Intro Macro - Sheflin
Essential Questions in Intro Macroeconomics 12/2013
(NOTE, we have not covered some of these topics yet, but will by the end of the
Many/most Final Exam multiple-choice questions will deal with these issues (as did the
HW assignments in one form or another). If you can answer these in words, you should
have no trouble with the multiple choice questions on the final. If you cannot, look up the
answers and if still having trouble, post on the FINAL EXAM RELATED chat room. See
the REVIEW GUIDE for more information and suggestions on how to study.
Graph means show the appropriate graphical analysis –ex: aggregate Supply and
Demand, Money Supply and Demand, Yield Curve, etc.Arrow diagram means be able to
trace out steps - MiIDP,Y Equation means be able to write out a related equation -
YOU SHOULD LIKELY STUDYTHIS FROM THE BOTTOM TO THE TOP – THAT
IS, FROM MATERIAL COVERED LATE IN THE COURSE, BACK TO THE
Items in italics will most likely NOT be on the exam
BACKGROUND AND MICRO ISSUES
1. How do economists measure the value of anything?
• By its market price determined by supply (reflecting costs and
scarcity) and demand (reflecting tastes)
2. What determines the price and quantity of any good or service?
• The demand curve; a change in demand means the whole curve shifts,
due to a change in income, tastes, or the prices of other relevant goods
3. What is opportunity cost and why is there no free lunch?
• Opportunity cost – the cost of an alternative that must be forgone in
order to pursue a certain action; or the benefits you could have received by taking an alternative action
• No free lunch – commonly used to describe situations in which
investors are not able to consistently make large profits without
bearing the risk of a potential loss
4. What does the invisible hand mean, and why does it suggest laissez-faire?
• Basis for belief in “free-market” capitalism in which individual self-
interest, coming together in a competitive market place, leads to a
socially efficient outcome as though “guided by the invisible hand of
5. What are the three questions answered by any economic system and how are they
answered under a market-based system
• What will be produced? How will it be produced? For whom will it be
6. What is the difference between capitalism, socialism, communism
• Capitalism – economic system based on private ownership of capital
• Socialism – economic system based on state ownership of capital
• Communism – abolishes private ownership
7. What is the definition of Microeconomics? Macroeconomics? Economics?
• Microeconomics – the study of decisions that people and businesses
make regarding the allocation of resources and prices of goods and
• Macroeconomics – studies the behavior of the economy as a whole and
not just on specific companies, but entire industries and economies
• Economics – branch of social science that deals with the production
and distribution and consumption of goods and services and their
CIRCULAR FLOW, NATIONAL INCOMEACCOUNTINGAND OTHER
1. 2 Important points of the Circular flow model • The equivalence of real and money flows
• The equality of production and income, and savings = investments
2. Define GDP (precisely)
• 5 components: domestically produced, final good, services, gross,
3. 3 Ways to calculate GDP (ValueAdded is one)
• 2 loops of circular flow model
• GDP= C+I+G+NX
• Nominal GDP= Real GDP(P)
4. What is the relation between Gross and Net Investment and Depreciation
• Net investment = Gross Depreciation
• Net investment = Gross investment - depreciation
5. Definition of Real and Nominal GDP
• Real GDP– level of GDPafter changes in inflation have been taken
• Nominal GDP– calculated at existing prices
6. How do you calculate real GDP from nominal? Formula
• Nominal GDP= Real GDP(P)
7. What is meant by deflating nominal GDP?
• Calculating Q from PQ
8. How do we measure/calculate unemployment, labor force, employment?
9. What are Discouraged Workers and Hidden Unemployment
• Discouraged workers – those who gave up on their job hunt, a part of
10. What is the CPI? What is it used for?
• Consumer price index – an index of the cost of all goods and services
to a typical consumer
11. How is the CPI calculated, very roughly (in a sentence)? • r = Pn/Pe
12. What are shortcomings of the CPI?
• Overstates the cost of living because it doesn’t reflect increases in
quality, or an allowance for the substitution of goods
13. Why do economists prefer the chained CPI?
• Provides a more accurate measure of the average change in the cost of
living than the standard CPI
14. What is the GDP deflator?
• Nominal/Real x 100
15. What is meant by chained ($2005) GDP?
• Real GDP
16. What is meant by seasonally adjusted data?
• Astatistical adjustment made to accommodate predictable
fluctuations as a function of the season of the year
17. What are some shortcomings of GDP as measure of economic activity and well
• Does not take into account nonmarket transactions, fails to account
for improved product quality, underground economy not included
1. What is the economic role of the financial system – what useful purpose does it
serve for the overall economy?
• Provision of liquidity, credit provision, risk management
2. What is Stock?
• Atype of security that signifies ownership in a corporation and
represents a claim on part of the corporation's assets and earnings
(shares of a company)
3. What is the major reason people buy stock?
• High reward, to make money/capital
4. What is leverage, liquidity, buying on margin, selling short? • Leverage – use of debt to supplement investment
• Liquidity – The ability to be easily redeemed for a value
• Buying on margin – buying securities on credit
• Selling short – selling assets, usually securities, that have been
5. What are the roles of dividends and the risk-adjusted discount rate in determining
the fundamental price of a stock (Stock Price=Dividends/(risk adjusted discount
rate dividend growth rate)?
• Determine what a stocks price should be using the stream of constant
dividends and risk adjusted discount rate (P=n/r)
6. What is a speculative bubble?
• Aspike in asset values within a particular industry, commodity, or
asset class.Aspeculative bubble is usually caused by exaggerated
expectations of future growth, price appreciation, or other events that
could cause an increase in asset values
7. How do stocks compare to bonds?
• Stocks tend to have a greater risk for the return, and a higher reward.
Bonds tend to be more stable than stocks (fixed rate of return year
8. How and why should you invest in stocks?
• By investing your money, you are getting your money to generate
more money by earning interest on what you put away or by buying
and selling assets that increase in value
9. What is the advantage of diversification?
• Risk reduction, capital preservation, ability to hedge your portfolio –
10. What is the efficient markets hypothesis, and how does it relate to random walks?
• EMH – An investment theory that states it is impossible to "beat the
market" because stock market efficiency causes existing share prices
to always incorporate and reflect all relevant information • Random walks – past movement or trend of a stock price or market
cannot be used to predict its future movement
11. What are Bonds? Bond Ratings, Junk Bonds, Treasury Bonds, Corporate Bonds,
• Bonds – A debt security, similar to an IOU
• Bond ratings – bond quality/credibility
• Junk bonds – a bond rate “BB” or lower because of its high default
• Treasury bonds – government issued debt
• Corporate bonds – bond issued by a corporation
• Municipal/S&L bonds – interest income is exempt from federal
12. What are Mutual Funds?
• Acollection of both stocks and bonds
13. What is a hedge fund? An ETF?
• Hedge fund – An aggressively managed portfolio of investments that
uses advanced investment strategies such as leveraged, long, short and
derivative positions in both domestic and international markets with
the goal of generating high returns
• ETF – Asecurity that tracks an index, a commodity or a basket of
assets like an index fund, but trades like a stock on an exchange. ETFs
experience price changes throughout the day as they are bought and
14. What is a stock index mutual fund, and why should you likely use it for long-run
• A type of mutual fund with a portfolio constructed to match or track
the components of a market index, such as the Standard & Poor's 500
Index (S&P 500); low operating expenses
15. What is a 401k? What should be in it?
• Employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis (saving for retirement)
16. What are derivatives?
• Asecurity whose price is dependent upon or derived from one or more
underlying assets; the derivative itself is merely a contract between
two or more parties
17. What’s an option? Afutures contract?Acall option?
• Option – right to buy or sell
• Futures Contract – contract to buy or sell a specified commodity of
standardized quality at a certain date in the future and at a market-
• Call Option – the option to buy a given stock at a given price before a
18. What’s an IPO?
• Initial Public Offering – The first sale of stock by a private company
to the public
19. What are primary and secondary financial markets?
• Primary market – where new securities are created; new stocks and
bonds are sold to the public for the first time
• Secondary market – what people are talking about when they refer to
the "stock market.” Ex: NYSE, Nasdaq
20. What are financial intermediaries?
• An entity that acts as the middleman between two parties in a
financial transaction. Ex: commercial bank, investment back,
MONEYAND THE FED
1. What is Money? Wealth? Income? How are they different?
• Money – the circulating medium of exchange as defined by a
• Wealth – a measure of the value of all of the assets of worth owned by a person, community, company or country
• Income – Money that an individual or business receives in exchange
for providing a good or service or through investing capital
2. Define M1, M2
• M1 – currency (coins and bills), checkable deposits, and travelers
checks (all of which are used in exchange) – most liquid
• M2 – checking account deposits and savings account deposits
3. What are the three functions of money?
• Medium of exchange, unit of account, and store of value
4. Why are the advantages of an economy using money rather than barter?
• Lowers transaction and info costs, allows specialization in labor, and
develops financial system
5. What is barter and what are the shortcomings of barter?
• Goods for goods (without money)
• Shortcomings: inefficient, high transaction costs
6. What is the Fed? Describe its structure. Why does the Fed have the structure it
does (12 banks, etc).
• The Federal Reserve
• Considerable independence – created by Congress, can be changed by
• Board of Governors, fed open market committee, federal reserve
banks, member banks, advisory councils; 12 banks divide nations into
7. What are the goals, tools/instruments, and targets of the Fed?
• Goals – price stability/control inflation
• Tools – open market operations, discount rate, reserve
• Targets – federal funds rate
8. Explain in words how a Fed open market purchase increases the money supply
• The government securities that are used in open market operations
are treasury bills, bonds, and notes. If the FOMC (Federal Open Market Committee) wants to increase the money supply in the
economy, it will buy securities. Conversely, if the FOMC wants to
decrease the money supply, it will sell securities.
9. What is the operating target of the Fed?
• Federal Funds Rate: the Fed picks a target r, the Fed fund rate that is
thought to be consistent with their goals and uses open market
purchases or sales to ‘nudge’the actual funds to the target value
10. What is the primary ‘traditional’policy tool of the Fed?
• Open market operations – purchase and/or sales of outstanding
government bonds from private bond dealers; also discount rate
which tends to passively follow funds rate and control of reserve
requirements – not used.
11. What are the ultimate goals of the Fed?
• They have two - Dual mandate
• Stable prices and maximum employment in that order (moderate
long-run rates follow from these, and many believe the maximum
employment in the long-run follows from price stability)
12. What is the Taylor Rule?
• The Fed increases interest rates in times of high inflation, or when
employment is above the full employment levels, and decreases
interest rates in the opposite situations
13. What is inflation targeting?
• Central banking policy that revolves around meeting preset, publicly
displayed targets for the annual rate of inflation. Ex: CPI
14. Is the Fed Independent? Why? How? (more on the Fed below)
• Yes – not owned; not a private profit-making institution
15. What is quantitative easing?
• Even in liquidity trap, Fed might be effective by increasing MS and
causing some inflation, and easing credit conditions
16. Why is Fed credibility important? • The Fed's credibility regarding control of inflation helps to anchor
public expectations of price stability. This makes the Fed's actions
more predictable in any given set of circumstances and strengthens
the monetary policy transmission mechanism and shortens policy lags.
SHORT RUN KEYNESIAN MODEL(all of the following refer to the Keynesian
model and the short-run only)
1. What determines aggregate prices and output?
• Aggregate demand / aggregate supply
2. What determines interest rates?
• Money demand / money supply nominal interest
3. What are the components of aggregate demand?
• Aggregate D = C+I+G+NX (NX=net exports=imports-exports)
4. Why is the aggregate demand curve downward sloping? (not so important)
• Interest rate effect, real balance effect, foreign purchases effect
5. What are the determinants of:
• *Consumption – Y-T, wealth
• Saving – Y-T, wealth
• *Investment – interest rates
• Government Expenditures – exogenous
• Exports – foreign income
• Imports – US income
6. What are the condition(s) for equilibrium?
• Occurs when agg demand = agg supply (Y=C+I+G+X-M)
• Unintended inventories = 0,AD=AS=Y, I=S
7. What is the role of inventories?
• Inventory change – part investment; unintended – demand slowing,
intended – business is good
8. What factors shift the aggregate demand curve? The aggregate supply curve? • Agg Demand Curve shifts – any changes in C, I, G, X-M
• Agg Supply Curve shifts – costs of production: wages, raw materials,
9. How does the stock market affect the economy?
• Significantly adds to the wealth effect – if people feel wealthier,
10. What are the ‘types’of unemployment?
• Structural unemployment – mismatch between skilled workers and
• Frictional unemployment – moving from one job to another (time in
• Cyclical unemployment – demand deficient, not enough demand
11. What is inflation and what causes it in the short-run?
• Inflation is a sustained increase in general price level
• Causes in SR: increase in money supply
12. What is the short-run Phillips curve and why is it important?
• The Phillips Curve cannot be stable in the short run
• Inverse relationship between unemployment and inflation; If inflation
is high, then unemployment is low
13. What is 45-degree line (Keynesian cross) analysis? (You do not have to know
how to ‘do it’just what it is and what it is used for).
• Illustrates whether consumption spending is equal to, greater than, or
less than the level of disposable income
14. What causes business cycles, and what are they?
• Business Cycles – Periodic, irregular ups and downs in economic
activity, such as expansions & contractions (recessions, depressions)
and peaks & troughs
• Caused by demand or supply shocks
15. How does monetary policy impact the economy in the short-run?
• SR: stabilizes business cycles and affects potential and real GDP • LR: affects prices
16. Which is the shorter and which the longer lag in monetary policy?
• Shorter: implementation lag
• Longer: impact lag
17. How does fiscal policy impact the economy?
• Governments can influence macroeconomic productivity levels by
increasing or decreasing tax levels and public spending. This
influence, in turn, curbs inflation, increases employment, and
maintains a healthy value of money
18. What is the effect of a government budget deficit?
• Have to pay interest on loans less for investment hinders economic
19. Which is the shorter and which the longer lag in fiscal policy?
• Shorter: impact lag
• Longer: implementation lag
20. What is the idea of the political business cycle?
• Changes in the economy as a result of political tactics before and after
elections. To gain voter support politicians will often expand the
economy prior to elections and implement reforms just after the
21. What is a consumption function? The mpc? the multiplier?
• C = F(Y-T,W)
• Expenditure multiplier = 1/(1-MPC)
• Ex: If C=100+0.9Y, MPC=0.9, Multiplier=1/(1-0.9)=10
22. Calculate the Government Expenditure multiplier formula
• 1 / (1-mpc) where mpc is the marginal propensity to consume, and
indicates the change in consumption resulting from a 1 change in
23. What is the paradox of thrift?
• The notion that individual savings (rather than spending) can worsen a recession; individual saving is collectively harmful
• Consumer spending contributes to the collective good, because one
person's spending is another person's income
24. What is the wealth effect?
• Changes in wealth will impact Consumption and Aggregate Demand
higher wealth, increase spending
LONG –RUN CLASSICAL MODEL (each of the following refers to the Classical
1. What determines output?
• Labor, full employment
2. What determines prices?
• Money supply
3. What determines interest rates?
• Savings and Investment real I; nominal I = real I + inflation
4. What is loanable funds theory?
• (Neo classical) – the rate of interest is the price that equates the
demand for and supply of loanable funds
• In other words: *the real interest rate is determined by savings (S)
and investment (I); S will equal I (according to Say’s Law)
5. What is Say’s law?
• "Supply creates its own demand" - hence no unemployment (other
than structural and frictional).
6. What is the quantity theory?
• States that there is a direct relationship between the quantity of
money in an economy and the level of prices of goods and services sold
7. What is the natural rate of unemployment (NAIRU)?
• The equilibrium rate of unemployment; verticalAS curve
8. What is the relation between the nominal and real interest rates and inflation? Formula
• i rea