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Midterm

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Department
Economics
Course
ECON 2000
Professor
All Professors
Semester
Fall

Description
Study Notes Chapters 1 and 2 • Endogenous vs. exogenous variables • Definition of Y, C, G, I and NX; stock vs. flow • Investment: new PP&L, new housing, increase in inventory (unsold goods) • GNP – GDP = factor payments from abroad minus factor payments to abroad • Gross national income = GDP – net income of foreigners • Net national income = gross national income – depreciation (capital consumption allowances) • National income = gross national income – indirect business taxes o Net interest = interest paid by domestic businesses – interest received + interest earned from foreigners • Imputed values: “rent” homeowners pay themselves and wages of public service workers GDP deflator = 100× Nominal GDP Real GDP • Personal income = national income – corporate profits – social insurance contributions – net interest + dividends + gov’t transfers to individuals + personal interest income → to get personal disposable income subtract personal tax payments • Nominal vs. real GDP o The GDP deflator is a weighted average of prices o GDP deflator = quantity × price /real GDP = (quantity/real GDP) × price • % change in (X  Y )  % change in X + % change in Y → with division use subtraction • Chain-weighted real GDP updates price every year; constant-price real GDP is less accurate • CPI index: Laspeyers (fixed basket, overstates inflation), Paasche (changing basket, understates inf.), Fisher (average of the two measured by square root of their product) o CPI = cost of basket in month Y/cost of basket in base period • The CPI is a weighted average of prices o CPI = (quantity of good in basket/base year CPI) × price of good • CPI bias: unmeasured changes in quality, substitution bias, introduction of new goods o Overstates inflation • CPI includes imported consumer goods; GDP deflator includes capital goods, “basket” changes every year • Employed, unemployed, labour force, Okun’s law (less GDP → more unemployment) • Overall price level and inflation can be measured by CPI or GDP deflator Chapter 3. Closed Economy • Production function: Y = F(K,L) → constant returns to scale where aY = F(aK,aL) o Increasing returns: aY < F(aK,aL) decreasing returns aY > F(aK,aL) • Assume that K, L, and Y are fixed • MPL = F (K, L + 1) – F (K, L) → hire labour until MPL = W/P = real wage • Rent capital until MPK = R/P = real rental rate; P = price of output • Diminishing marginal returns if only one factor is increased Y = MPL×L + MPK ×K • Neoclassical Theory of Distribution: each factor input is paid its marginal product – no economic profit given a competitive market and constant returns to scale α 1−α Y = AK L o Accounting profit = MPK×K + economic profit • Cobb-Douglas production function where  = capital’s share of total income o A= level of technology;  is between 0 and 1; constant returns to scale o MPK = Y/K; MPL = (1-)Y/L o Increase in capital raises MPL and lowers MPK; increase in labour lowers MPL and increases MPK; increase inAraises both marginal products proportionally o Y/L is average labour productivity; Y/K is average capital productivity • Disposable income = Y – T → C = C(Y – T) → positive relation o Marginal propensity to consume – increase in C when Y – T increases by $1 • I = I (r) → I is inversely related with real interest rate (cost of borrowing) • Government spending and taxes are exogenous • Equilibrium when aggregate supply = aggregate demand o Y (K ,L)=C (Y−T)+G+I(r) → r is the only endogenous variable that adjusts to equate the sides • Loanable funds: demand = investment, supply = saving, price = real interest rate • National saving = public saving + private saving = (T – G) + (Y – T – C) = Y – G – C o C = MPC  (Y  T) = MPC Y  MPC T • Balanced budget: T = G, budget surplus T > G, budget deficit T < G o In case of budget deficit gov’t issues Treasury bonds to finance spending • National saving does not depend on r so supply of loanable funds is a vertical line S =Y −C(Y −T ) −G o r adjusts to equilibrate the goods market and the loanable funds market simultaneously o In equilibrium, saving equals investment, which depends on r Chapter 4. Classical Theory of Inflation MV =PY • Quantity equation: → money supply  velocity = total transactions d • Money demand: (M/P) = kY → k is how much money people wish to hold for each dollar of income (exogenous); k = 1/V o Assume that V is constant so its rate of change is 0 o Inflation rate: π =ΔP/P =ΔM/M –ΔY/Y • Implies that money growth rate is the only factor causing inflation because Y is given • Seignorage – gov’t revenue from printing money; causes “inflation tax” by decreasing value of money • Fisher equation: i = r +  → i is nominal interest rate unadjusted for inflation o Fisher effect: an increase in  causes an equal increase in i o i = r + E → E = expected inflation rate o i – E = ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan o i – = ex post real interest rate: the real interest rate actually realized • Money demand depends positively on Y and negatively on i = L(r +Eπ,Y ) (M P) = L(i ,Y ) o Money supply and demand determine the price level → determines → determines i → determines money demand o For given values of r, Y, and E ,a change in M causes P to change by the same % o Increase in  causes a decrease in real money balances • In the long run E =  on average; in the short run E may cause a change in P without a change in M → increase in E increases P and decreases M/P to new equilibrium • In the long run, real wages are determined by MPL and labour supply, not inflation o Classical view of inflation: change in the price level is merely a change in the units of measurement • Costs of expected inflation: shoeleather cost, menu costs, relative price distortions, unfair tax treatment (tax on nominal not real income), general inconvenience o One benefit: reduces real wages without nominal wage cuts • Extra costs of unexpected inflation: arbitrary redistribution of purchasing power (borrowers and lenders), increased uncertainty (high inflation is highly variable) • Hyperinflation:   50% per month → huge costs on society o Caused by excessive growth of money supply • Classical dichotomy: theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables • Neutrality of money: changes in the money supply do not affect real variables Chapters 4 and 19. Money • M = C + D → money supply = currency (outstanding bills and coins) + demand deposits • In a fractional-reserve banking system, banks create money by lending a fraction of their deposits • Total money supply = (1/rr )  original deposit, where rr = ratio of reserves to deposits • Financial intermediation – process of transferring funds from savers to borrowers • Creation of money by the banking system increases the economy’s liquidity, not wealth • Leverage: use of borrowed money to supplement existing funds for purposes of investment; leverage ratio = assets/capital • Capital requirement: minimum amount of capital banks must hold to ensure they will be able to pay off depositors • Exogenous variables: o Monetary base: B = C + R → controlled by the central bank o Reserve-deposit ratio: rr = R/D → depends on regulations and bank policies o Currency-deposit ratio: cr = C/D → depends on households’preferences • Money multiplier: m = (C + D) / B = (cr +1) / (cr + rr) M = m × B o Increase in B increases M by the same %; decrease in rr or cr raises m and M • Monetary policy is conducted by Central Bank to control money supply o Open market operations: buying a bond → increasing money in the economy; selling a bond → reducing the money supply o Discount rate: the interest rate the Fed charges on loans to banks; higher rate → smaller monetary base  Deposit-switching – switching of federal gov’t bonds between the Bank of Canada and the chartered banks to regulate the money supply o Cannot fix both the quantity and the price of our currency → floating exchange rate permits independent monetary policy o The Fed can change rr by imposing reserve requirements or changing the interest rate it pays on deposits of banks o Households and banks holding excess reserves can also impact M Chapter 5. Small Open economy • Spending need not equal output; saving need not equal investment • Trade balance = NX = X – M = X – (C + I + G) = Y – (C + I + G) • Trade surplus: output > spending; exports > imports; size of the trade surplus = NX • Trade deficit: spending > output; imports > exports; size of the trade deficit = -NX • Net capital outflow = S – I; if S is greater – net lender; if I is greater – net borrower • NX = S – I → trade balance = net capital outflow → a country with trade deficit (NX< 0) is a net borrower (S < I) • Supply of loanable funds is S=Y−C(Y−T)−G ́ ́ and demand is I(r*) where r* is world interest rate o r* + θ → world interest rate plus country-specific risk premium, we assume it’s 0 o Assume perfect capital mobility (no restrictions on international trade in assets) and that domestic and foreign bonds are perfect substitutes r∗¿ o N X=S−I¿ → r* is exogenous and does not adjust for equilibrium • Fiscal policies starting at balanced trade: o Change in fiscal policy at home that reduces national saving or stimulates domestic investment spending results in trade deficit o Increase in the world interest rate due to a fiscal expansion abroad leads to trade surplus • e = nominal exchange rate, the relative price of domestic currency in terms of foreign currency • ε = real exchange rate, the relative price of domestic goods in terms of foreign goods P∗¿ e×P yen per$× yen perunitof USgoods o ε = → yenperunitof Japanesegoods ¿ o The higher ε, the cheaper the foreign goods are relative to domestic goods → higher imports and lower exports → lower NX o ε can be applied to relative prices of consumer baskets or total output • Net exports function: NX = NX(ε) → inverse relationship NXε( ) =S I r( * ) o ε is a vertical line on the graph • ε is the only variable that adjusts to ensure equilibrium o S – I(r*) is a vertical line • Trade policies re
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