Exam 2 Review (Chapters 9, 10, 11, 6 &5)
• Economy’s Price Level (P*): Measures the average prices of g&s in the economy.
o Hyperinflation: Extremely rapid/out of control inflation.
o Inflation (rate): The % increase from one year to next. Determined by CPI: (N-
O/O) x 100
o Deflation: A decline in the price level.
o Disinflation: A significant reduction in the inflation rate.
o Stagflation: A combo of inflation and recession, usually resulting from a supply
• Index Numbers
o Inflation Rate: PI this year-PI last year/PI last year x 100
• Price Indexes
1. The GDP Deflator = [(N GDP)/(R GDP)] x 100
2. The Producer Price Index (PPI) Like CPI, tracks the P of a mkt basket of g’s, but
PPI tracks the p’s firms receive for G&S at all stages of production.
3. The Consumer Price Index (CPI): Average of the p’s of G&S purchased by the
typical urban family of four. Shows how much P level has changed over time.
Used to find inflation rate. CPI = (exp.s in current year/exp.s in base year) x 100
The Reference Base Period: the CPI = 100
• Is the CPI Accurate?
o Substitution Bias: The Bureau of Labor Statistics (BLS) assumes consumers
purchases same amount of product each month, in reality: consumers less likely
to buy products that increase in P & more that increase least in P.
o Unmeasured Quality Change: Over time, products in CPI increase in quality (eg:
automobiles become more durable, better tech, etc.). These increase are difficult
to adjust for and result in overstating of pure inflation of some products.
o Inrod.n of new Goods: BLS only updates market basket of CPI every 10 years.
Therefore, new products aren’t included. P’s of products decrease over time and
that’s why these P decreases aren’t included in CPI until update.
o Outlet Sub. Bias: Consumers increase purchases at discount stores like Costco.
CPI tracks sales of traditional full-price retailers, so CPI didn’t reflect actually P
• How the CPI is used (3 Major Ways) o As a policy target
o To index payments
o Translate from Nominal to Real Values:
Real Wage Rate:
• Differences bet CPI & GDP Deflator
o GDP Deflator: Reflects P of ALL G&S produced in country, where CPI reflects the
p’s of a representative BASKET of G&S purchased by consumers.
o What is the inflation myth? The inflation tax
• Costs of Inflation?
o Menu Costs: The cost to firms of changing P’s (ex: having to print new menus
because of new P’s)
o Shoe leather costs: Opportunity cost of time and energy that people spend trying
to counter-act effects of inflation. (ex: holding less cash and having to make more
trips to the bank).
o The Fischer Effect: Explains relationship between inflation and N/R interest rates:
R interest rate(r) = N interest rate(i) – inflation rate. Therefore, R interest rate falls
inflation increase, UNLESS N rates increase at the same rate as inflation.
If expected inflation DOES NOT EQUAL actual inflation, what
happens? Lenders/borrowers can lose money. UNFAIRLY because its
from something unanticipated.
• If expected interest rate>Real interest rate, BORROWERS lose
b/c they had been borrowing high for so long, than unexpected
inflation decline occurs.
o If exp interest rate>R interest rate, LENDERS lose.
• Unfair redistributions of Wealth w/in society: Some people’s
incomes fall behind even in anticipated level of inflation
(redistribution of income). Also, firms and consumers will hold
more PAPER MONEY to facilitate their buying and selling. Anyone
holding paper $ will find its purchase power decreasing each year
by rate of inflation.
• Types of Inflation:
o Demand-Pull Inflation: When P levels rise b/c of an imbalance in the aggregate
(total in an economy in specific t period) supply and demand. When agg. D
heavily outweighs agg. S, P’s increase. CAUSED by “too many dollars chasing
too few goods”. o Cost-Push Inflation: When the general P levels rise (inflation) due to an increase
in the cost of wages & raw materials.
Per-Unit Prod.n Costs: Physical cost to manufacture an item (material +
• Tax Law on Interest Income:
o N Interest Rate (I) = R interest rate (r) + Inflation Rate
After-tax N interest rate
After-tax R interest rate
• Health Care
o Health Insurance:
o Single-Payer HC System: (Canada) Gov’t provides national health insurance to
all residents. Indivduals pay NOTHING for doctor’s visits, instead pay for medical
care through taxes.
o Socialized Medicine: (UK) Gov’t owns all hospitals and practices. Apart from
SMALL CO-PAYS, for prescriptions, healthcare provided with NO charge to
patients. Receives funding from taxes.
o Fee-for-service: Health insurance plan that where doctors/hospitals receive a
payment for each service they provide.
o Mkt-based Reforms
o Patient Protection & Affordable Care Act (PPACA/”Obamacare”): Makes
insurance less expensive for small businesses and individuals by allowing them
to enter into pool of healthy and sick people who pay same insurance premium.
Adverse Selection: When one party to a transaction takes advantage of
knowing more than other party. (ex: lemons). Reduces total quantity of
used cars bought & sold in market b/c few good cars = offered for sale.
• Insurance co.s “risk pool” when they sell policies. (frequency and
likeliness of loss).
Moral hazard: Actions people take after they have entered into a
transaction that make other party worse off. (ex: when people change
behavior after being insured, buying crappy sprinkler system after
purchasing fire insurance)
Asymmetric information: When one party has more/superior info than
Principal-agent problem: Problem caused by agents(doctors) pursuing
their own interests rather than the interests of the principals(patients) who
hired them. • Macroeconomic Goals & Policy, Business Cycle (SUPPLEMENTED)
o Business Cycle:
Peak and trough:
o Real GDP, (un)employment, & price level = closely related
Natural rate of unemployment: Normal rate of employment. Includes
frictional plus structural.
Potential GDP: Level of RGDP attained when all firms are producing at
Consumer Confidence: Measures the degree of optimism that consumers
feel about the overall state of the economy and their personal financial
Producer confidence: Same.
• Procyclical v. Countercyclical Measures: Pro: when the fed
(federal reserve system) aims to increase the severity of the
business cycle. Counter: when they mean to REDUCE the
severity of the biz cycle.
o Transfer Payments: Redistribution of income in the market
system. Considered “non-exhaustive” bc they don’t absorb
res.s or produce output.
Monetary Policy: actions the fed takes to manage money supply and
interest rates to pursue its macroeconomic goals. By the US Central Bank
( the Federal Reserve System): Assumed with “ceteris paribus” (all else
remains the same). Compare to what would’ve happened without policy.
Ex: a contractionary policy doesn’t cause P’s not to fall, rather just less
than they would have WITHOUT the policy. **
• The Mkt for Loanable Funds
o The Federal Budget: Tax Revenue v. Expenditure
Gov’t Spending = G + Transfer Payments + Interests on Debt
Tax Rev o Supply of Loanable Funds: Nat’l Saving (Saving) = Private saving + Public
Budget Surplus (Public saving>0): Gov’t spendingTax Rev
o Demand of loanable funds: Investment. Determined by the willingness of firms to
borrow money to engage in new investment projects, building new factories or
research. Supply of loanable funds = det. By willingness of HH’s and gov’t to
o Gov’t policies on the mkt for loanable funds: If gov’t inc. spending, budget deficit.
This reduces total amount of saving in economy (want to promote stimulation of
economy). S of loanable funds DECREASES (causes higher interest rate & eq.
Q is lower). Higher interest rate = lower investment spending by firms.
Market for loanable funds: interaction of borrowers and lenders
determines the market interest rate and quantity of loanable funds
Budget deficits and surplus
• “Crowding out” effect: When the gov’t borrows in order to balance
out its financial deficit, it “crowds out” some firms that would’ve