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York University
ECON 1010
Sadia Mariam Malik

ECON 1010 Final Exam-AID Review Package Course Coordinator: Samia Ashraf Coordinator E-mail: [email protected] TTutor: Jun Wangel Contributors: Raghav Goel, Jun Wang, Samia Ashraf York SOS: Students Offering Support Raghav Goel, Jun Wang, Samia Ashraf This document is directed to ECON 1010 students at York University whom are looking for an additional resource to aid them with studying for the course final exam. It has been created with regard to the Winter 2011 course and is subject to change for future courses. References: 1. Parkin, Michael, and Robin Bade. Macroeconomics : Can ada in the Global Environment. 7 th ed. Upper Saddle River: Pearson Education Canada, 2010. !"#$%&'()*(+(,-.'/01(234(#05(678089/7( 2'8:%"( Gross Domestic Product (GDP) Definition – the market value of all final goods and services produced within a country in a given time period • “market value” – the value of a product/service in dollars • “final goods and services” – an item that is bought by its final user; intermediate goods are goods purchased by a company to use to make another product ! Ex. flour purchased by a baker to make pastries is an intermediate good, but the pastries purchased by a customer for consumption are considered f inal goods (note: if the customer purchased flour from the baker, the flour would be considered a final good) • “within a country” – simply means produced within the physical boundaries of the country • “given time period” – usually a year (this would be annua l GDP), sometimes a 3 month period (quarterly GDP) Components • Consumption expenditure – the total payment for all the goods and services purchased by households • Investment – goods bought for future use (i.e. they will be not be consumed quickly, but will last some time) ! Note: investment does not only refer to businesses; families can make purchases such as houses which will provide future benefit and are considered investments, not consumption • Government expenditure – goods and services bought by federal, provincial, and municipal governments • Net exports – this is equal to exports minus imports (what we pay to other countries minus what we get from other countries) GDP Equation and Circular Flow Raising Marks, Raising Money, Raising Roofs 2 York SOS: Students Offering Support • Y = C + I + G + X – M, where Y is GDP, C is consumption expend iture, I is investment, G is government expenditure, X is total exports, and M is total imports • Y is also called income. This means GDP = Income = Y. Also notice that C, I, G, and -M) are expenditures, and so we can say Expenditures = Income. This is cal led circular flow. All this is saying is that one person’s expenditure is another’s income, and eventually, that income will become expenditure when that person buys goods, and so on. Measuring GDP Two Methods to calculate GDP (or as mentioned above, also known as Y): • Expenditure approach: add up all expenditures ! Equation: Y = C + I + G + X – M • Income approach: add up all the income earned ! Equation: Y = wages, salaries, and supplementary income earned + corporate profits + interest and miscellaneous income + farmer’s income + income from no -farm unincorporated businesses + indirect taxes – subsidies + depreciation • Remember, both approaches will yield the same value of Y because of circular flow • Nominal GDP – the value of Y expressed in dollars • Real GDP – goods and services produced valued at the prices of a reference base year (still in dollars) Limitations of GDP • Nominal GDP ! GDP can appear to increase even if production stayed the same (this is because rising prices will inflate the market value in dollars of good/services) • Real GDP ! Does not take into account household production such as preparing meals, cleaning, caring for children ! Does not take into account underground activity (eg. Illegal, “under the table” transactions) ! Does not take into account thing s of value which are hard to quantify, such as health and life expectancy, leisure time, environmental quality, and political freedom and social justice !"#$%&'();(+(,80/%8'/01(<8=-(#05(>[email protected]#%/80 ( Why is unemployment a problem? 1) Lost production for the eco nomy and lost income for the individual 2) Lost human capital – a laid off worker becomes “out of touch” after prolonged unemployment, and doesn’t have the new skills necessary to land a job Labour Force Survey – monthly survey conducted by Statistics Canada • Working age population – number of people aged 15 and over; consists of people either in the labour force or not • Labour force – members of the working age population who are employed or unemployed (but to be counted as unemployed, you must be looking for work or waiting to be called back to work or waiting to start a new job) • Four Labour Market Indicators 1) Unemployment rate = number of people unemployed / labour force x 100, where the labour force = number of people employed + number of people unemployed 2) Involuntary part time rate = number of involuntary part time workers / labour force x 100 (Note: an involuntary part time worker is a part time worker who wants to work full time) Raising Marks, Raising Money, Raising Roofs 3 York SOS: Students Offering Support 3) Labour force participation rate = labour force / working age population x 1 00 4) Employment to population ratio = number of people unemployed / working age population x 100 • Marginally attached worker – a person who is not working or looking for work, but wants to work • Discourage worker – marginally attached worker who has stopped looking for work because of repeated failure to find one Types of Unemployment • Frictional unemployment – caused by the time it takes workers to find the right job (even if the right employer for you is out there, it is impossible to find them immediately ) • Structural unemployment – when changes in technology or international competition change the skills necessary to perform jobs, people must switch to other industries and often relocate; this takes time • Cyclical unemployment – unemployment due the swings in the business cycle • Natural unemployment – the sum of frictional and structural unemployment (the normal state of the economy); this is also known as full employment Inflation – a change in the average level of prices • Inflation is a problem because 1) it arbitrarily redistributes money between lenders and borrowers and 2) entices people to start speculating, thus diverting them from doing their job Measuring Inflation • The inflation rate is approximated by the percentage change in the Consumer Price Ind ex (CPI). The CPI is a statistic calculated monthly by Statistics Canada to measure the average price paid by an urban consumer for a fixed basket of goods. • Calculating the CPI 1) Construct the “basket of goods/services” by choosing items which are purchasedby the average urban consumer. Assign weights to the items based on how much they cost. 2) Record the monthly price of each item. 3) Calculate the cost of the CPI basket by weighting the items against current prices and base year prices (the base year is an arbi trarily chosen to have a CPI of 100). 4) CPI = cost of CPI basket at current prices / cost of CPI basket at base year prices x 100 • Inflation rate = percentage change in CPI !"#$%&'())(+(678089/7(2'8:%" ( !"#$#%&"'()#*+,'+(-.-%#/0&5(1'8:%"(/0(!"#$%#&'()234(A-&&(=&@8:B( • Economic growth rate = percentage change in real GDP Potential GDP – level of real GDP when the quantity of labour employed is at the full employment (or natural) level • Finding potential GDP 1) Find the equilibrium quantity of labour hours by locatin g the intersection of the labour demand and labour supply curves 2) For this quantity of labour hours, find the corresponding real GDP output on the aggregate production function ! The aggregate production function graphs the relationship between real GDP and l abour hours 3) The quantity of real GDP at the equilibrium labour hours quantity is the potential GDP Raising Marks, Raising Money, Raising Roofs 4 York SOS: Students Offering Support • Growth Determinants of Potential GDP 1) Growth of the supply of labour: the labour supply curve shifts to the right, the equilibrium labour quantity increases, shift up along the aggregate production function to a higher potential GDP 2) Increase in labour productivity: the demand for labour increases because labour is more efficient, the labour demand curve shifts to the right and the equilibrium labour quan tity increases, this is represented on the aggregate production function by an upwards vertical stretch Growth Determinants of labour Productivity • Physical capital growth – increase in capital per worker increase worker output • Human capital growth – increase in skill level of workers increases worker output • Technological advances – more productive capital and efficient processes lead to increased worker output Growth Theories • Classical growth theory – GDP growth is temporary because as soon as GDP increas es, people are healthier and have more children, thus reducing the GDP per capita back to subsistence levels ! Proposed by Adam Smith, David Ricardo, and Thomas Malthus, known as the Malthusian Theory • Neoclassical growth theory – sole determinant of economic growth is technological growth ! Proposed by Robert Solow, known as the Solow model • New growth theory – economic growth is a product of knowledge capital; i.e. entrepreneurs are the lifeblood of the economy (note: knowledge capital is not subject to diminis hing returns, and so can produce endless growth) ! Developed by Paul Romer, based on the ideas of Joseph Schumpeter ! Suggestions for achieving (faster) growth: 1) stimulate saving to encourage investment in new ideas, 2) stimulate research and development to accelerate scientific progress, 3) encourage international trade to take advantage of specializing, and 4) improve the quality of education to enhance research ( !"#$%&'()CD(E/0#07&F(G#H/01F(#05(>0H&-%9&0% ( Financial Institutions and Markets • Physical Capital vs. Financial Capital: physical capital: tools, machines, equipment produced in the past to product goods today; financial capital: funds used to buy physical capital • Gross investment is total amount spent on new capital. Net investment is the changevalue of capital. • Wealth is the value of the things we own. Saving increases wealth, it is whatever that is not spent or paid in taxes. Markets for Financial Capital • Loan markets: businesses get loans for expenditures such as inventories, households get loans for high-priced items e.g. mortgage • Bond markets: Trade bonds, which are a promise to make set payments on specific dates, terms of bonds vary • Stock markets: Shares of a corporations stocks are sold, stocks represent ownership of the company, and have a claim on the company’s profits Raising Marks, Raising Money, Raising Roofs 5 York SOS: Students Offering Support Financial Institutions Operate as both a borrower and lender in financial markets. • Banks: Use deposits to buy government bonds and securities and make loans • Trust and Loan Companies: Similar to banks, administer estates , trusts, pension plans • Credit Unions and Caisses Populaires: owned, operated by depositors and borrowers, limited to their own provincial boundaries, small but common • Pension Funds: receive pension contributions from firms, workers, use funds to buy portf olio of bonds and funds to generate income • Insurance Companies: provide risk-sharing services e.g. home, car, theft, funds that are not paid out as claims are used to buy bonds and stocks to generate additional income Solvency and Liquidity • Net worth: market value of what a firm has lent minus market value of what it borrowed, if this is positive, the firm is solvent, they can remain in business • Liquidity is the ability of the firm to pay its obligations – a firm can be solvent but not liquid Interest Rates and Asset Prices • Financial assets: stocks, bonds, short -term securities, if the asset price rises and everything else remains the same, the interest rate falls The Market for Loanable Funds • Financial investment comes from three sources: Household sa ving, government budget surplus, borrowing from international sources , all the individual financial markets form the loanable funds market I= S + (T-G) + (M-X), a government budget surplus will contribute to investment, while a deficit competes with investment • Private saving S and government saving (T -G) equals national saving • Nominal rate is interest paid/amount borrowed while real interest rate adjusts for inflation and is approximately equal to nominal interest rate minus the inflation rate • Demand for loanable funds : relation between quantity of loanable funds demand and the real interest rate: affected by the real interest rate and expected profit (which is influenced by the real interest rate), therefore: higher interest rate, smaller quantity of loa nable funds demanded and vice versa; if expected profit increases (e.g. expansion), investment and demand will increase • Supply of Loanable Funds is the relationship between quantity of loanable funds supplied and the real interest rate: 5 factors that af fect it are real interest rate, disposable income, expected future income, wealth and default risk Higher interest rate= greater quantity of loanable funds supplied and vice versa Increase in disposal income/ decrease in future income/ decrease in wealth/ greater default risk will increase the supply of loanable funds • Equilibrium in Loanable Funds Market: when demand curve and supply curve intersect Surplus of funds: supply > demand, interest rate falls to restore equilibrium Shortage of funds: demand > su pply, interest rate rises to restore demand Changes in demand: an increase in demand (e.g. increase in expected profit) shifts demand curve right, interest rate rises and quantity supplied rises, decrease would be the opposite Changes in supply: an increas e in supply (e.g. increase is disposable income) shifts supply curve right, lower interest rate, quantity demanded rises, decrease would be the opposite Government in the Market for Loanable Funds Raising Marks, Raising Money, Raising Roofs 6 York SOS: Students Offering Support • Government surplus: increases supply, decreases interest rate which decreases household saving and quantity of private funds supplied, lower interest rate leads to increase in quantity demanded and therefore investment increases • Government deficit: increases demand of loanable funds, real interest rate rises whi ch increase household savings and private funds supplied, higher interest rate decreases quantity of funds demand and investment • Crowding-Out Effect: Government budget deficit raises real interest rate and decreases (“crowds out”) investment !"#$%&'()I(+(,80&JF(%"&(4'/7&(K&H&@(#05( >[email protected]#%/80( -,.+'&/'0#$123 ' Money • any commodity or token that is generally acceptable as the means of payment • medium of exchange – generally accepted in exchange for goods and services • barter – exchanged one good or service directl y for another, before money came into use • barter also required a double coincidence of wants • unit of account – agreed measure for stating the prices of goods and services • store of value – anything that can be held and exchanged later for goods and services • Means of payment – method of paying for goods and services or of settling a debt • Consists of - Currency – coins and Bank of Canada notes, declared by the government • Deposits at banks and other financial institutions • Not money: cheques, debit cards, credi t cards Official measures of Money M1 - currency held outside the banks, demand deposits at chartered banks (owned by individuals and businesses) M2+ • M1 in addition to personal savings deposits and non -personal deposits at trust and mortgage loan companies, credit unions, caisses populairs, and other financial institutions • Liquidity – property of being instantly convertible into a means of payment with little loss in value • M2+ is considered to be liquid asset, thus part of money, because it ceasily converted to currency The Banking System Depository Institutions • private firm that takes deposits from households and firms and makes loans to others, three types as follows: • Chartered banks – private firm, chartered under the Bank Act of 1992 to receive deposits and make loans • Credit union – cooperative organization that receives deposits from and make loans to its members • Trust and mortgage loan company – privately owned depository institutions • Reserves – currency in a bank’s vault plus its depo sit at the Bank of Canada • Bank owns four types of assets: overnight loans, liquid assets, investment securities, loans • Economic functions: create liquidity, minimize the cost of borrowing, minimize the cost of monitoring borrowers, pool risk Raising Marks, Raising Money, Raising Roofs 7 York SOS: Students Offering Support Central Bank • public authority that supervises other banks and financial institutions, financial markets, and payments system and conducts monetary policy, it has three roles as follows • Banker to banks and government, Sole issuer of bank notes • Lender of last resort – ready to make loands when the banking system as a whole is short of reserves Payments system – banks make payments to each other to settle transactions by their customers, consists of the following • Large value transfer payments (LVTP) – electronic payments system that allows financial institutions and their customers to make large payments instantly and with the sure knowledge that payments have been made • Automated clearing settlement system (ACSS) – system through which non-LVTP transactions are handled How Banks Create Money Quantity of deposits is limited by: • Monetary base – sum of Bank of Canada notes outside the Bank of Canada, banks’ deposits at Bank of Canada, and coins held by households, firms and banks • Desired reserves – the reserves that banks wish to hold, as oppose to bank’s actual reserves - Reserve ratio – fraction of a bank’s total deposits that are held in reserves - Desired reserve ratio – ratio of reserves to deposits that a bank wants to hold - Excess reserves – actual reserves minus desired re serves • Desired currency holding – • Currency drain ratio – ratio of currency to deposits, measures the leakage of currency from banking system Money creation process: b anks have excess reserves ! lend excess reserves ! deposits increase ! quantity of money increase ! new money used to make payments ! part of new money remains on deposit ! some of new money is currency drain (leakage of currency from banking system) ! desired reserves increase because deposits increased ! excess reserves decrease, but remain positive Money multiplier – ratio of the change in the quantity of money to the change in monetary base ; M = (1+a)/(a+b) " MB • M – quantity of money; MB – monetary base; a – current drain ratio; b – desired reserve ratio Quantity of money that people choose to hold depends on: price level; interest rate; real GDP; financial innovation Demand for money curve • relationship between the quantity of real money demand ed and the interest rate when all other influences on the amount of money that people wish to hold is the same • Leftward and rightward shifts because of increase or decrease in real GDP; shifts along the curve determined by increase or decrease in interest rate Interest Rate Determination • Interest rate – amount received by the lender and paid by a borrower expressed as a percentage of the amount of loan -When calculating perpetuity (bond that promises to pay a fixed amount of money each year forever): -Interest rate = dollar payment per year ÷ price of bond " 100 Raising Marks, Raising Money, Raising Roofs 8 York SOS: Students Offering Support -Money market equilibrium – balanced by Bank of Canada through target the quantity of money or the interest rate Quantity Theory of Money • Increase in the quantity of money brings an equal percentage i ncrease in the price level • P=M(V/Y) V/Y is independent of M, therefore increase in price level brings equal increase in money supply • Inflation rate- money growth rate – real GDP growth rate !"#$%&'()LD(6M7"#01&(N#%&(#05(O#@#07&(8?( 4#J9&0%-(( Currencies and Exchange Rates • Foreign exchange market: currency of one country is exchanged for the currency of another • Exchange rate: price at which one currency trades for another • Nominal exchange rate is how exchange rate is normally stated e.g. in units of focurrent per Canadian dollar • Real exchange: relative price of good compared to price of good in foreign country • Exchange rate exhibits instant response to changes in variables (i.e. changes rapidly) The Foreign Exchange Market • Demand for one currency is s upply of another • Quantity of Canadian $ demanded depends on exchange rate, world demand for Canadian exports, interest rates in Canada and other countries, expected exchange rate in the future. Supply of Canadian dollars is similar expect that it depends o n demand for imports rather than exports. • Law of Demand: The higher the exchange rate, the smaller is the quantity of Canadian dollars demanded due to the export effect (high exchange rate means Canadian goods are more expensive, less demand for Canadian dollars) and expected profit effect (higher exchange rates have a lower potential to appreciate in value, therefore less demand for Canadian dollars). • Law of Supply: The higher the exchange rate, the greater is the quantity of Canadian dollars supplied due to import effect (higher exchange rate means foreign goods are less expensive, supply more Canadian dollars when we buy these foreign goods) and expected profit effect (when exchange rate is high, higher profit from selling Canadian dollars than if it wa s low). Demand for Canadian dollars increases (curve shifts right): • When: world demand for Canadian exports increase, Canadian interest rate differential rises, expected future exchange rate rise, decreases in the opposite scenario Supply of Canadian dollars increases (curve shifts right): • When: Canadian imports increase, Canadian interest rate differential falls, expected future exchange rate falls, decreases in the opposite scenario *Note: Important to know how combinations of changes in demand and s upply will change the exchange rate. Interest Rate Parity • Equal rates of return, takes into account appreciations/depreciations of currency (exchange rate expectations) Purchasing Power Parity Raising Marks, Raising Money, Raising Roofs 9 York SOS: Students Offering Support • Equal money of value, if you take exchange rate into account, prices of identical goods in different countries should be the same Nominal vs. Real Exchange rate • Nominal: Nominal Exchange Rate E=RER x (P*/P) • Real Exchange Rate RER=E x (P*/P) P*=foreign price level, P=Canadian price level Balance of Payments Accou nts • Current account= exports – imports – net interest income – net transfers • Capital account= foreign investment in Canada – Canadian investment abroad + Statistical Discrepancy *Note in exams, normally do not deal with statistical discrepancy • Official Settlements Account= Change in official accounts (usually given) • ***The sum of these three accounts should equal 0. • Borrowers and Lenders, Debtors and Creditors Net borrowers are borrowing more from the world than they lend and net lenders are lending morhan they borrow. Debtor nations are net borrowers looking at their entire history and creditor nations are net lenders during their entire history. Net Exports: exports of goods and services minus imports Government sector balance: net taxes minus governm ent expenditures Private sector balance: savings minus investment Exchange Rate Policy • Flexible: exchange rate is determined by demand and supply (most countries today) • Fixed: exchange rate is set at a value determined by the government • Crawling peg: exchange rate changes periodically based on a set target (China) !"#$%&'()PD(Q11'&1#%&([email protected](#05(3&9#05 ( Aggregate Supply • Long-run: relationship between the quantity of real GDP supplied (how much firms produce) and the price level when money wage rate chang es with price level to achieve full employment, VERTICAL • Short-run: relationship between quantity of real GDP supplied and price level when money wage rate and prices of other resources remain constant UPWARD SLOPING • Changes in potential GDP: shifts LAS cu rve, increases will shift it right, potential GDP increases when full employment quantity increases, quantity of capital increases, or there is technological advancement • Changes in money wage rate: shift SAS, increases in wage rate shift the SAS curve left The money wage changes either due to changes in full employment or expectations of inflation. Aggregate Demand • Quantity of real GDP demanded depends on: price level, expectations, fiscal and monetary policy, world economy • Relationship between quantity of real GDP demanded and price level • Slopes downward due to wealth effect (if price level decreases, real wealth increases) and substitution effects (if price level rises, substitute future consumption for current consumption) • When price level changes, there is a movement along the AD curve. • Increase in expected future income increases aggregate demand (shifts right) Raising Marks, Raising Money, Raising Roofs 10 York SOS: Students Offering Support • Fiscal Policy: tax cuts or increases in transfer payments increases aggregate demand • Monetary Policy: increase in quantity of money increases a ggregate demand • Increases in aggregate demand shifts AD curve right, decrease shift AD curve left. Short-Run Macroeconomic Equilibrium • Occurs at the point of intersection of AD curve and SAS curve • Example: if price level is above equilibrium price level, demand is less than supply and firms lower their prices Long-Run Macroeconomic Equilibrium • Occurs at the point of intersection of LAS and AD curve • Money wage rate adjusts to put SAS curve through the full employment level • Economic growth is represented b y rightward shift of LAS curve The Business Cycle • Below full-employment equilibrium: potential GDP exceeds real GDP, the gap is known as an output gap, which is also known as a recessionary gap • Full-employment equilibrium: real GDP equals potential GDP, n o output gap • Above full-employment equilibrium: real GDP exceeds potential GDP, output gap is called inflationary gap Fluctuations in Aggregate Demand • Short-run effect: increase in aggregate demand shifts aggregate demand right, real GDP and price level increase, inflationary gap exists • Long-run effect: with an increase in demand and price level, workers demand higher wages, higher wages shift the SAS curve and full employment is restored Fluctuations in Aggregate Supply • Example: oil prices rise, firms de crease production, SAS curve shifts leftward, real GDP falls and price level increase= stagflation • When supply shock ends, economy returns to full employment Macroeconomic Schools of Thought • Classical View: economy is self -regulating and always at full employment • New Classical: business cycle responses are efficient responses of well -functioning market economy • Keynesian: if left alone, economy would not operate at full employment, need fiscal and monetary policy • Monetarist: economy is self -regulating and should operate at full employment with steady money growth and sound monetary policy !"#$%&'()RD(6M$&05/%.'&(,[email protected]%/[email protected]/&'- ( Y: real GDP/aggregate income; Yd= Disposal income; C: planned consumption expenditure; I: investment; G: government expenditures on go ods and services; Net import=X (exports) -M (imports); S: planned savings Real GDP=Y=C+I +G+(X -M) Disposal income=Yd=Y -NT=C+S Marginal Propensity to Consume : the fraction of change in disposal income that is consumed. Raising Marks, Raising Money, Raising Roofs 11 York SOS: Students Offering Support MPC=#C/#Yd= (C1-C0)/Yd1-Yd0 MPC is the slope of the consumption expenditure function. The general form of the consumption function: C=C0+MPC(Yd) ---autonomous consumption expenditure+ induced consumption expenditure Marginal Propensity to Save: MPS=#S/#Yd= (S1-S0)/Yd1-Yd0 MPS is the slope of the savings function. The general form of the saving function: S=S0+MPC(Yd) ---autonomous saving+ change in savings caused by change in disposal income " MPC+MPS=1 Movements& Shifts in consumption expenditure& saving func tion: • A change in disposal income brings movements along the consumption and saving function; Changes in expected future disposal income/real interest rate/wealth canshifts. • $ expected future disposal income /$wealth/%in real interest rate &shifts the consumption function upward and the savings function downward. • $wealth while other conditions unchanged & stimulates consumption expenditure/%savings Import function: M=M0+MY---autonomous imports+ induced imports Marginal Propensity of Import: M=MPM=#M/#Y=M1-M0/Y1-Y0 Aggregate planned expenditures : C=a+b(1-t)y---autonomous consumption expenditure + induced consumption expenditure AE=C+I+G+(X-M) =(a+I+G+X)+[b(1-t)-M]Y =A+[b(1-t)-M]Y---autonomous expenditure + induced expenditure The Multiplier: The multiplier=change in equilibrium expenditure/ change in autonomous expenditure ' ' Change in Equilibrium expenditure (real GDP)= the multiplier x change in autonomous expenditure !Y=#A/1-[b(1-t)-M]&Multiplier=#Y/#A =1/1-[b(1-t)-M] =1/1- the slope of the AE curve • If t=0, M=0&multiplier with no taxes & imports, Multiplier=1/1 -b =1/1-MPC=1/MPS • Imports and income taxes decrease the value of t he multiplier The price level, AE and AD: • A change in the price level shifts the AE curve and results in a movement along the AD curve. • A change in the price level causes a change in the aggregate planned expenditure and the quantity of real GDP demanded. • $ in price level& % in the multiplier In the long run, the multiplier is 0, and the real GDP=potential GDP. While price level constant, $ in aggregate planned expenditure shifts the AD curve to the right. Raising Marks, Raising Money, Raising Roofs 12 York SOS: Students Offering Support !"#$%&'()SD(>[email protected]#%/80F(T0&[email protected]&0%(#05( O.-/0&--([email protected]&( Inflation -continual increase in price level which is the average of price of goods and services; money is losing value -Calculated by the annual percentage change in the price level which = (Price level this yr -Price level last yr)/ Price level last yr " Long-run inflation happens when quantity of $ grows faster than potential GDP. Short run inflation: Demand-pull inflation – from an initial increase in aggregate demand, arise from: • Increase in the quantity of money – when government buys bonds, money supply $, aggregate demand $, price $ • Increase in government expenditure • Increase in exports • Increase in investments Cost-push inflation – inflation that results from an initial increase in costs, arises from • Increase in money wage rates; • Increase in the money prices of raw materials, which results in: Firms willing to supply smaller amounts, aggregate supply %, price level $ and real GDP %, known as stagflation. This results in higher unemployment rate, which government responds by increase money supply to induce aggregate demand, restore full employment, but there is a further increase in price level. If government does not respond, the economy has high unemployment until the price of raw materials falls. " Inflation is costly when it’s unexpected, so pe ople devote resources from producing goods & services to forecast inflation; this shifts LAS curve leftward. Effects of Inflation: Failure to anticipate inflation imposes costs in: Labour market – redistribution of income: high inflation rate leads to $ profit for employer, % purchasing power for employee - Departure from full employment Market for financial capital – redistribution of income: high inflation rate transfer money from b orrower to lender - Too much or too little lending and borrowing Forecasting inflation – made difficult by sources of inflation (demand -pull or cost-push); speed of change Rational expectation – most accurate forecast possible, based on all the relevant inf ormation available Correctly anticipated inflation – money wage rate rises according to inflation, results in natural unemployment rate • There are still costs: • Transaction costs – time spent by people to avoid incurring loss from the falling value of money • Tax effects – dollar return on investment is effected, which in turn effects the tax collected on these returns • Increased uncertainty – about future long-term inflation rate Interest rates and inflation: Raising Marks, Raising Money, Raising Roofs 13 York SOS: Students Offering Support • Nominal interest rate -the return% on an asset such as bonds; the opportunity cost of holding money; – adjusts to balance the demand for money and the quantity of money in each nation’s money market. The higher the inflation is, the higher the nominal interest rate is. • Real interest rate--the return% on an asset in terms of what can buy; adjusts to balance investment demand and savings supply in the global market for financial capital. Real interest rate= (Nominal interest rate -inflation rate)/1+inflation rate Inflation rate influences interest rate • 1% rise in inflation rate leads to 1% rise in nominal interest rate • Equilibrium nominal interest rate (approximately) = real interest rate + expected inflation rate • Real interest rate keeps constant, borrowers must adjust the nominal interest to keep pace withe inflation rate to keep lenders willing to lend The Philips Curve: Phillips curve – shows relationship between inflation and unemployment, long -term or short-term • Change in natural rate of unemployment shifts both the SR and LR Phillips curfve Short-run Phillips curve • tradeoff between inflation and unemployment, expected inflation rate and natural rate of unemployment constant • shifts downward when the expected inflation rate falls Long-run Phillips curve • relationship between inflation and unemploym ent when the actual inflation rate equals the expected inflation rate • vertical at the natural rate of inflation • when expected inflation rate changes, SR Phillips curve shifts, but LR Phillips curve remains constant !"#$%&'()UD(E/-7#@([email protected]/7J(( Fiscal Policy - Fiscal policy is a change in taxes or spending by the government to achieve full employment, price stability, and L-T economic growth. Federal Budget: Surplus--- revenue>outlays (expenditures) Deficit--- revenueovernight rate>settlement balance rate • When banks want to slow inflation, it raised the overnight rate. Open market inflations: changes in the reserves of the banking system - If B of C buys securities, reserves of commercial banks increase - If B of C sells securities, reserves of commercial banks decrease Monetary Policy Transmissions: • When B of C lowers the overnight rate: R(interest rate)and e(exchange ra te)decrease, money supply, credit loans, consumption&investment, aggregate demand, net exports, GDP and inflation increase. • When B of C raises the overnight rate: Vice Versa Conclusion: # The B of C’s goal is to keep the inflation rate around 2%/yr; # Banks use an interest rate strategy targeting the overnight rate; # Monetary policy is to manage inflation rate. Interest Sensitive Expenditure- relationship between interest sensitive expenditure and real interest rate Raising Marks, Raising Money, Raising Roofs 15 York SOS: Students Offering Support - Downward sloping curve i.e. inverse relationsh ip between IE and r - Interest-sensitive components are: autonomous consumption, investment and net exports Raising Marks, Raising Money, Raising Roofs 16 ECON 1000 Final Exam-AID Review Package Course Coordinator: Juris (George) Rodin Coordinator E-mail: [email protected] Tutor: Michael Moretto Tutor: Yahel Nov Contributors: Michael Moretto, Yahel Nov, Juris (George) Rodin, Cynthia Jeevakumar, Nihal Mahmood Students Offering Support sponsors: York SOS: Students Offering Support Preface: This  document  is  directed  to  ECON  1000  students  at  York  University  whom  are  looking  for  an  additional   resource  to  aid  them  with  studying  for  the  course  final  exam.  It  has  been  created  with  regard  to  the  Fall  2008   course  and  is  subject  to  change  for  future  courses.       References: 1. Parkin,  Michael,  and  Robin  Bade.  Macroeconomics  :  Canada  in  the  Global  Environment.  6th  ed.   Upper  Saddle  River:  Pearson  Education  Canada,  2006.     Chapter  1  Ȃ  What  is  Economics?     Definition  of  Economics   ƒ Our inability to satisfy all our wants is called scarcity ƒ The choices that we make depend on the incentives that we face. An incentive: a reward that encourages or penalty that discourages an action. Economics social science that studies the choices that individual, businesses, governments and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices. ƒ two main parts: Microeconomics and Macroeconomics Microeconomics ƒ Microeconomics study of choices that individuals & businesses make, the way choices interact in markets, and influence of governments. Macroeconomics ƒ Macroeconomics study of performance of the national economy and the global economy. Two  Big  Economic  Questions   o How do choices end up determining what, how and for whom goods and services get produced? o When do choices made in the pursuit of self-interest also promote the social interest? What, How & For Whom ƒ Goods & Services the objects that people value and produce to satisfy human wants. What determines the items that we produce How ƒ factors of production: o Land is the natural resources o Labour is the work time and work effort ƒ human capital, which is the knowledge and skill that people obtain. o Capital is the tools, instruments, machines, buildings that businesses use to produce goods and services. o Entrepreneurship is the human resource that organizes labour, land, and capital. For Whom ƒ Land earns rents, Labour earns wages, Capital earns interest, and Entrepreneurship earns profit. What, How and For Whom Tradeoffs ³:KDW´▯7UDGHRIIV ƒ What goods and services get produced depends on choices made by each one of us, by our government, and by the business that produce the things we buy ³+RZ´▯7UDGHRIIV ƒ How goods and services get produced depends on choices made by the businesses that produce the things we buy. ³)RU▯:KRP´▯7UDGHRIIV ƒ Big tradeoff ± the tradeoff between quality and efficiency Opportunity Cost ƒ The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen. ƒ Central idea of economics: every choice involves a cost. Choosing at a the Margin Raising Marks, Raising Money, Raising Roofs 2 York SOS: Students Offering Support ƒ The benefit that arises from an increase in an activity is called marginal benefit ƒ The cost of an increase in an activity is called marginal cost. Responding to Incentives ƒ A change in marginal cost or a change in benefit changes the incentives that we face and leads us to change our choice. ƒ The central idea of economics is that we can predict how choices will change by looking at changes in incentives ƒ Less of an activity is undertaken when its marginal cost rises or marginal benefit falls Human Nature, Incentives and Institutions ƒ Economists take human nature as given and view people as acting n their self-interest. Economics:  A  Social  Science   ƒ What is statements are called positive statements and they might be right or wrong. We can test a positive statement by checking it against the facts ƒ What ought to be statement are called normative statements. These statements depend on values and cannot be tested. ƒ economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies Unscrambling Cause and Effect ƒ Ceteris paribus is a Latin term that means ``other things being equal`` or ``if all other relevant things remain the same`` ƒ Economists try to avoid fallacies ± errors of reason that lead to a wrong conclusion ƒ Two main types: Fallacy of Composition, Post hoc fallacy Fallacy of Composition ƒ The fallacy of composition is the (false) statement that what is true of the parts is true of the whole ore that what is true of the whole is true of the parts Unscrambling Cause and Effect ƒ The post hoc fallacy is the error of reasoning that a first event causes a second event because the first occurred before the second Chapter  2  Ȃ  The  Economic  Problem   Production  Possibilities  and  Opportunity  Cost   ƒ (PPF) is the boundary between those combinations off goods and services that can be produced and those that cannot. Production Possibilities Frontier ƒ The PPF illustrates scarcity because we cannot attain the points outside the frontier. ƒ We can produce at all points inside the PPF and on the PPF. Production Efficiency ƒ We achieve production efficiency if we cannot produce more of one good without producing less of some other good. When production is efficient, we are at a point on the PPF. ƒ If we are at a point inside the PPF production is inefficient Tradeoff Along the PPF ƒ Every choice along the PPF involves a tradeoff ± we must give up something to get something else ƒ All tradeoffs involve a cost ± an opportunity cost Opportunity Cost ƒ The opportunity cost of an action is the highest-valued alternative forgone. ƒ The PPF helps us to make the concept of opportunity cost precise and enables us to calculate it. ƒ Along the PPF, there are only two goods, so there is only one alternative forgone: some quantity of the other good Opportunity Cost is a ratio ƒ Opportunity cost is a ratio ƒ It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the production possibilities frontier. ƒ ***REFER TO PAGE 36 IN TEXTBOOK*** Increasing Opportunity Cost ƒ This phenomenon of increasing opportunity cost is reflected in the shape of the PPF. Raising Marks, Raising Money, Raising Roofs 3 York SOS: Students Offering Support ƒ The PPF is bowed outward because resources are not all equally productive in all activities. Using  a  Resource  Efficiently   The PPF and Marginal Cost ƒ The marginal cost of a good is the opportunity cost of producing one more unit of it. ƒ We calculate marginal cost from the slope of the PPF. As the quantity increases, the PPF gets steeper and marginal cost increases. Preferences and Marginal Benefit ƒ To describe preferences, economists use the concept of marginal benefit. ƒ Marginal benefit of a good or service is the benefit received from consuming one more unit of it. ƒ We measure the marginal benefit of a good or service by the most that people are willing to pay for an additional unit of it. ƒ It is a general principle that the more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it. Efficient Use of Resources ƒ When we cannot produce more of any one good without giving up some other good we have achieved production efficiency, and were producing at a point on the PPF ƒ When we cannot produce more of any good without giving up some other good that we value more highly, we have achieved allocative efficiency and we are producing at the point on the PPF tat we prefer above all other points Economic  Growth   ƒ Expansion of production is called economic growth. ƒ Economic growth increases our standard of living. The Cost of Economic Growth ƒ 2 factors influence economic growth: technological change and capital accumulation ƒ Technological change the development of new goods and of better ways of producing goods and services. ƒ Capital accumulation the growth of capital resources, which includes human capital ƒ To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services Gains  from  Trade   ƒ Concentrating on the production is called specialization. ƒ We can gain by specializing in the production of the good in which we have a comparative advantage and trading with others The Cost of Economic Growth ƒ Comparative advantage is when one can perform an activity at a lower opportunity cost than anyone else ƒ A person who is more productive than others has an absolute advantage ƒ Absolute advantage involves comparing productivities ± production per hour ± while comparative advantage involves comparing opportunity costs ƒ absolute advantage does not mean you have a comparative advantage in every activity Dynamic Comparative Advantage ƒ At any given point in time, the resources and technologies available determine the comparative advantages that individuals and nations have ƒ Learning by ±doing is the basis of dynamic comparative advantage ƒ Dynamic comparative advantage is a comparative advantage that a person (or country) possesses as a result of having specialized in a particular activity and as a result of learning-by-doing, having become the producer with the lowest opportunity cost. Economic  Growth   ƒ People gain by specializing in the production of those goods and services in which they have a comparative advantage and then trading with each other ƒ Central economic planning ƒ To make a decentralized coordination work, four complementary social institutions that have evolved over many centuries are required: firms, property rights, markets and money Firms Raising Marks, Raising Money, Raising Roofs 4 York SOS: Students Offering Support ƒ A firm is a economic unit that hires factors of production and organizes those factors to produce and sell goods and services Property Rights ƒ The social arrangements that govern the ownership use and disposal of resource goods, and services are called property rights ƒ Real property includes land and buildings ƒ Financial property includes stocks and bonds and money in the bank ƒ Intellectual property in the intangible product of creative effort Markets ƒ A market is any arrangement that enables buyers and sellers tog et information and to do business with each other Money ƒ Money is any commodity or token that is generally acceptable as a means of payment Circular Flows Through Markets ƒ Households specialize and choose the quantities of labour, land and capital and entrepreneurship to sell or rent to firms. Firms choose the quantities of factors of production to hire. These flow through the factor markets. ƒ Households choose the quantities of goods and services to buy, and firms choose the quantities to produce. These flow through the goods markets. ƒ Households receive incomes and make expenditures on goods and services. Coordinating Decision ƒ Markets coordinate individual decisions through price adjustments. Chapter  3:  Demand  and  Supply     Markets  and  Prices   ƒ Competitive market ± a market that has many buyers and sellers, so no single buyer or seller can influence the price ƒ Produces offer items for sale only if the price is high enough to cover their opportunity cost. And consumers respond to changing opportunity cost by seeking cheaper alternatives to expensive items ƒ The opportunity cost of an action is the highest valued alternative forgone ƒ The ratio of one price to another is called a relative price, and a relative price is an opportunity cost ƒ 7KH▯QRUPDO▯ZD\▯RI▯H[SUHVVLQJ▯D▯UHODWLYH▯SULFH▯LV▯LQ▯WHUPV▯RI▯D▯³EDVNHW´▯RI▯all goods and services. To calculate this UHODWLYH▯SULFH▯▯ZH▯GLYLGH▯WKH▯PRQH\▯SULFH▯RI▯D▯JRRG▯E\▯WKH▯PRQH\▯SULFH▯RI▯D▯³EDVNHW´▯RI▯DOO▯JRRGV▯▯FDOOHG▯D▯SULFH▯ index) ƒ 7KH▯WKHRU\▯RI▯GHPDQG▯DQG▯VXSSO\▯GHWHUPLQH▯UHODWLYH▯SULFHV▯▯DQG▯WKH▯ZRUG▯³SULFH´▯PHDQV▯UHODWLYe price Demand   ƒ Wants are the unlimited desires or wishes that people have for goods and services ƒ The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. ƒ The quantity demanded is measured as an amount per unit of time The Law of Demand ƒ The law of demand: other things remaining the same, the higher the price of a goods, the smaller is the quantity demanded and the lower the price of a good, the greater the quantity demanded ƒ Higher prices reduce the quantity demanded for two reasons: substitution effect and income effect Substitution Effect ƒ each good has substitutes ± other goods that can be used in its place. As opportunity cost of a good rises, people buy less of that good and more of its substitutes Income Effect ƒ When a price rises certius paribus▯▯WKH▯SULFH▯ULVHV▯UHODWLYH▯WR▯SHRSOH¶V▯LQFRPHV▯▯6R▯IDFHG▯ZLWK▯D▯KLJKHU▯SULFH▯DQG▯DQ▯ unchanged income, people cannot buy all the things they previously bought. They decrease the quantities demanded of at least some goods and services, normally, the goods whose price has increases will be one of the goods the people buy less of Demand Curve and Demand Schedule ƒ Demand refers to the entire relationship between the price of the good and quantity demanded of the good. ƒ Quantity demanded refers to a point on a demand curve ± the quantity demanded at a particular price Raising Marks, Raising Money, Raising Roofs 5 York SOS: Students Offering Support ƒ Demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on conVXPHUV¶▯SODQQHG▯SXUFKDVHV▯UHPDLQ▯WKH▯VDPH A Change in Demand ƒ When any factor that influence buying plans other than price of the good changes, there is a change in demand ƒ 6 factors change demand: price of related goods, expected future prices, income, expected future incomes, population, preferences Price of Related Goods ƒ A substitute is a good that can be used in place of another good. ƒ A complement is a good that is used in conjunction with another good Expected Future Prices ƒ If the price of a good is expected to rise in the future and if the good can be stored, the opportunity cost of obtaining the good for future is lower today than it will be when the prices has increased. They buy more of the good now before the price is expected to rise ƒ Your current demand increases and you future demand decreases ƒ Similarly, if the price of a good is expected to fall in the future, the opportunity cost of buying the good today is high relative to what is expected to be in the future Income ƒ A normal good is one for which demand increases and income increase. ƒ An inferior good is one for which demand decreases as income increases Expected Future Growth ƒ When expected future income increases, demand might increase Population ƒ Demand also depends on the size and age structure of the population. The larger the population, the greater is the demand for all goods and services; the smaller the population, the smaller is the demand for all goods and services Preferences ƒ 3UHIHUHQFHV▯DUH▯DQ▯LQGLYLGXDO¶V▯DWWLWXGHV▯WRZDUGV▯JRRGV▯DQd services A Change is the Quantity Demanded Versus a Change in Demand ƒ &KDQJHV▯LQ▯WKH▯IDFWRUV▯WKDW▯LQIOXHQFH▯EX\HUV¶▯SODQV▯FDXVH▯HLWKHU▯D▯FKDQJH▯LQ▯WKH▯TXDQWLW\▯GHPDQGHG▯RU▯D▯FKDQJH▯LQ▯ demand. They cause either a movement along the curve or a shift of the demand curve ƒ A point on the demand curve shows the quantity demanded at a give price. So a movement along the demand curve shows a change in the quantity demanded. Movement along the Demand Curve ƒ If the price of a good changes but everything else remains the same, there is a movement along the demand curve. ƒ A fall in the price of a good increases the quantity demanded and a rise in the price of a good decreases the quantity demanded A shift of the Demand Curve ƒ If the price of a good remains constant but VRPH▯RWKHU▯LQIOXHQFH▯RQ▯EX\HUV¶▯SODQV▯FKDQJHV▯▯WKHUH▯LV▯D▯FKDQJH▯LQ▯ demand for that good Supply   ƒ If a firm supplies a good or service, the firm: has the resources and technology to produce it, can profit from producing it, and plans to produce it and sell it ƒ The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price The Law of Supply ƒ law of supply: certius paribus, the higher the price of a good, the greater the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. ƒ Higher price increase the quantity supplied because marginal cost increase. As the quantity produced of any good increase, the marginal cost of producing the good increases Supply Curve and Supply Schedule ƒ Supply refers to the entire relationship between the quantity supplied and the price of a good. ƒ Quantity supplied refers to a point on a supply curve ± the quantity supplied at a particular price ƒ Supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers planned sales remain the same Minimum of Supply Price ƒ The supply curve can be interpreted as a minimum-supply-price curve. Shows the lowest price at which someone is willing to sell another unit. A change in Supply Raising Marks, Raising Money, Raising Roofs 6 York SOS: Students Offering Support ƒ When any factors that influence the selling plans other than the price of the good changes, here is a change in supply. Factors: the price of resources used to produce the good, the prices of related goods produced, expected future prices, the number of suppliers, technology Prices of Productive Resources ƒ If the price of a product resource rises, the lowest price of a producer of a god that uses that resources is willing to accept rises, so supply of the good decreases Prices of Related Good Produced ƒ Substitutes in production ± goods that can be produced by using the same resources ƒ Compliments in production ±goods that must be produced together Expected Future Prices ƒ If the price of a good is expected to rise, the return from selling the good in the future is higher than it is today. Supply of the good decrease today and increases in the future Technology ƒ 7KH▯WHUP▯³WHFKQRORJ\´▯LV▯XVHG▯EURDGO\▯WR▯PHDQ▯WKH▯ZD\▯WKDW▯IDFWRUV▯RI▯SURGXFWLRQ▯DUH▯XVHG▯WR▯SURGXFH▯a good. ƒ A positive technology change occurs when a new method is discovered that lowers the cost of producing a good ƒ A positive technology change increases supply and a negative technology change decreases supply A Change in the Quantity Supplied Versus a Change in Supply ƒ &KDQJHV▯LQ▯WKH▯IDFWRU▯WKDW▯LQIOXHQFH▯VHOOHUV¶▯SODQ▯FDXVHV▯HLWKHU▯D▯FKDQJH▯LQ▯WKH▯TXDQWLW\▯VXSSOLHG▯RU▯D▯FKDQJH▯LQ▯ supply. They cause a movement along the supply curve of a shift of the supply curve ƒ A point on the supply curve shows the quantity supplied at a giving price. Movement along supply curve shows a change in the quantity supplied. A shift of the supply cure shows a change in supply. Market  Equilibrium   ƒ Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers ƒ The equilibrium price is the price at which the quantity demanded equals the quantity supplied. ƒ The equilibrium quantity is the quantity bought and sold at equilibrium price. ƒ A market moves towards its equilibrium because: price regulates buying and selling plans, price adjusts when plans GRQ¶W▯PDWFK Price as a Regulator ƒ The price of a good regulates the quantities demanded and supplied Price Adjustments ƒ If the price is below equilibrium there is a shortage ƒ If the price is above equilibrium there is a surplus ƒ A shortage forces the price up ƒ A surplus forces the price down ƒ The best deal available is when the quantity supplied and the quantity demanded are equal C HANGES IN D EM AND AND SUPPLY Demand: 1. When demand increases, both the price and the quan
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