Economics

Question 1

Income Approach for Gross Domestic Product (GDP)

Answer 1

Income approach also grosses up National Income (NI) back to GNP

GDP = Factor Pmts + Wages/Rent/Interest/Profits + Capital Consumption Allowance + Indirect Taxes, net of subsidies

Capital Consumption Allowance = Depreciation is added back in b/c it is a benefit that adds value to the production of goods

Question 2

Expenditure Approach for Gross Domestic Product

Answer 2

GDP = C + Ig + G + Xn

C = Personal consumption expenditures - favorite pastime

Ig = Gross private domestic investment - i.e. investments by businesses in capital assets like a building, equipment

G = Government purchases - what the gov't does best

Xn = Net exports  - foreigners' spending on our exports

(Silly Mnemonic: the eX is consuming a CIGGy )

Question 3

Compute Net Domestic Product (NDP)

Answer 3

GDP
(Capital Consumption Account)

=Net Domestic Product

Question 4

Compute National Income

Answer 4

Net Domestic Product
(Net Foreign Income Factor)
(Indirect Business Taxes - paid by final consumers)*

= National Income

*indirect business taxes means that US companies pass on the taxes to the final consumers, which makes the tax indirect. Companies act as a “tax collector” for the Government

National income excludes income earned by foreigners and includes income earned by our US nationals whether they are at home or overseas

Question 5

Compute Personal Income and Disposable Income

Answer 5

National Income
\+ Transfer payments*
(Social Security Contributions)
(Undistributed Corporate Profits)**
(Corporate Income Taxes)

= Personal Income
x Personal Tax %

= Dispsoable Income

• payments from the Gov’t such as welfare

**exclude undistributed corp profits b/c have not converted into actual income

Question 6

What represents the intensity and duration of a business cycle?

Answer 6

Intensity is represented by the troughs and peaks of the cycle.

Duration is represented by the recession and expansion phases.

Question 7

What do the peaks and troughs in the business cycle represent?

Answer 7

Peaks = Econcomy reached its highest level of output (Real GDP)

Troughts = Economy reached its lowest level of output (Real GDP)

Question 8

Marginal prosensity to consume

Answer 8

% delta in spending / % delta in income = MPC

Question 9

Marginal prospensity to save

Answer 9

% delta in savings / % delta in income = MPS

Question 10

What do Marginal Prospensities to consume and save tell us?

Answer 10

1 - MPC = amount that is being saved by others.

When we consume our income, it becomes someone’s else source of savings and vice versa.

1 - MPS = amount that is being consumed (spent) by others

Question 11

What causes the demand and supply curves to shift?

Answer 11

When there are changes in factors OTHER than price.

Question 12

What moves up and down the demand and supply curves respectively?

Answer 12

Changes in price.

Question 13

Supply curve’s relationship

Answer 13

Price of supply directly affects the quantity supplied to the market.

Firms will only increase the quantity of the supply when it would fetch higher prices because they are motivated to maximize profits, need to fetch highest prices when possible.

Question 14

Price Elasticity of Demand

Answer 14

Tells us whether consumers will respond to a change in prices. Elastic ( > 1) means consumers will subsitute with lower-cost options. Inelastic (

Question 15

Income Elasticity of Demand

Answer 15

Tells us whether consumers will demand more when their income increases.

The more income a consumer has, the more the consumer can demand of a normal good.

Lower income = demand for inferior goods increases

% change in Qty Demanded / % change in income = IED

Question 16

What is the catch about inferior goods vs. normal goods?

Answer 16

Has nothing to do with the quality of inferior and normal goods. Has to do with the consumers’ buying power. The more that consumers can buy, the more demand there is for normal goods. The less that consumers can buy (i.e. lost a job), the more the consumers will grativate towards inferior goods (canned foods over fresh foods).

Question 17

What is the meaning behind “liquidity preference”?

Answer 17

It really means that we consumers prefer money (cold hard cash) over anything else because it is the most liquid asset to have on hand.

Question 18

When or where is profit maximized? What’s the logic behind it?

Answer 18

MR = MC is when profit is maximized.

Logic is MR represents the additional revenue earned on selling one more unit while MC represents cost of producing one more unit

MC is a u-shaped curve. When MC intersects with the MR line, that is where profit is maximized.

MC concerns only VARIABLE cost. The ATC (and VC) follows the MC curve.

If MC is below MR, firm will want to produce more output to meet that MR.

If MC is above MR, firm will want to cut back on output and lower price to get MC to meet MR to maximize profit.

Question 19

GDP represents…

Answer 19

The monetary value of all final goods and services produced in an economy during a year using either domestic- or foreign-supplied resources (the country’s output)

Excludes intermediate goods, which are goods that are purchased for resale or for further processing or manufacturing.

Excludes nonproductive transactions that have nothing to do with the production of final goods and services like financial transactions - making a home loan has nothing to do with producing a good or service.

Compute either under Income or Expenditure approach (X consuming a CIGGy)

Question 20

What is the opportunity cost for using capacity of a factory for $25,000 compared to renting out the factory space for $10,000?

Answer 20

Answer is $10,000 because it represents the lost opportunity to make $10,000 by renting even though it may have been the right decision to use the capacity. Remember we are looking at the opportunity COST, not the difference (we are not looking at margin). Opportunity cost questions are asking us to look at the whole cost, not the difference.

Question 21

Net Exports

Answer 21

Part of GDP Expenditure approach

Represents the spending by foreigners on goods produced in the home country (OUR domestic production), less by home country’s spending on foreign imports

Total Exports (X) - Total Imports (M) = Net Exports aka Xn

Question 22

What economic variable relates to the activity of net exports?

Answer 22

Changes in relative income between the domestic and foreign countries affect the net exports.

Why? We spend more on imports when our disposable income increases because we can buy more imports.

For foreigners, when their income increases, they buy more of our exports.

Question 23

Multiplier Effect

Answer 23

Economists are interested in the multiplier effect because it explains how one small change in an investment can have a greater impact on the GDP.

An investment is an autonomous expenditure. When we change our own investments at an individual level, we can cause a GREATER shift in the national income and GDP. Hence, this is why economists and policy makers focus on the multiplier effect. Helps them figure out what policies to influence the autonomous spending to cause an economy-wide shift. Example - make people save more for retirement in 401(k) than relying on Social Security pay outs from the Government.

Basically, one small change multiplies to a greater overall impact (like the Butterfly Effect. One swish of a butterfly’s wings can cause a hurricane across the world).

Question 24

What is the story between the Multiplier Effect and an economy’s money supply?

Answer 24

We can figure out how much the banking system can expand the money supply when banks get new deposits or additional reserves.

Beware - if the exam question asks you about what economists think of the multiplier effect and is silent on the money supply, it is really asking you about the investment spending. Has nothing to do with the money multiplier (tricky!!)

Question 25

Aggregate Demand

Answer 25

Represented as a schedule of curve showing the amount of real GDP (output) that the buyers altogether desire to buy at each price level.

Aggregated Demand shows the relationship between Price level and real GDP is INVERSE.

Question 26

Three Price Effects that explain the inverse relationship of the Aggregate Demand

Answer 26

Three Price Effects that EXPLAIN the inverse relationship of the Aggregate Demand:

Real GDP, Interest Rate, and Foreign Purchases (spending on imports)

1) When real GDP declines, our purchasing power declines and we have to cut back on spending. Hence, our spending falls below the price levels.
2) When prices go up, consumers demand more money. Interest is the cost of borrowing more money. We end up driving up interest rates, making it expensive for businesses to borrow money to invest in equipment that’d increase output (output drops instead).
3) When prices of our own goods rise relative to foreign prices, foreign consumers will cut back to spending on our goods because it has gotten to be too expensive for them. Hence, demand for our goods will drop while the prices are going up (opposite direction). We end up buying more of the foreign goods instead.

Question 27

Just In Time vs Traditional

Answer 27

JIT = Demand-Pull approach –> production is triggered by a sale first

Typically includes small lot sizes, minimal setup times/costs, and balanced workloads to minimize inventory build up

Traditional = Push-Through approach -> produce (build up) inventory then sell it

Question 28

What’s Average-Marginal Rule? How will this help you on the exam?

Answer 28

The rule states that whenever the marginal magnitude is ABOVE the average magnitude, that average rises. The average magnitude is trying to catch up with the margin.

It can be marginal cost, marginal revenue, whatever. Anytime the exam asks a question where the average is rising, it means it is trying to reach the margin that is above it.

Alternatively, the exam can say that the margin is above the average, it means the average will RISE to that margin.

Question 29

In a monopolistic competitive market, where does the marginal revenue line fall?

Answer 29

MR line is BELOW the Demand curve. Remember that the firms are price-takers. They have to follow what the demand curve is.

Question 30

Rules of Thumb about Foreign Exchange Markets (unrestricted)

Answer 30

Rules of Thumb:

1) Countries purchase imports by buying foreign currency to make the purchase. Cannot transact directly with your own domestic currency.
2) Hence, triggers a demand for that country’s CURRENCY in addition to its goods
3) Demand curve interacts with the supply curve and determines what will be the exchange rate. The interactions of the demand and supply curves are SHIFTS. Recall shifts of these curves are due to factors OTHER than Price.

These factors are due to:

1) changes in consumer tastes
2) relative changes in income
3) relative interest rates

  (ex) real interest rate in US goes up, while Europe's rates remains the same.  Europeans will take advantage of investing in the US to get more in return and thus, increase the supply of Euros.  Now, there are more Euros in the supply, the Euro will start to depreciate (supply curve shifts right)

Question 31

How are exchange rates determined? And why?

Answer 31

By the interaction of the SUPPLY and DEMAND curves for foreign currencies in foreign markets because when we want to buy another country’s goods, we have to pay for them in that country’s currency. We end up triggering a demand for that country’s currency in order to transact.

Interaction of the supply and demand curves are due to shifts of these curves due to 1) Changes in consumer tastes, 2) relative changes in income, and 3) relative interest rates.

(When in doubt, just graph the demand and supply curves and follow the direction on whether the currency appreciates or depreciates).

Question 32

Assuming that exchange rates are free to fluctuate, what are the factors that would cause a country’s currency to APPRECIATE on the foreign exchange market?

Answer 32

The country’s currency will appreciate when either:

Demand for that country’s currency increases > Demand curve shifts to the right > Currency appreciates (price goes up)

or

Supply for that country’s currency decreases > Supply curve shifts to the left > Currency appreciates (price goes up)

Example of a country’s currency being appreciated in the foreign exchange market is when its income is slow to grow compared to other countries and imports less than exports. Why? 2 interlinking reasons

1) Imports less than exports means the country’s exports are cheap. Foreigners want to buy these exports on the cheap, but will have to get that country’s currency in order to transact. Hence, triggers a demand for that country’s currency (shifts to the right), appreciating the currency.
2) Because so many foreign buyers are coming into the market, they are using up the supply of that country’s currency (supply of currency decreases). Hence, the supply curve shifts to the left, appreciating the currency.

Question 33

The entire formula from GDP to Disposable Income

Answer 33

GDP
(Capital Consumption Allowance*)  *fancy for Depreciation
--------------------
Net DP
(Indirect Biz Tx)
(Foreign Factor)
----------------------
National Income, Net of Foreign Factor 
\+Transfer Payments
(Social Security Contributions)
(Corporate Income Taxes)**
(Undistributed Corp Earnings)**
------------------------
Personal Income
(Personal Income Tax)
----------------------
Disposable Income

**Back out the corporate-related items b/c they do not apply to the individual’s income