Review sheet for second test, 6 April 1999

Review session for second midterm (Tuesday 6 April):

Two: first at 5.15 p.m. Monday April 5 in room 120 Bellamy;

Second at 6.45 p.m. Monday April 5 in room 221 Bellamy.

Your second test will cover chapters 6 through 14, although you cannot expect to answer all the questions unless you still remember the vocabulary and concepts from chapters 1 through 5. The test will be about 60 multiple choice questions.

Key points from each chapter include:

6.  National Income Accounting.  Final as opposed to intermediate goods.  GDP as opposed to GNP.  Methods of estimations/calculation: Value-added (resource-cost) and expenditure.  Real and nominal (money): price indices, the consumer price index (CPI: change in cost of fixed basket of goods and services) and GDP deflator.  Final goods as C + I + G + (X - M).  G is government purchases, distinction between purchases and transfer payments.  GDP does not measure welfare or well-being, it measures market output of final goods.

7. The business cycle. Expansion-boom-contraction-recession

Unemployment, employment, and not in the labor force; rates. Structural, Cyclical, and Frictional unemployment.

Full employment, 'natural rate' of unemployment.

Inflation and its effects; anticipated (expected) versus unanticipated inflation, effects -- 'winners' and 'losers'.

'Real' versus 'money' interest rates, etc.: Money = real + inflation.

Interest rate changes and bond price changes [nominal interest rate up, price of bonds down, vice-versa]
 
 

8. - Aggregate Demand and Aggregate Supply, AD, SRAS, LRAS, in the goods and services market, and the concepts of equilibrium and potential (full employment) output;

- Why AD slopes down (real balance effect [purchasing power of the stock of money when price level changes], interest sensitive spending, exports and imports if our prices change and foreign ones don't)

- LRAS is vertical -- natural rate of unemployment [equals "full employment"]

- SRAS slopes up, for given input prices -- input prices at the price level SRAS cuts LRAS [because if output prices change and input prices have not adjusted yet, production profitability changes so output will change]

- How adjustment occurs: if off LRAS, output prices (the Y-axis) and input prices (where SRAS cuts LRAS) are inconsistent, so input prices will move toward output prices, shifting the SRAS to the new input price level; process continues until back on LRAS with AD and SRAS intersecting on LRAS.

- Money (nominal) versus real again (e.g. GDP, interest rates, etc)

- Loanable funds market and resource (employment) market

- Fiscal [government tax and expenditure] and Monetary [money supply, interest rates] policy (definitions, tools, who decides)
 
 

9. - Changes in aggregate demand and aggregate supply; movement to new equilibrium

- AD = C + I + G + (X -M); anything that changes AD changes aggregate demand; SRAS depends on (expected) input prices; LRAS is vertical, depends on capacity of economy to produce output. Why AD and SRAS have the slopes they do.

- Speed of adjustment and consequences if slow (costs to being out of LR equilibrium; case for discretionary policy to return to LRAS) or fast (leave economy alone)

10. - Keynesian (Aggregate Expenditure) model [AE = planned C + I + G + (X -M)]; determinants of Consumption, MPC, MPS, APC, APS

- autonomous expenditure; if planned expenditure does not equal income, what happens? [unplanned inventory change leading to output change]; possibility of equilibrium at income level different from LRAS, i.e. different from full employment (natural rate of unemployment) output.

- the multiplier, connection to MPC, how to calculate, how to use

- multiplier is [1/(1 - mpc)]; multiply initial change in autonomous expenditure to get final change in equilibrium GDP [Why? Because spending change implies income change implies more spending implies more income change etc]

- planned versus actual investment, connection to inventory change

- aggregate expenditure and its components
 
 

11. - Keynesian fiscal policy and critiques; "crowding out" (government borrowing raises interest rates, reduces private interest-sensitive spending; why international flow of funds to loanable funds market will dampen size of crowding out effect [if interest rate in US up, ceteris paribus foreign funds will flow in and reduce interest rate increase dampening crowding out effect; but also will tend to increase foreign value of $, reducing net exports and thus AD. Which effect dominates is an empirical question])

- Timing problems; why discretionary fiscal policy is non-feasible in US except in extreme circumstances

- automatic stabilizers [features of tax and expenditure structures that dampen AD changes; examples include income tax, corporate profits tax, unemployment compensation]

- government borrowing, interest rates, international capital flows, effects on exchange rates, exports, and imports

12. - Definition of money; idea of liquidity -- immediately usable for transactions

- Banks, the Fed, and money supply; the connection: fed liabilities à bank reserves à required reserve ratios à money; deposit expansion multiplier ($1 of reserves 'supports' $1/(required reserve ratio) of bank liabilities, i.e. deposits)

- tools of monetary policy: required reserve ratio, open market operations, discount rate and "target" federal funds rate

- expansionary and restrictive monetary policy; which is appropriate when

- Fed liabilities are currency and bank reserves; hence Fed buying existing bonds, pays the public, increases reserves, expands money supply; Fed selling bonds reduces its liabilities (when the Fed is paid, currency goes out of circulation or reserves are reduced), contracts money supply.
 
 

13. - Demand for money -- the demand to hold some wealth in the liquid form, money, rather than as some other asset; transactions, precautionary, and 'speculative' motivations.

- Opportunity cost of holding money -- the nominal interest rate, i.e. what you give up by holding money (not interest-earning) rather than the closest substitute, an interest-earning asset

- Hence, increase money supply à nominal interest rate down à real interest rate down à investment, other interest-sensitive spending (consumer durables) up à AD up à output up if there is spare capacity (below full employment), prices up if at or above full employment;

- Decrease money supply à nominal interest rate up à real interest rate up à I, C down à AD down à output and/or prices down.

- Time lags -- effects of changes in money supply not felt immediately, but after a time lag -- of uncertain and maybe variable length (6 to 18 months)

- In long run, expansionary money supply effects will mainly be on price level, not output;

- Alternative (monetarist) view: spending is the appropriate alternative to holding money, therefore direct effect from money supply changes to AD; effects on output temporary, on prices permanent.

- PxQ = MxV, definition of velocity -- (nominal GDP)/(money supply). The faster velocity, the shorter the time you hold money on average; hence when nominal interest rates up, more expensive to hold money, you hold less, get rid of it quicker, velocity up. Velocity changes reduce size of real (AD, output) effects of monetary policy. In extreme -- very rapid money supply growth, hyperinflation -- no output effects at all, all effects on velocity and price level. Then expansion of money supply increases nominal interest rate, no effect on real interest rate.

14.    Expectations: adaptive (based on past) versus rational (use all information; random errors).

Phillips curve: relationship between rate of unemployment and rate of inflation, apparent short-run trade-off between more inflation or more unemployment.

Anticipated versus unanticipated demand stimulus, evidence that there is no long run ability to deviate from the natural rate of unemployment (i.e. the long run Phillips curve is vertical, the short run Phillips curve can move as expectations adjust).

15.     Stabilization policy: activists versus non-activists.

Source of macro instability; speed of self-correcting mechanism; timing difficulties of discretionary policy [because monetary policy has effect after a time lag of uncertain length, plus recognition and decision lags]; impact of rules.

How implement:
    activists -- leading indicators, forecasting, other indicators;
    non-activists, rules for money supply growth or money GDP growth or price level.