmetrical, i.e. people like raises but hate wage cuts] (c)
nominal interest rates cannot fall below zero, so zero or negative inflatio]]n constrains financial
markets. Key points:
       - If expectations are „rational‟, credible announcements of anti-inflation policies will have
           lower costs [in terms of unemployment] than „surprise‟ contractionary policies.
       - Output is related to employment [Okun‟s Law], so policy that targets real GDP also targets
       - Because policy targets are multiple, there must be tradeoffs between them

Chapter 19: International trade: Mostly review of chapters 3 and 4, in context of international trade.
Comparative advantage, relative opportunity cost (in terms of goods) again. You specialize in, and
export, the thing that you have comparative advantage in producing [means you are the low opportunity
cost producer of]. Trade restrictions -- tariffs, quotas. Exports raise domestic price of exported good,
benefit producers, hurt consumers; imports lower domestic price of good, hurt producers, help
consumers. Protection – hurts consumers because raises price, helps domestic producers because
increases domestic production. Costs of protection (widely spread, diffuse, small to any individual, large
in total) versus benefits of protection (concentrated, large to individuals affected but small in total);
protection usually the result of ‘rent-seeking’ – using politics to gain a benefit.

Chapter 20: International Finance. Balance of Payments definitions -- credit if US resident receives the
payment, debit if a foreign resident receives the payment. Foreign exchange rate is price of one currency
(country's money) in terms of another. Demand and supply of a foreign currency; how transactions (e.g.
imports, tourist spending) effect D/S for foreign currency, hence the exchange rate. Appreciation (value
in terms of other currency up) and depreciation (value in terms of other currency down) of a currency.
Demand and Supply of a currency influenced by interest rate differentials [higher interest rates draw in
foreign funds, raise demand and exchange rate (currency appreciates), ceteris paribus] and inflation rate
differentials [faster inflation implies more supply, less demand for currency, currency depreciates ceteris
paribus], Balance of payments (payments: credit if payment comes in, debit if payment goes out) and
items therein. Current and capital balances, how they offset each other and connect to foreign borrowing.
The national accounting identity: (X – M) = (S – I) + (T – G), trade balance = private sector surplus +
government surplus.

You have lots of time; read the questions carefully and take your time. You will probably do better than
you expect.