Jose de la Puente
Final Exam Summery
Chapters: 1 -16
Chapter 2: Scarcity, Choice and Economic Systems
Society’s Production Choices
PPF: Production Possibilities Frontier: All combinations of two goods that can be produced with the
• Choices are limited to points on or inside the PPF. (“There is no such thing as free lunch”)
o Productive Efficient: on the PPF
o Productive Inefficiency/Recession: inside the PPF.
o Economic Growth:
Tech changes or increase in resources, allows us to choose greater
production of all types of goods.
If resources are used to produced goods and not consumed: bigger growth.
• Law of increasing Opportunity Cost: the more of something we produce, the greater the
opportunity cost. (the PPF is steeper as we move rightward)
• Specialization (Expertise, Minimizing Downtime and Comp. Adv.) and Exchange
o Each person is concentrated on a limited number of productive activities.
o Total production will be higher if the person specializes in what he was the comp.
o AbsoluteAdv.: produce more of a good using fewer resources.
o ComparativeAdv.: if the opp. cost is smaller.
• Resource Allocation:
o Traditional Economy: according to the long-lived practices.
Stable and predictable.
o Command Economy: explicitly instructions from higher authority.
o Market Economy: free to do what they want with the resources.
Markets and prices
Sensible allocation of resources
USA: mix between command and market.
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Chapter 3: Supply and Demand
Economic model design how prices are determined in certain types of markets.
Circular flow (to the right): how goods and payments flow
• Product Markets: goods and services are bought and sold.
• Firms: receive revenue for selling goods and services and pay salaries for labor.
• Resource Markets: labor, land and capital are bought and sold.
• Households: receive salaries for their labor and spent them on goods and services.
Quantity demanded (single point): number of units that buyers would choose to buy.
• Law of demand: when price rises, quantity demanded will fall (ceteris paribus).
• The demand curve: graph of demand schedule
o Demand Schedule: list of quantities of goods demanded at different prices.
o Change in price: along the curve
o Shift of Demand Curve: Factors that shift the curve rightward
Income and Wealth (up): for normal goods (for inferior goods demand will
change leftward because people don’t want them and can afford superior
Substitute (up): used in place of.
Complement (down): if it goes up, it would be more expensive and demand
Expected Price (up): if a higher price is expected, people are going to buy
more now to sell or consume in the future.
Quantity supplied (single point): amount of a good that sellers would choose to sell.
• Law of supply: when price of a good rises, quantity of the good will rise.
• Supply Curve:
o Supply Schedule: list of quantities of goods produced at different prices.
o Change in Price: along the curve
Fall: leftward (less profitable)
Rise: Rightward (product becomes more profitable)
o Shift of Supply Curve: Factors that shift it rightward
Input: wages, resources, etc (down): lower cost of production, therefore
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Price of alternatives (down): other goods firm could produced instead of
the current one.
Tech. advance: reduce cost of production
Number of firms (up): more firms, more supply.
Expected price (down): I hope the price will rise; therefore I don’t sell my
products yet, to sell more at the higher price later.
Weather (favorable): increases yields and therefore supply.
Supply and Demand: Equilibrium (the state of rest): Buyers would like to pay the lowest possible
price, while sellers would like to sell at the highest price possible.
Equilibrium of Price and Quantity (demanded and supplied must be the same): constant unless
any curve shifts.
• Excess demand: below equilibrium price.
• Excess supply: above equilibrium price.
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Chapter 6: Production, Income and Employment
• Total value of all final goods and services produced for the marketplace during a period of
time within the nation’s border.
o Total value: dollar value
o Final goods: only those sold to their final users. (final price includes intermediate
o Produced: Not land or stocks.
o Period of time: used products were once in the GDP; therefore buying a used
product does not count as part of the GDP.
o Within the nation’s border: includes output by foreign resources located in the
USA. (USAworkers on other lands does not form part of the USA’s GDP.)
• Reporting GDP
o Annualization: what we would have produce during a year if we produced at that
quarter’s rate all four quarters.
o Real vs. Nominal GDP: purchasing power (base year 2005)
o Growth rates
• Tracking GDP:
o Expenditure Approach: GDP = C + I + G + NX
Consumption goods and services (C): What is purchased by households as
final goods (70% of GDP).:
• Imported (included but later subtracted in NX)
• Imputed Items (included): food products produced and consumed
by farms and housing services provided by owner-occupied homes.
• New home construction (not included): considered investment.
Private Investment goods and service (I): purchased by business firms as
• Plant, Equipment and Software
• Changes in Inventories: if inventory declines (more is consumed
than produced) we use negative values.
• New-Home Construction
Government goods and services (G): investments (police cars, schools,
courthouses, etc.) and consumption (wages, computers, gasoline vor
government vehicles, etc.)
• Transfer payments are not included: Social Security payments,
Net exports (NX): we deduct all U.S. imports.
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o Value AddedApproach: adding up each firm’s contribution to the product as it is
produced. (That is the revenue minus the cost of all the intermediate goods that it
o Factor Payment Approach: payments to the owners of the resources used in
production (land (rent), labor (wages), capital (interest payment) and
Basically: Adding the income of a firm.
o Total Output = Total Income
• GDP Problems
o Quality Changes: ignore some quality changes
o Underground Economy: illegal (drugs, prostitution or avoid tax)
o Nonmarket Production: People do themselves rather than hiring. Housecleaning,
typing, sewing, lawn moving and child rearing.
Employment and Unemployment
• Types of Unemployment
o Frictional: between jobs or just entering the labor market. Searching but not
o Seasonal: weather, tourist patterns, Christmas, etc. Seasonal adjustment:
unemployment rate would be adjusted to no show this harmless effect.
o Structural: job seekers and employers are mismatched (people without the skills to
do the available jobs). Old industries are replaced with new ones
o Cyclical (macroeconomics cause): caused by business cycle: recessions. When
cyclical unemployment is zero = full employment.
• Costs of Unemployment
o Opp. Cost: lost output – Slump
o Other costs: suicides, prisons, etc.
• How Unemployment is measured:
o Unemployed: willing and able to work but do not have a job.
Worked one or more hours? Yes: Employed.
No: Temporary layoff? Yes: Unemployed.
No: Searched for work? Yes: Unemployed.
No: Not in the Labor Force.
o Unemployment rat = Unemployed / Labor Force
Labor Force = Unemployed + Employed)
Involuntary Part-Time Workers
Discouraged Workers: no hope for finding job, don’t look for one; therefore
are categorized as not in the labor market.
o The Six “U”s.
o The Establishment Survey: count jobs
o Employment-Population Ration
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Chapter 7: The Price Level and Inflation
When the Price Level rises, the value of the dollar –purchasing power- falls.
Valueof measure∈current period ×100
Valueof measure∈base period
CPI: Consumer Price Index (base period is July 1983)
Is an index for the cost of a market basket of goods (price level) purchased by households.
• What is considered p in the CPI and not in the GDP:
o Used goods.
o Purchases of imports of other countries.
o It also tracks rents and what owners would pay if they had rented their homes.
• Leaves out purchases by:
o U.S. Exports
• The Market Basket: updated every two years by interviews.
• Inflation Rate: how fast the price level is changing (%). CPI’s growth rate.
o Price level rises – inflation rate will be positive.
o Policy Target
o Index Payments
o Nominal to Real Values
• Real Variables andAdjustment for Inflation
o RealWage= CPI∈t hat year ×100
o Provisos about Real Earnings:
Nonwage benefits (insurance)
CPI overestimates inflation
• Real GDP: not measured with inflation
o Types of goods and services are different.
• Accurate: No it overstates, because bias.
o Substitution Bias: people substitute products:
Updating market basket every 2 years.
Change with the changes of price of products.
Still: only within narrow categories and not among categories.
o New Technologies:
These are introduced after a lag.
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o Changes in Quality
Charging more because the consumer is getting more: not inflation.
o Growth in Discounting
Discount outlet lowers the prices
The Costs of Inflation
• Inflation Myth: when price rises, revenues rise.
o Inflation can redistribute purchasing power from one group to another, but it does
not decrease average real income.
• Redistributive Cost of Inflation
o Inflation shifts purchasing power away from those waiting for a nominal payment
and toward those who must pay.
o Expected inflation: if the expected inflaton is correct, it will not harm anyone.
%Change in RV = %ChangeNominal - %ChangeInflation
• Higher: people with payments win.
• Lower: people to receive payments win.
• Resource Cost of Inflation
Cost for Consumers (price changes quickly, time is lost)
Cost for Producers
Costs for Wealth Management
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Chapter 8: The Classical Long-Run Model
• Classical: long-run
• Keynesian: economics fluctuations
Assumptions: markets clear (quantity demanded = q. supplied)
Output: labor market and production function
• Labor Supply (upward): how many people will want to work at each wage rate.
o The greater the wage rate, the more people will want to work.
• Labor Demand (downward): how many people firms will want to hire at each wage rate.
o The greater the wage rate, the less people firms will want to hire.
Diminishing returns to labor: gains from specialization are harder to get as
we keep adding workers. Output rises, but by less and less with each new
• Equilibrium Total Employment: Full employment: no cyclical unemployment. It happens
Employment to Output:Aggregate Production Function
• Total output the economy can produce with different quantities of labor given constancy in
resources and technology.
• Increase in number of workers means increase in output.
o Declining slope: diminishing returns to labor.
Equilibrium Real GDP: in the long-run view, economy reaches its potential output
• Labor Market: tells us how many people work.
• Production Function: how much output this people produce.
Simple Economy: spending = output = income
• No savings:
Say’s Law: spending = output
• Each time a good or service is produced, an equal amount of income is created.
• Supply creates its own demand.
• Gov: taxes (T) and government purchases (G)
• Households: taxes and savings (S)
• Business: buys capital goods (investment spending) (Ip)
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• Total Spending = C + Ip + G
o Total output (GDP) = Total Income
o Planned Investment Spending (Ip)
o Net Tax Revenue (T)
T = Total Taxes – Transfers
o Disposable Income
Disp. Income = Total Income – Net Taxes
S = Disp. Income – Consumption
• If Leakages = Injections, the Total Spending = Total Output
o Leakages: Net Taxes (T) and Savings (S)
o Injections: Government purchases (G) + Investment Spending (Ip)
The Loanable Funds Market: savings are made available to business and gov.
• Supply of loanable funds is equal to S.
o The q. supplied goes up if the interest goes up.
• Dem and of loanable funds is equal to
o Business: Ip (The q. demanded goes down if interest goes up)
o Gov: budget deficit (independent from the interest)
• Quantity of funds supplied (S) is equal to quantity of funds demanded (Ip + G – T).
o Leakages = injections
Fiscal Policy: no demand-side effects at all.
Crowding Out: decline in one sector’s spending caused by the increase in some other sector’s
spending: Total spending remains the same.
• Increase in gov purchases (G) means more borrowing.
o Interest rate goes up.
S increase, therefore C falls.
o The drop in C is equal to de increase in G.
Chapter 9: Economic Growth and Rising Living Standards
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• Rule of 70: If it grows at x% per year, it will double in 70/x years.
• What makes economy grow? GDP: these elements combined= total output
o Producitvity: output produced by the average worker in an hour
Total output/total hours
o Average hours: total hours/total employment
o EPR: Employment-Population Ratio (EPR)
o GDP= Productivity *Average Hours * EPR * Population
o GDP per Capita = Productivity *Average Hours * EPR
%∆GDP per Capita = %∆Productivity * %∆Ave. Hours * %∆EPR
• Growth in the EPR: when total employment rises faster than total population
o What changes total population? Changes in Labor Supply and Labor Demand
When Ls rises, wages decrease; when Ld rise wages increase.
• Better when Ld increases faster than Ls.
Growth of Ls: more people want to work
• Cut in taxes
• Cut some transfers payments (unemployment benefits, etc)
Growth of Ld: business want to hire more
• Increase workforce skills
• Subsidize employment
o Significantly sustained growth in EPR is not realistic.
• Productivity Growth: Increases in the Capital Stock (most important)
o Increase in the amount of capital available for the average worker.
Rise in capital per worker (capital stock/total employment) causes
productivity to rise.
o Planned Investment: how much we add to the capital stock. / Depreciation: how
much is taken away from capital stock.
Policies to increase Ip:
• Business: incentive to invest (more demand for funds)
o Corporate profits tax reduction
o Investment tax credit.
• Households: incentive to save (more supply of funds: less interest)
o Decrease in capital gain tax
o More consumption tax
o Less transfers (more fear to consume)
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• Gov: shrinking budget deficit (more money for the businesses and
o BUT: gov spending is also investment and allows
Human Capital: skills and knowledge
Limits to Growth from Capital
• The richer the country, the harder it is to grow by increasing
• The more capital, more depreciation. It’s harder to keep growing.
• Productivity Growth: Technology (Shifts Prod. Function upward)
o Same capital used in a more productive way (Technology)
o Discovery based Growth: continual supply of new ideas
No diminishing returns
• Research and Development Spending: private and government
• Institutional Infrastructure and Innovation: Laws for intellectual
property, honesty, impartial judicial system
o Catch-Up Growth: copying technologies already used in richer countries.
China, India, etc.
• Growth Policies: Summery
o Fiscal Policy and Economy Growth: change output by altering q. of resources
available (supply-side effects).
o Apolicy can have competing effects on growth. (mutltiple effects)
o Policies that affect Growth: page 256.
• Costs of Economic Growth: economic growth requires some group to give up
o Budgetary Costs: tax cuts will force us to either redistribute the tax burden or cut
o Consumption Costs: more investment means less consumption (PPF btw. Capital
goods and consumption goods)
o Sacrifice of Other Social Goals: achieving social goals (less pollution) requires to
sacrifice growth and more growth sometimes requires to sacrifice social goals.
Chapter 10: Economic Fluctuations
• Can the classical Model Explain Economic Fluctuations? No.
o Labor Supply curve: how many people would like to work
Shift only with change in preferences: change very slowly
o Labor Demand: how many people will firms want to hire
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Labor Market Clear: everything is fine, except:
• if real wage does not change to equilibrium, there would be
• because of wage rigidity: firms do not want to lower wages
Why would this happen?
• Less productivity: decrease in cap. stock or if they forget
o Wars: unlikely
• Change in total spending
o Contradicted by Say’s law: spending = income
• Then, what triggers econ fluctuations? Booms and Recessions, why?
o Popcorn and Yogurt (communication breakdown)
o Change in Production: if a company thinks they will sell more/less, production will
change and thus everything else to.
o Change in Spending: if consumers believe a recession/boom is coming, they will
o Say’s law (more saving, more gov and firms spending) is true over longer periods
of time. How the loanable Funds market could fail from turning savings into
Saving vs. Supply of Funds: not all saving is supplied
• “piggy bank”: fear of money not being paid back
• Total Spending falls below total Income.
Supply of Funds vs. Lending: not everything is invested or lent
• Banks: collect savings and lend them, but fear they won’t get paid
• Total Spending falls below total Income.
Other Influences in Interest rate:
• If savings increase and interest rate does not fall, firms will not
borrow more money,
• Interest rate as a cause of booms/recessions
o Rise: more saving (less consumption), less borrow (less
o Drop: less saving (more consumption), more borrow (more
• Expansions and Recession for the last 50 years (page 282).
o 50% of recessions are cause by oil prices.
o Defense Spending
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Chapter 11: Short-Run Macro Model
Spending depends on income, and income depends on spending.
• Consumption Spending
Disposable Income = Income - (Taxes – Transfers)
Wealth = assets – liabilities
Interest Rate: rise in interest rate causes a decrease in consumption
Expectations: optimism means more consuming
o Disposable Income
The Consumption Function: Consumption Spending (y) vs. Disposable
• Vertical Intercept:Autonomous Consumption Spending
o No Disposable Income: people still consume
• Slope: Marginal Propensity to Consume
o Btw 0 and 1: how many cents we spend out each one dollar
o MPC= ∆Consumption(y)/∆Disposable Income(x)
• Equation: C = a + b (Disposable Income)
o a: autonomous consumption (vertical intercept)
o b: MPC (slope)
o Consumption and Income Line: DI plus taxes paid
Line showing aggregate consumption spending at each level of income or
With fixed taxes, the line shifts downward by the amount of tax times the
• Change in Income: Along the line
• Change in anything else (Tax, interest, expectation, wealth): shift
• Total Spending:
o Other Components: GDP and Income are always the same number
Investment Spending (Ip): does not include changes in inventory
Government Purchases (G):
Net Exports (NX)
o Aggregate Expenditure: sum of spending by households, firms, governments and
the foreign sector on final goods and services produced in the U.S.
AE = C + Ip + G + NX
∆AE = MPC * ∆GDP
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• Equilibrium GDP: output at which output (GDP) andAggregate Expenditure
(AE) are equal.
o If GDP (what firms produce) is bigger thanAE (what they sell) there would be an
excess inventory and if it is smaller there would be a shortage of inventory.
o Inventories and Equilibrium GDP: Find the output level at which the change in
inventory is zero.
∆Inventory = GDP –AE
Graph: ad each component to the Consumption – Income line.
o 45-Degree Line: translator that helps us find the equilibrium
o GDP greater than equilibrium: AE line below the 45-degree line: excess inventory
(output/production in the future will be less)
o GDP less than equilibrium: AE line above the 45-degree line: shortage inventory
(output/production in the future will be more)
o With Services is different
o Equilibrium and Employment
AE may be low and GDP would be below full employment (cyclical
AE may be high and GDP would be above full employment (overheat.)
• Change in Spending
o Change in Investment Spending
Chain reaction (usually within a year):
• More investment
• Income will rise
• Consumption will rise
• Sales will rise
• Income will rise again
o Expenditure Multiplier: number by which the change in investment must be
multiplied to get the change in equilibrium GDP.
Expenditure Multiplier = 1 / (1-MPC)
Sustained increase in investment will cause sustained increase in GDP
• ∆GDP = Exp. Multiplier * ∆G (or I, or T or NX)
o Multiplier in Reverse: Investment Spending decreases
Same behavior as the normal multiplier but negative.
o Other Spending Changes: change in any sector will create a similar chain reaction
Government purchases (G)
Net Exports (NX)
Autonomous Consumption (a)
o AE will shift upward/downward by the initial change in spending and Equilibrium
GDP will rise by the initial change times the expenditure multiplier.
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• The Multiplier Process and Economic Stability
o The larger the multiplier the more unstable the economy.
o Automatic Stabilizer: feature of the economy that reduces the expenditure
multiplier (shrinks impact of spending changes)
Taxes and Transfers that depend on Income: disposable income would be
Imports: part of consumption: income rises, imports rise too
• MPC (therefore the multiplier too) will be smaller when income is
regarded as temporary.
o Automatic Destabilizers: feature of the economy that increases the expenditure
multiplier (enlarges impact of spending changes)
Assets Prices, Wealth and Consumption (expansion: stocks go up)
• Wealth goes up; autonomous spending increases.
Output and Investment Spending
• As GDP rises; companies need more equipment to produce goods
o Real-World Multipliers
Around 1.5 in the U.S.
• Much smaller than in the 30s.
On the long Run the expenditure multiplier is 0
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Chapter 12: Fiscal Policy
Changes in Government spending, transfer payments and taxes
• The Short-Run: Countercyclical Fiscal Policy (reversion or prevention of
recessions or booms)
o Mechanics of the Countercyclical Fiscal Policy
In the short run, fiscal policy does have demand-side effects on output and
• How much more spending the G needs (∆G)?
• ∆GDP= Expenditure Multiplier * ∆G
o Find ∆G depending on the desired GDP.
Net Taxes: cutting taxes or increasing transfers
• Increase spending by households
• Net Tax Multiplier: number a ∆NT is multiplied by to get the
o Net Tax Multiplier = -MPC * Expenditure Multiplier.
o Negative because an increase in Taxes will cause a
decrease in the GDP.
o ∆GDP= Net Tax Multiplier * ∆T
Balanced Budget Multiplier (When G is paid off with an increase in T.)
• As the government multiplier (normal expenditure multiplier) is
more than the net tax multiplier, an equal increase in G and T will
mean an increase.
• The Balanced Budget Multiplier: the final multiplier effect of equal
changes in G and t. It is always 1!
o Problems with the Countercyclical Fiscal Policy
Timing: it takes long (months) for fiscal changes to be enacted
Irreversibility: after the boom/recession is over, fiscal policy should be
stopped. But many people would oppose the reversal once everythins is
Taxes and Forward-Looking Behavior: As taxes increase only temporarily,
households will save more, and the expenditure multiplier will be smaller.
Reaction of the Fed
• The Long Run: Deficits and the National Debt: fiscal policy has long-run
o Gov. figures (spending, debt or tax revenues) should be viewed in relation to the
GDP (as percentages).
o Outlays, Revenue, and the Deficit
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Gov Outlays: total outflow of funds (on purchases, transfer payments, and
interest on the debt).
Recession: transfers rise (more unemployment), tex revenue falls (less
income and corporate taxes) = deficit increases (or surplus decreases)
Expansion: transfers decrease and tax revenue rises = deficit decreases (or
o National Debts and Deficit
Budget Deficit: add to federal debt (Gov sells bonds)
Budget Surplus: subtract from national debt (Gov buys them)
• National Debt: Myths and Realities
o Myth: We do not have to pay the debt (ever). If, however, the amount of interest
rises faster than income, then we will have a problem.