ECO 2013-01 --- Quick Review for Second Midterm, Tuesday 9 November.

The exam will cover chapters 6 through 13. Some key issues to concentrate on from the covered chapters follow below. This is just quick notes in text, no diagrams. You would be wise in preparing for the test to also look at the regular notes, which have diagrams in them, and to look at the "chapter quiz" multiple choice questions in the workbook. There is a review session on Monday 8 November at 6.45 p.m. in room 049 Bellamy.

Chapter 6 [second half]: The idea of a price index and the distinction between 'real' [price change has been taken out] and 'nominal' on 'money.' The CPI -- Consumer Price Index, ratio of cost of a fixed basket of goods and services to the cost of the same basket in the base period, times 100 to make it an index with the base period index number 100. Inflation as the rate of change of the price level, i.e. a price index. 'Real' = 'money' minus inflation, approximately.

Chapter 7: Almost entirely definitions about employment and unemployment. Ideas of the labor force [employed plus unemployed], labor force participation rate [ratio of labor force to working age population], unemployed [not gainfully active but actively seeking gainful activity], employed [having gainful activity], not in the labor force [not gainfully active and not seeking gainful activity]. Types of unemployment: frictional [normal turnover, search]; structural [available jobs don't match characteristics of job-seekers where they are]; cyclical [caused by business cycle, aggregate demand for labor less than available supply of labor]. Full employment is not zero unemployment, it is zero cyclical unemployment -- and equivalent to the unemployment when actual GDP equals potential GDP -- the capacity of the economy to produce output at a sustainable rate in the long run.

Chapter 8 and first half of 12: Aggregate Demand and Aggregate Supply. A metaphor for the whole economy: we draw the graphs with the price level for output [GDP price deflator] on the vertical, real GDP on the horizontal. Aggregate Demand shows how much output the economy wants to buy for given money supply, income, foreign income and prices, wealth, etc, at different levels of the price level for output. It slopes down because (1) wealth effect: higher prices mean the money people hold buys fewer goods, so they want to buy fewer; (2) substitution effects: higher prices mean higher money interest rates, people want to buy less with borrowed money; and higher US prices mean US goods are more expensive relative to foreign goods, so people want to buy fewer US goods. In the long run, Aggregate Supply is vertical: it reflects potential, full employment GDP, i.e. the capacity of the economy to produce output at a sustainable rate in the long run -- and that is the same whatever the price level. In the short run, SAS -- short run aggregate supply -- slopes up to the right because input prices are initially fixed when output prices change, so if output prices go up, input prices fixed, it is more profitable to produce so producers want to supply more. In the longer run, input prices will adjust to a sustainable level more appropriate to the output price level, so the SAS will shift up or down to bring output back to the LAS -- long-run aggregate supply -- potential GDP level.

AD can be shifted by changes in expectations, or changes in government fiscal or monetary policy, or changes in foreign economic conditions -- anything that changes how much US output people will want to buy at an unchanged output price level. LAS is shifted by things that cause economic growth, move the PPF out: technical change, investment in physical or human capital, better organization. SAS is shifted by things that effect input prices -- wage rates, import prices, etc.

Keynesian Macro assumed in the short-run ALL prices were fixed, so argued that expenditure on output would determine the level of output. If planned aggregate expenditure was different from actual output, output would have to adjust -- and inventory change would be the signal to make it, because the difference between planned expenditure and actual output would result in unplanned inventory change. AD, Aggregate Demand, and AE, Aggregate Expenditure, both have the same defining equation, C + I + G + (X - M), but the meaning is different -- in the AE case, C and I are planned rather than actual. Changes in AE will produce larger changes in equilibrium output and income because of multiplier effects -- the change in spending changes household income, therefore consumption expenditure, therefore output and incomes again, etc etc.

Chapter 9: This was about the relationship between GDP and labor input, i.e. employment. The emphasis should be on what increases labor productivity and therefore causes growth in output [investment in human capital, more physical capital per worker, technical change, better organization]; on the notions of job search [looking for a good job, not just any job, generally takes longer] and what may prolong it [anything that lowers the opportunity cost of unemployment -- e.g. higher unemployment compensation, another worker in the household]; and the idea of job rationing -- employers may rationally choose to pay more than the lowest wage they could, e.g. to get better workers, or buy loyalty and greater productivity, etc.

Chapter 10: This was a parallel chapter on capital, saving, and investment. Apart from definitions, key ideas are that investment -- purchase of new physical capital -- can be expected if the expected profit rate on the investment is bigger than the opportunity cost, i.e. the real rate of interest [money rate minus the inflation rate]. More projects will pass this test if the real interest rate is lower, so the investment demand curve will slope down to the right. If expectations improve, so the expected profit rate on most projects rises, the curve will shift out to the right. Private saving is household saving plus corporate saving; it is likely to be positively related to interest rates [i.e. slope up to the right], if inelastically [there are both substitution and income effects, in opposite directions, for households]. But government can also save [if T - G is positive, that is government saving -- net taxes minus government purchases]; and we can borrow from the rest of the world [if M - X is positive, that is foreign saving -- we imported more than we exported, we borrowed to pay for that difference]. Financial capital is mobile between countries, and it will respond to interest rate differentials, with appropriate allowance for risk differentials; this is the overall reason why the saving supply curve slopes up to the right, higher real interest rates will produce more finance to pay for investment.

Chapter 11: This is about economic growth. Skip the portion on growth accounting. Key issues here are prerequisites for growth: markets, clear and enforceable property rights, monetary exchange, thereby permitting incentives for the activities that facilitate growth -- investment in physical and human capital, and discovery of new technology. Then we looked at three forms of growth theory: Malthusian or Classical growth theory, which argues that if incomes rise above the subsistence level, population will grow until wages are driven back down to subsistence levels; neoclassical growth theory that stresses technical change inducing investment and saving, and suggests that eventually all countries would reach the same steady state with the same technology, and no growth because diminishing returns to capital would mean that there was no profit from raising capital per worker more; and so-called new growth theory, which argues that new knowledge, i.e. technical change, can have large external [positive spillover] effects, and therefore if technical change continues it can indefinitely offset diminishing returns to capital and growth can continue for ever.

Chapter 12 second half: Getting straight what the size of the multiplier is. The Marginal Propensity to Consume MPC [the fraction of an extra dollar of disposable income spent on consumption] measure how much consumption expenditure will change when income changes, so how much extra aggregate expenditure [and therefore output] there will be. MPC + MPS = 1, by definition. So, in an economy with no taxes or foreign trade, the multiplier will be 1/MPS or 1/(1 - MPC). Taxes and foreign trade reduce the size of this expenditure multiplier, because they mean a smaller fraction of a change in income is spent on US-produced output [and therefore generates more extra output, more income, more rounds of expenditure and output increases].

Chapter 13: Fiscal Policy. Fiscal policy is changing government purchases, transfers, or taxes, to affect the macro economy. Definitions -- budget surplus, deficit, balanced budget, government debt. Automatic fiscal policy is that which happens just because of the structure of taxation and government entitlement [transfer payment] programs -- automatic stabilizers. Discretionary fiscal policy is deliberate changes in the government budget stance; in the US, it is not really feasible because the constitutional structure means that decisions take too long and are too uncertain [it is used a good deal in countries, e.g., with parliamentary systems, where decisions on taxes and government spending can be taken much faster -- e.g. Canada]. Fiscal policy multipliers can be calculated: with only lump-sum taxes and no foreign trade, the government purchases multiplier will be 1/(1 - MPC); the lump-sum tax multiplier will be smaller because initially taxes change disposable income, not output itself -- so is -[MPC/(1 - MPC)]. Induced taxes are taxes that change with income or output -- like income taxes or sales taxes. Expansionary fiscal policy is fiscal policy that increases AD, tends to increase output and the price level; contractionary fiscal policy is fiscal policy that reduces AD, tends to reduce output and the price level. Traditional view is that fiscal policy has small effects on AS; supply-siders argue that fiscal policy can have large impacts on AS via effects on incentives to work and save/invest. Size and even direction are theoretically unclear because income and substitution effects work in opposite directions.