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What is macroeconomics?

Macroeconomics is concerned with the economic activities and outcomes of an entire economy, typically an entire nation or region comprising several nations.


What are the most common issues considered in macroeconomics?

  1. Aggregate demand
  2. Aggregate supply
  3. Business cycles
  4. Inflation/deflation
  5. Gross measures of activity and status
  6. Role of government


Identify the 5 major sectors (or elements) of a macroeconomic free-market flow model.

  1. Individuals
  2. Business entities Flow model expanded for macroeconomic analysis:
  3. Government entities
  4. Financial entities
  5. Foreign entities


In a macroeconomic free market flow model, what are "injections"?

The amounts of expenditures not for domestic consumption added to the domestic production are called "injections".

These consist of:

  1. Government spending/subsidies
  2. Investment expenditures
  3. Exports


In a macroeconomic free market flow model, what are "leakages"?

The amounts of individual income that are not spent on domestic consumption.

They consist of:

  1. Taxes
  2. Savings
  3. Indirectly, imports


The foreign sector plays a role in the macroeconomic free market flow because of:

Imports and exports

  1. Imports from foreign supplier= results in outward flow of payments beyond domestic economy.
  2. Exports to foreign= results in receipt of payments that flow outside domestic economy.


Identify important gross measures used in macroeconomics:

  1. Nominal Gross Domestic Product (GDP)
  2. Real Gross Domestic Product;
  3. Potential Gross Domestic Product;
  4. Gross National Product (GNP);
  5. Net National Product;
  6. National Income;
  7. Personal Disposable Income


Define "Nominal Gross Domestic Product" (GDP):

Measures the total output of FINAL goods and services produced in the domestic market for EXCHANGE during a period.


What does GDP NOT include:

It does NOT include:

  1. Goods/services which require additional processing;
  2. Illegal activities;
  3. Activities for which there is no market exchange (do-it-yourself activities);
  4. Good produced in foreign countries by US owned entities.


Describe the two measurement approaches of GDP:

  1. Expenditure Approach - This measures GDP using the value of final sales and is derived as the sum of the spending of: 
    • Individuals - consumption expenditures
    • Businesses - investments
    • Governmental entities - goods/services purchased
    • Foreign buyers - net exports of US produced goods/serv
  2. Income Approach - Measures GDP as the value of incomes and amounts received for resources; the sum of:
    • Compensation
    • Rental income
    • Proprietors' and corporate income
    • Net interest
    • Taxes on production and inputs
    • Depreciation, and miscellaneous items


Define "Real Gross Domestic Product" (Real GDP):

Measures the total output of final goods and services produced in the domestic market for exchange during a period AT CONSTANT PRICES (using a price index).

  • Real GDP = Nominal GDP adjusted for changing prices
    • Real GDP per capita = Real GDP per Individual 
      • Real GDP/Population
  • The GDP deflator is a comprehensive measure of price levels used to derive real GDP.
    • Calculation would be:
      • Real GDP = (Nominal GDP/GDP deflator) x 100


True or false: An increase in nominal GDP will always result in an increase in real GDP.

False: During a period of rising prices (inflation), the application of a price index to nominal GDP will result in a real GDP that is LOWER than nominal GDP.


Define "Net Gross Domestic Product" (Net GDP):

Measures GDP less capital consumption during the period. (GDP - Depreciation)


Define "Potential Gross Domestic Product (Potential GDP)":

Measures maximum output that can occur in domestic economy at a point in time without creating upward pressure on the general level of prices:

  • It's a theoretical measure - Assumes full use of available technology and current resources
  • Commonly estimated by adjusting actual GDP (for business cycles, unemployment, ect.)
  • The point of maximum final output will be a point on the production-possibility frontier for the economy.


What's a "Production-possibilty curve"?

It measures the maximum combination of various goods and services an economy can produce at a given time with available technology and efficient use of all available resources.


Gross Domestic Product (GDP) Gap:

It's the difference between Real GDP and Potential GDP:

  • Real GDP < Potential GDP= Positive GDP Gap= inefficiency in the economy - economy is operating at less than full capacity, which implies unemployment and under-utilized plant and equipment.
  • Real GDP > Potential GDP= Negative GDP Gap= economy is operating above normal full capacity, which will put upward pressures on prices.


Define "Gross National Product" (GNP):

Measures the total output of all goods and services produced WORLDWIDE USING U.S. RESOURCES.

  • It includes goods and services produced in foreign countries by US owned entities.
  • It's the primary measure of the US economy.
  • It includes both the cost of replacing capital (depreciation factor) and the cost of investment in new capital.


Define "Net National Product" (NNP):

Measures the total output of all goods and services produced worldwide using US resources, but does not include a value for depreciation (only included the cost of investment of new capital).

  • NNP= GNP - Depreciation factor


Define "National Income" (NI):

Measures the total payments for economic resources included in the production of all goods and services; includes payments for:

  • Wages
  • Rents
  • Interest
  • Profits


Define "Personal Income" (PI):

Measures the amount (portion) of national income, before persona income taxes, received by individuals.

  • PI = NI - Corporate profits - social security deductions + dividends and interests received by individuals + Govt transfer pymts to individuals


Define "Personal Disposable Income" (PDI):

Measures the amount of income individuals have available for spending, after taxes are deducted from total personal income.

  • PDI = PI - Income taxes


Who determines employment and unemployment data?

The Bureau of Labor Statistics


What are the 2 surveys the Bureau of Labor Statistics use?

  1. Current Employment Survey - a monthly sample survey of 160,000 businesses and govt entities designed to measure employment (ONLY), w industry and geographic details.
  2. Current Population Survey - a monthly sample survey of approximately 60,000 households designed to measure both EMPLOYMENT and UNEMPLOYMENT, w demographic details.


Who is considered in the labor force?

Those individuals at least 16 years old who are working (excluding those on active duty) or who are seeking work.


Who is NOT considered in the labor force?

  • Less than 16 years old
  • Retired
  • Not seeking work (those who become discouraged)
  • Institutionalized


What is frictional unemployment?

  • Those in the labor force not employed because:
    • Are in transition between jobs
    • Don't have info needed to get matched up w an employer
    • Includes, for example:
      • Those moving to seek employment
      • Those looking for a job they believe meets their education or experience.


What is Structural Unemployment?

Those not employed because:

  • The need for their prior jobs have been greatly reduced or eliminated.
  • They lack the skills for currently available jobs.
  • For example: advent of computers and software greatly reduced the need for bookkeepers; many became structurally unemployed.


What is Seasonal Unemployment?

Those out of work because their jobs regularly and predictably vary by the season of the year.

  • For example, school bus drivers generally are seasonally unemployed during the summer.


What is Cyclical Unemployment?

Those who are not employed because of a downturn in the business cycle.

  • An economic downturn (recession) reduced the current demand for employees (labor).
  • Unemployment number of greatest policy concern.


What is the official Unemployment Rate?

Percentage of labor force not employed

  • Unemployed (all categories) / Size of Labor Force


What is the Natural Rate of Employment?

Those unemployed due to frictional, structural, and season reasons. (Not cyclical)

  • You would have this unemployment regardless of the state of the economy.
  • Structural+Frictional+Season Unemp/Size of labor force


Define "Official full employment":

Officially, full employment exists where there is no cyclical unemployment.

When there is official full employment, there could still be frictional, structural, and/or seasonal unemployment.


What is "aggregate demand"?

  • Total spending in economy (spending approach to GDP).
  • It's the sum of all demand curves.
  • It's the sum of:
    • Consumption Spending
    • Investment Government Spending
    • Net Exports (net imports subtracted)


What entitles "Consumption Spending"?

Spending by individuals on goods and services.

  • It does not include new housing (that's investment)
  • Accounts for about 70% of aggregate US spending
  • Primarily determined by Persona Disposable Income (PDI)


Define the Consumption Function:

It measures the relationship between Personal Disposable Income (PDI) and Consumption Spending (CS)

  • CS > PDI = Borrowing (going to debt) or spending savings
  • CS < PDI = Savings


What measures the "Average Propensity to Consume" (APC)?

Measures the percent of disposable income (PDI) spent on consumption (CS).

  • Example: If PDI is $1.00 and CS is .85, then APC is 85%
  • Average Propensity to Save is the reciprocal of APC.
  • APS + APC = 100%


What measures the "Marginal Propensity to Consume" (MPC)?

Measures the change in consumption spending as a percent of the change in disposable income.

  • Example:
    • If $1.00 of ADDITIONAL disposable income is received and an ADDITIONAL .90 is spent on consumable goods, MPC= .90/1.00 =90%
  • Marginal Propensity to Save (MPS) is the reciprocal of MPC. MPC+MPS = 100%


What's Investment Spending?

  • It's spending on capital investments, including:
    • Residential construction
    • Non-residential construction
    • Business property, plant, and equipment
    • Business inventory
  • Accounts for about 15% of aggregate US spending.
  • Tends to fluctuate more than consumption.


What are the factors that influence Investment Spending?

  • Interest rates - perhaps the most significant factor.
  • Demographics
  • Consumer confidence
  • Consumer income and wealth
  • Level of capacity utilization
  • Technological advances
  • Vacancy rates
  • Current and expected levels of sales


Define Government Spending:

  • It's the purchase of goods and services by all levels of the governments. 
  • Excludes transfer payments - not for goods or services 
  • Changes in government spending typically impact taxes, which impact personal disposable income, which change personal consumption.
  • Changes normally occur in different periods.
  • Changes in govt spending are also financed by govt borrowing.


How does Government Spending affect Aggregate Demand? *Discretional Fiscal Policy*

It directly affects aggregate demand by changes to:

  • Government spending
  • Government taxation Discretionary Fiscal Policy - Government changes to spending or taxation to impact aggregate demand.


How does the Discretionary Fiscal Policy affect the Aggregate Demand?

Fiscal Policy Action    To Increase AD    To Decrease AD

Govt Spending            Increases              Decreases

Taxation                      Decreases             Increases

Transfer payments       Increases             Decreases


Define Exports and Imports:

  • Exports: Amount of foreign spending on goods
  • Imports: Amount of US spending on foreign goods.
  • Net exports = Exports-Imports
    • Positive = Exports > Imports : Increases AD 
    • Negative = Imports > Exports : Decreases AD
    • For the last 20 years, the US has been a net import country (negative exports - decreases AD)


What are the factors that influence Imports/Exports?

Primary factors influencing a country's relative imports/exports include:

  • Relative levels of income and wealth
  • Relative currency exchange rates
  • Relative price levels
  • Relative inflationary rates
  • Import/Export restrictions and tariffs


Change in Aggregate Demand is a:

Shift in aggregate demand curve.

  • Factors other than price change.


What are examples of factors that would shift aggregate demand curve outward?

  • Reduction in personal or corporate taxes 
  • Improved consumer confidence
  • New technology resulting in increased investment
  • Interest rates declines
  • Govt spending increases
  • Exports increase/imports decrease
  • Increases in wealth (e.g. stock market gains)
  • Opposite effets would shift curve inward


What's the Multiplier Effect?

It's a ripple effect of a change in demand on total change in demand

  • Example: Increased investment spending = more personal income = more consumption spending
  • A change in spending is multiplies as it flows through the economy


How is the Multiplier Effect Measured?

It's measured using Marginal Propensity to Consume (MPC).

  • Multiplier = Change in spending x [ 1 / (1-MPC) ]
  • Example:
    • Assume MPC= .80
    • Investment spending: +$10,000,000
    • Multiplier: $10M x [ 1 / (1-.80) ]
      • $10M x [ 1 / .20 ]
      • $10M x 5 = $50M
      • An increase in investment spending of $10M would cause an increase in demand of $50M.


List the significant factors that cause a negatively sloped demand curve.

  1. Interest rate factor;
  2.  Wealth-level factor;
  3.  Foreign purchasing power factor


Define "Aggregate Supply":

Total output of goods and services produced in the economy at different price levels.

  • Aggregate supply curve slope depends on theory followed:
    • Classical Aggregate Supply curve
    • Keynesian Aggregate Supply curve
    • Conventional Aggregate Supply curve


Describe the Classical Aggregate Supply Curve:

  • It's completely vertical, reflecting no relationship between aggregate supply and price level.
  • No change in output as price increases at full employment
  • It may be associated with the very short-term when factors of production cannot be changed and in the long term when all inputs to the production process are fully utilized (including having full employment).


Describe the Keynesian Aggregate Supply Curve:

  • This curve is horizontal up to the (assumed) level of output at full employment, then sloped upward, reflecting that output is not associated with price level until full employment is reached.
  • There's increasing supply at a price until full employment, then increased supply ONLY with increased price.
  • It has a "kink" at the level of output at full employment.


Describe the Conventional Aggregate Supply Curve:

  • This curve has a continuous positive slope with a steeper slope beginning at the (assumed) level of output at full employment.
  • Supply increases with price, but requires proportionally higher prices are full employment.


What are the changes in the Aggregate Supply?

A change in aggregate supply is a shift in the aggregate supply. *Factors other than price change.

  • Example of factors that would shift curve outward:
    1. Resources available increase
    2. Cost of resources decrease (labor included)
    3. Technological advances occur
    4. NOT the price of the item supplied, that causes a movement along a given supply curve.
  • Opposite effects would shift curve inward


Which of the following effects is most likely to accompany an unexpected reduction in aggregate supply, assuming conventional supply curve?

A reduction in aggregate supply will shift supply curve left, resulting in lower quantity of output at higher price.


What is the Aggregate (Economy) Equilibrium?

The equilibrium real output and price level for an economy are determined by its agreggate demand and supply curves. Graphically, it occurs where the aggregate demand and supply curve intersect:



What happens to equilibrium with changes in aggregate demand / aggregate supply? 

Changes in AD and AS will change the equilibrium.

The new aggregate equilibrium will depend on:

  • Whether demand or supply is increased or decreased
  • The extent of each increase/decrease
  • Which theoretical supply curve is assumed.
  • The degree of shift in curve(s) relative to prechange equilibrium.


If the Classical Supply Curve is assumed, show what happens to equilibrium when the AD and AS change:

  1. An increase in aggregate demand alone results in only higher price levels.
  2. An increase in aggregage supply alone results in more output at a lower price.


If the Keynesian Supply Curve is assumed, what happens to equilibrium when AD and AS changes?

  1. An increase in aggregagte demand alone results only in more output until output at full employment, at which point output and price levels increase.
  2. An increase in aggregate supply alone will not affect either output or price levels unless aggregate demand intersects supply where it is positively sloped.


If the Conventional Supply Curve is assumed, what happens to equilibrium when AD and AS change?

  1. An increase in aggregate demand alone will increase both output and price level. 
  2. An increase in supply alone will increase output, but reduce price level. 


An increase in the value of the Chinese currency RMB relative to the US dollar would most likely cause what?

An increased aggregate demand in the U.S.

An increase in the value of the Chinese RMB relative to US dollar would most likely increase aggregate demand in the US. An increase in the value of Chinese RMP relative to US dollar would make Chinese goods more expensive in the US ands US goods less expensive in China. 

As consecuence, fewer goods would be bought from China by US customers and more goods bought from US by Chinese consumers. Furthermore, US consumers might also buy (substitute) more US goods for the now more expensive Chinese goods. 


A rise in a country's exports would most likely cause which shift?

The aggregate demand curve would shift outward.

A rise in exports of a country most likely would shift the aggregate demand curve outward; i.e., there would be an increase in demand. 


The aggregate demand and supply curves intersect at a price and quantity that are: (relative to potential GDP)

Either at, above, or below potential GDP.

Potential GDP is the maximum amount of various goods and services an economy can produce at a given time with available technology and full utilization of economic resources.

The point at which the aggregate demand and aggregate supply curves intersect is equilibrium--the real output (and price level) for an economy. The real output may be at, above, or below potential GDP (output). 


What are business cylcles?

They are cumulative fluctuations (up and down) in aggregate real gross domestic product.

  • They are measured in real GDP
  • Recur over time
  • No consistent pattern of length (duration) or magnitude (intensity)
  • They impact different industries at different times and with different effects
  • They take the form of graph attached.



Identify and describe the elements of business cycles:

  1. Peak: Point that marks the end of rising aggregate output (expansionary period) and the beginning of a decline of output (recessionary period).
  2. Trough: Point that marks the end of a decline in aggregate output (recessionary period) and beginning of an increase in output (expansionary period). 
  3. Economic Expansion or Expansionary Period: Periods during which aggregate output is increasing.
  4. Economic Contraction or Recessionary Period: Periods during which aggregate output is decreasing. 


Define "Recession":

  • There is no official quantitative decision
  • Natural Bureau of Economic Research qualitative definition:
    • "A significant decline in economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment...industrial production, and whole sale retail." 
  • Its unofficial quantitative definition: 
    • 2 or more quarters of negative change in real GDP
    • Downturn in real GDP of 10% or less


Define "Depression": 

  • No official quantitative definition.
  • Not officially recognized by National Bureau of Economic Research as a separate circumstance or period.
    • "If you don't define it, you won't have it".
  • Unofficially depression defined:
    • Decline in real GDP exceeding 10%
    • Decline in real GDP lasting 2 or more years


What are the primary causes of business cycles?

  • There's no single theory that fully explains the causes and characteristics of business cycles.
  • Nevertheless, a major cause is changes in: 
    • Business investment spending (plant, equipment, etc.) and
    • Consumer spending on durable goods (goods used over multiple periods, like major appliances, automobiles, etc.)
  • If ecomomy is in equilibrium, resources are being fully utilized. 
  • A decrease in investment and consumer spending will result in output declining. This is a recessionary period and results in less than full utilization of economic resources - unemployment will increase and plant and equipment will be underutilized.  


Declines/Increases in Consumer Spending and Business Spending may be caused by what factors:

  1. Changes in taxes
  2. Changes in interest rates
  3. Changes in outlook and confidence


What are Business Cycle Indicators

Changes in specific measures of economic activity that are associated with changes in overall business cycle.

  • Indicator types:
    • Leading economic indicators
    • Lagging economic indicators


Describe "Leading Indicators":

  • They are changes in measures that occur before changes in the business cycle.
  • Economists and business groups use them in an effort to anticipate changes in the business cycle
  • They include measures of:
    • Consumer expectations
    • Initial claims for unemployment
    • Weekly manufacturing hours
    • Stock prices
    • Building permits
    • New orders for consumer goods
    • Real money supply


Describe "Lagging (Trailing) Indicators":

  • Changes in measures that occur after changes in business cycle.
  • They are used to confirm elements of business cycle timing and magnitude.
  • They include measures of:
    • Changes in labor cost per unit of output
    • Ratio of inventories to sales
    • Duration of unemployment
    • Commercial loans outstanding
    • Ratio of consumer installment credit (land loan, home construction loan) to personal income.


Over time, what results of changing prices and price levels?

  • Changes in prices and price levels will cause changes in various measures of economic activity and economic outcomes. 
    • For example, changing price levels created the need for a measure of gross domestic product (GDP) adjusted for changing price levels, called Real GDP. 
    • Adjustments to squeeze out the effects of price levels on economic measures are accomplished by using price indexes (or indices).


What are Price Indexes?

Price indexes convert prices of multiple periods to what they would hace been in a single base period.

  • Base period = 100%
  • Each period measured as a percent of base period
  • Bureau of Labor Statistics prepares most US indexes.


Identify three common price indices:

  1. Consumer Price Index (CPI);
  2. Wholesale Price Index (WPI) or Purchase Price Index (PPI);
  3. Gross Domestic Product (GDP) Deflator.


Define "Consumer Price Index" (CPI):

CPI relates price of a basket of goods and services during a period to a price of that basket in a prior base period.

  • Most common CPI index is CPI-U = Consumer Price Index for all urban (U) consumers.
  • Base period for CPI-U is average prices for 36 month period 1982 through 1984.
  • Base period 100%


  • 1982-84 base=100.0%
  • 2012 = 229.6%
  • 2013 = 233.0%


  • 2012 prices were 129.6% higher than 1982-84 base period.
  • 2013 prices were 133% higher than 1982-84 base period.




CPI-U - Measuring Inflation/Deflation Example:

Rate of change in CPI-U measures rate of inflation/deflation.


  • 2013 CPI-U = 233.0
  • 2012 CPI-U = 229.6
  • 2012->2013 change = +3.4
  • Rate of change = 3.4 / 229.6 = .0148 = 1.48%
  • 2013 inflation rate = 1.48%



What's the Purchase Price Index (PPI), formerly Wholesale Price Index (WPI)*:?

  • It measures the average change over time in the selling prices received (revenues received) by domestic producers for their output. 
  • The prices included are from the first commercial transaction of producers for their domestically produced goods, services, and construction output.
  • Calculations are done in the same way as CPI-U but because the price changes are from the perspective of the producer/seller, the values used are selling prices of (revenues received by) the first producer rather than the cost to end buyers. 


What entitles the Gross Domestic Product (GDP) Deflator?

  • It relates Nominal GDP to Real GDP
  • It attempts to include all spending in GDP
  • It is the most comprehensive measure of price level since GDP includes not only consumer and business spending, but also government and net exports.
  • Composition of basket changes more frequently than CPI or PPI (WPI)

GDP Deflator = (Nominal GDP / Real GDP) x 100


Define "Inflation":

  • It's the rate of increase in the price level. 
  • The most common yardstick to measure inflation/deflation is CPI-U
  • The U.S. has experienced annual inflation since the 1930s. 


What are the two fundamental causes of Inflation?

  1. Demand induced (Demand-pull) inflation: Aggregate spending for goods and services exceeds productive capacity of the economy at full employment.
    1. Excess demand pulls up prices.
  2. Supply Induced (Cost-push) Inflation: increases in the cost of inputs result in higher prices passed on to end user. 
    1. To the extent the producer absorbs the increase in cost of inputs and does not pass them on to final buyer, inflation does not occur (or is differed).
    2. An increase in cost of inputs, shifts aggregate supply curve inward. As a result, price level increases, and generally output decreases, causing unemployment to increase. 


What are the Consequences of Inflation?

  1. Results in lower current wealth and real income, which results in reduced aggregate demand:
    1. Because of inflation, monetary items ( those fixed in dollar amount) lose purchasing power.
    2. Consumers on fixed incomes, or those with incomes that do not keep pace with inflation, will reduce consumption.
    3. Similarly, creditors repaid w a fixed number of dollars will be able to purchase less with those dollars.
    4. The effect of less consumption is a reduction in aggregate demand leading to lower output and higher unemployment.
  2. Results in higher interest rates as lenders seek to keep up with inflation, which results in reduced investment capital goods:
    1. Higher interest rates increase the cost of borrowing, which reduces the both consumer spending and business investment in capital goods.
    2. Further, lenders may tighten loan requirements, and thereby, squeeze marginal borrowers out of the market, which also would reduce spending. 
  3. Generally leads to uncertainty in the economy, which results in postponed economic commitments:
    1. The changing real value of the dollar makes it an uncertain measure for making economic decisions.
    2. Price increases are create uncertainty about future costs, prices, profitability, and cash flows.
    3. Consequently, individuals and businesses are likely to postpone investments, which in turn, reduces current demand and future productive capacity. 
  4. Inflation = Primary target of fiscal / monetary policy:
    1. Because inflation has signnificant adverse consequences for the economy, control of inflation is a primary economic objecive of government fiscal and monetary policy. 


Describe "Deflation":

  • It's the annual rate of decrease in the price level. 
  • Deflation is different from disinflation, which is a decline in the rate of inflation.
  • Like inflation, deflation may be caused by changes in aggregate demand and/or aggregate supply:
    • Demand changes can result in deflation when there is a significant decrease in demand (as might be caused by significant drop in consumer confidence) which results in a widespread reduction in prices by sellers in an attempt to stimulate sales.
    • Supply changes can result in deflation when there is an increase in aggregate supply (as might be caused by significant drop in cost of inputs) that significantly exceeds an increase in aggregate demand. This, too, results in sellers reducing prices in an effort to increase sales. 


How does Inflation distort reported income?*

  • Depreciation is NOT reflective of current fixed-asset replacement costs.
    • Depreciation (expense) reflects the portion of the historical cost of the asset allocated at the current period. 
    • Since the asset may have been acquired many periods ago, during inflation, the current allocation will reflect the old price of the asset, not the current price (replacement cost) of asset. 


Example - Measuring percentage change adjusting for inflation:

  • Expenditures 10 yrs ago= $72,800
  • Last year's expenditures= $100,500
  • CPI 10 yrs ago= 121.3
  • CPI las year = 168.5
  1. 168.5 - 121.3 = 47.2
  2. 47.2 / 121.3 = .38911 = inflation rate
  3. $72,800 x 1.38911 = $101,127 (Adjusted for inflation)
  4. $101,127 - $100,500 = $627
  5. $627 / $101,127 = .0062 or .6% decrease


What is correct regarding the CPI for measuring the estimated decrease in a company's buying power?

  • The products a company buys should differ from what a consumer buys.
    • The CPI measured change over time of a basket of goods and services purchased by consumers, not by companies.
    • Goods and services purchased by companies would be expected to be different that those purchased by consumers.


Example of GDP Deflator:

Year GDP Deflator

  • 2001 - 175
  • 2002 - 180
  • 2003 - 184

If Nominal GDP is $11,500 billion, what's the real GDP for 2003?

  1. GDP Deflator = (Nominal GDP / Real GDP) x 100
  2. 184 = (11,500 / x) x 100
  3. 1,150,000 / x = 184
  4. 1,150,000 = 184x
  5. 1,150,000 / 184 = $6,250 billion Real GDP


  1. 2003 prices are 184% of base period prices.
  2. $11,500 / 1.84= $6,250 billion Real GDP


Money Roles Defined:

  • Money is central to economic activity
  • Functions of money are:
    • Medium of exchange - common means of payment in exchange for goods/services
    • Measure of value - Common denominator for assigning value and measuring economic activity
    • Store of value - Retains value over time to be used in the future. 


Who controls the money supply?

  • The United States Federal Reserve System (the Fed) manages the money supply and regulates the banking system. 
  • Through its management of money supply and related activities, the Fed can excercise significant influence over elements of the economy. 


What are the 3 measures of money that the Fed provides? What do they include?

  • M1: narrowest definition (measure) of money.
    • Definition based on intruments used for transactions.
    • They are the primary financial instruments used for transactions.
    • Includes:
      • Paper currency and coin currency held outside banks.
      • Check-writing deposits in banks - funds that can be accessed using checks. 
  • M2:
    • The primary focus of Fed actions to influence the economy.
    • Includes all items in M1 plus:
      • Savings deposits
      • Money-market deposits
      • Certificate of deposits less than $100,000
      • Individual-owned money-market mutual funds
  • M3: Includes all items in M2, plus:
    • ​Certificates of deposits greater than $100,000
    • Institutional-owned money-market mutual funds


What does the Federal Reserve System (Central Banking System in U.S.) consist of? 

  1. Federal Board of Governors = Seven-member policy making body of the Federal Reserve System.
  2. Fed Open-Market Committee = Twelve-member body responsible for implementing monetary policy to effect money supply through open market operations.
  3. Federal Reserve Banks = Twelve district banks each responsible for a geographical area.
    1. Owned by member institutions, including:
      1. Commercial Banks
      2. Savings and Loan Associations
      3. Mutual Saving Banks
      4. Credit Unions
  • Members of banks operate under uniform policies of the Fed.
  • Individual, business firms, and other entities deal with these financial intermediatries, but not directly with the Federal Reserve Banks. 


Define "Monetary Policy": 

  • It is concerned with managing the money supply to achieve national economic objectives, including:
    • Economic growth
    • Price level stablity
  • The Fed exercises monetary policy through:
    • Reserve requirements
    • Open market operations
    • Discount rate


Fed exercised monetary policy through Reserve-Requirement Changes, explain:

  • Reserve-Requirement changes: Percentage of loans made by banks that must be held in reserve.
    • A bank's ability to issue check-writing deposits is limited by a reserve-requirement by the Fed on check-writing deposits.
    • Example:
      • 10% reserve requirement = $10 held in reserve for every $100 in loans.
      • Increasing reserve requirements = Decreases loans and money supply.
      • Decreasing reserve requirement = Increases loans and money supply.


The Fed can exercise monetary policy through Open Market Operations, explain:

  • Open Market Operations: Fed buying and selling U.S. Treasury debt with member banks. 
    • Example:
      • Buying US Treasury debt from member banks= Increases funds available to banks for loans.
    • Buying debt from member banks = Increases money supply
    • Selling debt to member banks = Decreases money supply
    • Open market operations are one of the preferred methods of changing the money supply because it permits changes of various degrees. 


The Fed can exercise monetary policy through Discount Rate, explain:

  • Discount rate = interest rate member banks pay when borrowing from the Fed.
    • Borrowing from the Fed increases a bank's reserves with the Fed because the borrowing is credited to the bank's reserves with the Fed, not withdrawn from the Fed Bank.
    • Increased reserves, banks are able to increase loans.
    • Increasing discount rate = Reduced borrowing and reduced money supply
    • Decreasing discount rate = Increased borrowing and increased money supply


What are the government's efforts to increase aggregate spending (and reduce unemployment, increase GDP, etc.)? 

  • Policy Type                         Government Action
  • Increase govt spending     Fiscal
  • Reduce taxes                      Fiscal
  • Increase money supply      Monetary


Fiscal and Monetary Policy Summary:

  • Monetary policy: Primary approach used:
    • Implemented more quickly
    • Less political influence
    • Does not redistribute output and income as much as fiscal policy. 
  • Fiscal Policy: Approved by Congress, changes may be delayed, or never approved. Takes too much time. 


True or False: An increase in money supply will tend to reduce the market rate of interest:

True: An increase in money supply will lower the short-term interest rates. See graph:


An economy is at the peak of the business cycle. What policy package is the most effective way to dampen the economy and prevent inflation?

  • Reduce government spending
  • Increase taxes
  • Reduce money supply
  • Increase interest rates

All of these 4 fiscal and monetary policy actions would function to dampen demand, and therefore, economy would help prevent inflation. 


Which action is the acknowledged preventive measure for a period of deflation?

  • Increasing money supply = When the economy is in deflation, increase in money supply (for example, lowering reserve requirements or lowering discount (interest) rates, will stimulate demand and increase general price level.