Macro Issues

Background and Micro Issues

1, How do economists measure the value of anything?

price
2. What determines the price and quantity of any good or service? graph
demand and supply
3. What is opportunity cost and why is there no free lunch?
The value of the next-best choice available. There is always an opportunity cost.
4. What does the invisible hand mean, and why does it suggest laissez-faire?
The idea that markets balance themselves (self-regulating), creating efficiency; free
market.
5. What are the three questions answered by any economic system and how are
they
answered under a market-based system
what, how, and for whom
6. What is the difference between capitalism, socialism, communism
Capitalism is an economic system based on private ownership of capital; market
determines price and signal shortage and surplus owners then allocates resources.
Socialism is an economic system based on state ownership of capital; market
determines prices and central authority allocate resources.
Communism is a form of socialism that abolishes private ownership; central authority
allocate resources.
7. What is the definition of Microeconomics? Macroeconomics? Economics?
Microeconomics- the branch of economics that studies the economy of consumers or
households or individual firms; study of decisions that people and business make
regarding the allocation of resources and price of goods and services.
Macroeconomics- the branch of economics that studies the overall working of a national
economy; studies behavior of economy as a while and not just on specific companies,
but entire industries and economics
Economics: the branch of social science that deals with the production and distribution
and consumption of goods and services and their management

CIRCULAR FLOW, NATIONAL INCOME ACCOUNTING AND

OTHER MEASUREMENTS

2 Important points of the Circular flow model

The equivalence of real and money flows, the equality of production and income, and
savings=investment
2. 3 Ways to calculate GDP (Value Added is one)
Key points in definition of GDP: domestically produced, final goods and services, gross,
C+I+G+NX, valued at market prices, total flow
calculate GDP :Two loops of Circular Flow model, GDP= C+I+G+NX, Nominal
GDP=Real GDP(P)
calculate GDP 1) Output method: where you calculate total value of all final goods and
services produced 2) Income method: finding total income of nation (rent, wages,
interest and profit) 3) Expenditure method: finding total amount of money spent in
economy
3. What is the relation between Gross and Net Investment and Depreciation
Net investment = Gross Depreciation; Net investment = Gross investment - Depreciation

4. Definition of Real and Nominal GDP

Real GDP: Been deflated or inflated to reflect changes in price level; after changes
inflation have been taken into account
Nominal GDP: Prices that prevail when output is produced; calculated at existing prices
GDP price index: Measure of the price of a specified collection of goods and services;
"market basket" in a given year as compared to the price of an identical collection of
goods and services in a reference year
5. How do you calculate real gdp from nominal? Formula
Nominal GDP = Real GDP(P)
Real GDP = (Nominal GDP/GDP price index) X 100
6. What is meant by deflating nominal gdp?
(Nominal GDP/GDP deflator) X 100 = real GDP; deflating nominal GDP into real
measure
7. How do we measure/calculate Unemployment, Labor Force, Employment
Surveys
8. What are Discouraged Workers and Hidden Unemployment
Given up looking for work, not actively seeking employment
9. What is the CPI? What is it used for?
Consumer Price Index: index of cost of all goods and services to consumer
10. How is the CPI calculated, very roughly (in a sentence)?
Cost of CPI basket at current period price/Cost of CPI basket at base-period price X 100
11. What are shortcomings of the CPI?
New goods bias, quality change bias, commodity substitution bias, outlet substitution
bias (Overstates cost of living b/c it doesn't reflect increase in quality, or allowance for
substitution of goods)
12. Why do economists prefer the chained CPI?
(Its seen as more accurate)Chained CPI is a measure of inflation created by the Bureau
of Labor Statistics that has been touted as a more accurate way to factor rises in the
cost-of-living into, among other things, social security benefits and the tax code.
13. What is the GDP deflator?
Measure of the level of prices of all new, domestically produced, final goods and
services (Nominal/Real X 100)
14. What is meant by chained ($2005) GDP?
Weighted average of successive year (real gdp)
15. What is meant by seasonally adjusted data?
Made to accommodate predictable fluctuations as a function of the season of the year
16. What are some shortcomings of GDP as measure of economic activity and well-
being?
As a measure of economic development, GDP is a useful but fundamentally flawed
statistic.

INVESTMENT RELATED
1. What is the economic role of the financial system – what useful purpose does it serve
for
the overall economy?
Provision of liquidity and deal with risks of asset
2. What are stocks (equity)?
Shares of a company
3. What is the major reason people buy stock? Why do firms issue stock?
High reward, make capital gain, make profit off some dividends, gain control of
company.
4. What is leverage, liquidity, buying on margin, selling short?
Leverage: Use of borrowing money (debt) to increase return of cash investment
Liquidity: Ability to easily redeemed for value, convert assets into cash quickly
Burying on margin: Buying securities on credit, borrowing money from broker to make
investment
Selling short: Selling a stock with hope of buying it back at a lower price.
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 stock price should be using the stream of constant dividends and risk
adjusted discount rate (Stock price=dividends/risk adjusted discount rate-dividend
growth rate)
6. What is a speculative bubble?
Price of stock is insanely high, spike in asset values
7. How do stocks compare to bonds as an investment?
Bonds are a debt to be repaid (fixed rate of return); Stocks are an equity to be
gained/lost (high risk, high reward)
8. How and why should you invest in stocks?
to diversify
9. What is the advantage of diversification?
- Lessens the risk
10. What is the efficient markets hypothesis, and how does it relate to random walks?
What
does it suggest for your personal investing?
No one consistently beats the market, securities (stock prices) quickly reflect relevant
information, and past stock prices are not useful in predicting future
11. What are Bonds? Bond Ratings, Junk Bonds, Treasury Bonds, Corporate Bonds,
Muni/S&L Bonds?
Bond: debt investment where investor loans money to either a company of the
government for a defined period of time at a given interest
Bond Ratings: rating that provides prospective buyers information on whether a bond is
worth the risk
Junk Bonds: a high yield bond; rated below investment grade at time of purchase
Treasury Bonds: Fixed-interest U.S. government debt security with maturity of more than
10 years; government issued debt
Corporate Bonds: Bond issued by corporation; expand business
Muni/S&L Bonds: interest income is exempt from federal income tax; debt security to
finance capital expenditures
12. What are Mutual Funds?
Collection of stocks or bonds
13. What is a hedge fund? An ETF?
Hedge fund: a private investment organization that employs risky strategies that often
made huge profits for investors
ETF (exchange-traded fund): a security that tracks an index, a commodity or a basket of
assets like an index fund, but trades like a stock on an exchange
14. What is a stock index mutual fund, and why should you likely use it for long-run
investing?
stock index mutual fund - a type of mutual fund with a portfolio constructed to match or
track the components of a market index, such as the S&P 500
15. What is a 401k? What should be in it?
401k plan: the common name for the tax qualified, defined-contribution pension account
defined in subsection 401k of the Internal Revenue Code. Within a 401k there should be
a stock diversified fund which can create a higher return, risk averages out over time
16. What are derivatives?
a security whose price is dependent upon or derived from one or more underlying assets
(most common of which are stocks, bonds, commodities, currencies, interest rates and
market indexes)
17. What’s an option? A futures contract? A call option?
option: a financial derivative that represents a contract sold by one party to another
party, offers the right to buy, sell, or hold a security
futures contract: a contractual agreement, generally made on the trading floor of a
futures exchange to buy or sell a particular commodity at a pre-determined price in the
future
call option: an agreement that gives an investor the right to buy a stock, bond or other
financial instrument
18. What’s an IPO?
- IPO (Initial Public Offering): the initial selling of securities such as stocks or
bonds by a firm into the open market in order to raise capital.
19. What are primary and secondary financial markets?
Primary financial markets: where securities are created, firms float new stocks and
bonds to the public for the first time (IPO)
Secondary financial markets: also referred to as "stock market," where securities are
openly traded in major exchanges around the world
20. What are financial intermediaries?
an entity that acts as the middleman between two parties in a financial transaction
(includes banks, insurance companies, and mutual funds).
MONEY AND THE FED
What is Money? Wealth? Income? How are they different?
Money: Anything accepted as a medium of exchange
Wealth: Total value of what a household owns minus what it owes
Income: Expenditures gained by an individual during a particular period of time
2. Define M1, M2
M1: Currency, checking accounts, and travelers checks. most liquid
M2: M1+savings accounts, other assets.
3. What are the three functions of money?
- Medium of exchange, unit of account, 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?
Exchange goods/services w/o money; needs a double coincidence of wants, less
convenient
6. What is the Fed? Describe its structure. Why does the Fed have the structure it does
(12
banks, etc). What is the FOMC?
Fed: Boards of governor, open market committee, fed reserve banks, member banks,
advisory councils: 12 banks divide nation into 12 districts, acting as fiscal agents for U.S.
Treasury balance power and conflicts.
7. What are the goals, tools/instruments, targets of the Fed?
Goals-price stability, Tools-open market ops, discount rate, reserves , Targets-fed funds
rate
8. Explain in words how a Fed open market purchase increases the money supply
Can purchase Treasury bonds from banks and other holders releasing cash to be
circulated in MS (Fed gets funds for purchase merely by writing a check and thus
creates money)
9. What is the operating target of the Fed (answer – the fed funds rate)?
Fed Funds rate
10. What is the primary ‘traditional’ policy tool of the Fed?
open-markets
11. What are the ultimate goals of the Fed?
price stability, maximum employment, stable interest rates
12. What is the Taylor Rule?
Taylor’s rule is a formula developed by Stanford economist John Taylor. It was designed
to provide “recommendations” for how a central bank like the Federal Reserve should
set short-term interest rates as economic conditions change to achieve both its short-run
goal for stabilizing the economy and its long-run goal for inflation.
13. What is inflation targeting?
Inflation targeting is a monetary policy in which a central bank has an explicit target
inflation rate for the medium term and announces this inflation target to the public.
14. What is the liquidity trap and why does it matter?
Liquidity trap: a situation in which conventional monetary policy loses all tractio
15. Is the Fed Independent? Why? How? (more on the Fed below)
Fed independence Not owned or private-profit making institution
16. What is quantitative easing?
the introduction of new money into the money supply by a central ban
17. What is unconventional monetary policy?
The unconventional monetary policies that the Federal Reserve has pursued since 2008
– pushing short-term interest rates to zero, promising to keep them there for a long time
and buying trillions of dollars in bonds in its quantitative easing – have not resulted in life
insurers becoming riskier despite the widespread belief to the contrary.
18. Why is Fed credibility important?
The importance of the Fed's credibility can be illustrated by the consequences of its
absence in the 1970s. This paper discusses the roots of the Fed's current credibility: a
systematic approach to controlling inflation, transparency of its policy decisions, and
timely communication of the decisions and the considerations upon which they are
based.

SHORT RUN KEYNESIAN MODEL (all of the following refer to the

Keynesian model and the short-run only)

What determines aggregate prices and output? graph

AD/AS (determines prices and output)
2. What determines interest rates? graph
Md/Ms -> nominal interest
3. What are the components of aggregate demand?
C+I+G+NX
4. What are the determinants of Consumption? Saving? Investment? Government
Expenditures? Exports? Imports?
Determinants of consumption: Y-T, Wealth
Determinants of Saving: Y-T, Wealth
Determinants of Investment: Interest rate
Determinants of Government expenditures: Exogenous
Determinants of Exports: Foreign income
Determinants of Imports: U.S. income
5. What are the condition(s) for short-run macro equilibrium?
planned investments = actual investment, unintended inventories=0
(AD=AS=Y, I=S)(AD=AS=Y, I=S)
6. What is the role of inventories (what makes them go up or down and what does each
signify)?
Inventory change-part investment
unintended-demand slowing
intended-business is good
7. What factors shift the aggregate demand curve? The aggregate supply curve?
Changes in C, I, G; production costs, wages, technology
8. How does the stock market affect the economy?
wealth effect; consumption increases, (D, Y does too)
9. What are the ‘types’ of unemployment?
Frictional: moving from one job to another
Structural: mismatch between skilled workers and employers' needs
Cyclical: demand deficient
10. What is inflation and what causes it in the short-run?
Rise in general level of price, increase in MS
11. What is the short-run Phillips curve and why is it important? graph
Inverse relationship between unemployment and inflation in SR (high inflation, low
unemployment)
12. What causes business cycles, and what are they?
ups and downs of the "normal" economy, caused by demand and supply shocks/shifts
13. How does monetary policy impact the economy in the short-run?
SR: stabilizes business cycles and affects potential and real GDP; LR: affects prices
14. Which is the shorter and which the longer lag in monetary policy?
Long impact lag and short implementation lag
15. How does fiscal policy impact the economy? Graph, arrow
Government spending and taxation; affects AD and distribution of income
16. What is the effect of a government budget deficit?
Pay interest on loans--> less for investment--> hinders economic growth
17. Which is the shorter and which the longer lag in fiscal policy?
Short impact lag, and long implementation lag
18. What is the idea of the political business cycle?
Politicians essentially "create" their own economy so that it looks like that economy is
doing well; strategy to get elected
19. What is a consumption function? The mpc (marginal propensity to consume)? the
multiplier?
C=F(Y-T, W)
C=A+BY
MPC=B
Y=1/(1-MPC) ←-----multiplier (government expenditure)
20. Calculate the Government Expenditure multiplier. Formula
1/(1-MPC); measures how much MS increases in response to change in monetary base
Marginal propensity to consume=change in consumption/change in personal disposal
income
Formula: (1/(1-MPC))
21. What is the paradox of thrift?
Paradox of Thrift states that individuals try to save more during an economic recession,
which essentially leads to a fall in economic growth
22. What is the wealth effect?
The “wealth effect” refers to the premise that consumers tend to spend more when there
is a bull market in widely-held assets like real estate or stocks, because rising asset
prices make them feel wealthy

LONG –RUN CLASSICAL MODEL (each of the following refers to

the Classical Model)

What determines output?

Labor, full employment
2. What determines prices?
money supply (equilibrium in As and AD determines price level)
3. What determines interest rates? Graph
saving and investment -> real i; (nom i=real i + inflation)
4. What is loanable funds theory?
Financial assets or money that is available to borrow. This theory is based on the
concept that corporations providing goods and services demand capital. Purchasers of
goods and services provide capital. Borrowers demand loanable funds that are indirectly
made available by savers who allow banks access to their assets.
5. What is Say’s law?
Supply creates its own demand
6. What is the quantity theory of money?
MV=PY (M-> P only since V is constant and y at FE)
PY/M = velocity = (nominal GDP/money)
7. What is the natural rate of unemployment (NAIRU)?
Vertical AS curve
8. What is the relation between the nominal and real interest rates and inflation? Fisher’s
equation
I nominal = i real + expected inflation
9. What causes inflation in the long-run?
increase in MS growth
10. What causes unemployment in the long-run?
Frictional and structural factors
11. What is crowding out?
reduction in private C or I b/c of increase in govt. spending
12. How does fiscal policy affect the economy in the long-run?
Not needed, G crowds out , no changes in D
13. How does monetary policy affect the economy in the long-run?
Only affects P (Ms.>nominal spending->p)
14. What is the long-run Phillips curve and what does it imply? What makes the short-
run
curve shift to the right?
LR: no tradeoff between inflation and unemployment, consistent with nru, VERTICAL
SR: shifts to right b/c of increasing inflationary expectations; when AS shifts left
15. What role do inflationary expectations play in inflation and the Phillips curve?
Inflationary expectations are the expectations that consumers have concerning future
inflation. Inflationary expectations work for aggregate demand much like buyers'
expectations work for market demand. Buyers seek to purchase a good at the lowest
possible price.Expansionary efforts to decrease unemployment below the natural rate of
unemployment will result in inflation. This changes the inflation expectations of workers,
who will adjust their nominal wages to meet these expectations in the future. This leads
to shifts in the short-run Phillips curve.
16. What is the debate between rules and discretion in monetary policy?
Active versus passive policy
the question of whether monetary policy should be guided by legislated rules or left to
the discretion of the policymaker
17. What is the time-inconsistency problem as related to monetary policy?
The problem that arises when a decision maker, especially a policy maker, prefers one
policy in advance but a different one when the time to implement arrives. Knowing this,
others will not find the commitment to the first policy credible.
Best plan for future period will not be optimal when it arrives
18. What is meant by the classical dichotomy/neutrality of money?
Real and nominal variables analyzed separately
An economic theory that states that changes in the aggregate money supply only affect
nominal variables, rather than real variables; therefore, an increase in the money supply
would increase all prices and wages proportionately, but have no effect on real
economic output (GDP), unemployment levels, or real prices (prices measured against a
base index). T
19. What monetary growth rule has been suggested by Friedman and others, and why?
Quantity theory of money: states that money supply has a direct, proportional
relationship with the price level. While mainstream economists agree that the quantity
theory holds true in the long run, there is still disagreement about its applicability in the
short run.
LR rate of growth of Y from MV=PY will keep P constant and will avoid problems of lags,
politics
20. What is meant by rational expectations? What does it imply about business cycles?
About
fiscal and monetary policy?
- Assumption that individuals make reasonable forecasts; fiscal/monetary
have NO impact on classical model

ECONOMIC GROWTH

What is the long-run average rate of growth in real GDP? Real GDP per capita?
3%
2%
2. How does long-run U.S. growth generally compare with Europe? Asia? Africa?
Faster than Europe and Africa, slower than Asia
3. What is productivity? Why does it matter to economic growth?
Productivity is an average measure of the efficiency of production. It can be expressed
as the ratio of output to inputs used in the production process
4. What is the role of technology in economic growth?
The role played by technology in simulation of growth and development in emerging
markets is quite profound. It is significant in economic development hence is extremely
important to understand.
5. What is the role of each of the following in economic growth:
- Political structure, property rights, human capital, capital, savings, education,
natural
resources, industrial policy, population growth, research and development, taxes, free
trade, trickle down economics, government budget deficits
Role of political structure in economic growth: prop rights, resource allocating
Role of Property rights in economic growth: economic freedom, innovation
Role of Human capital in economic growth: increases factor productivity
Role of capital in economic growth: increases investment and productivity
Role of savings in economic growth: leads to investment in LR
Role of education in economic growth: investment in human capital
Role of Industrial policy in economic growth: does not help
Role of population growth in economic growth: low pop growth causes eco growth
Role of research and development in economic growth: knowledge as public good,
externalities
Role of taxes in economic growth: reduces savings and thus investment
Role of free trade in economic growth: increase economic growth that enables countries
to attain a place above their PPC
Role of trickle down economics in economic growth: encourage business owners
Role of government budget deficits in economic growth:
6. How do you calculate growth rates?
using the rule of 72
7. What is the rule of 72? (Or 70)? How do you use it?
growth rate = 72/# years to double
8. How does an increase in saving affect the economy in the long run? (short-run?)
S up->I up->growth up
S up->C down->D down->Y down
9. Explain the idea (1 sentence) of each of the following theories of economic growth:
a) Classical/Malthusian:limited resources (land) leads to diminishing
returns and ultimately decline in per capita wages to subsistence levels
b) Neo-Classical – Solow Model: economy grows along long run steady
state with ultimately no growth in per capita gdp/income unless technological
change
c) Endogenous or New Growth Theory: internal determinants of
technological change and thus growth
d) Creative Destruction: continuous progress and improved standards of
living
10. What’s wrong with Malthus’ law? (Why hasn’t it held for developed countries?)
Doesn't account for increase in capital, technology or endogenous fertility decisions

CAPITAL, INTEREST , GROWTH RATES AND DISCOUNTING

What is capital? Human capital
It is money that can be invested in business ventures for the purpose of making a profit.
2. What role does capital play in the macroeconomy in the SR (hint investment and agg
D)?
LR (output and growth)?
SR: increase in capital good production increases investment and shifts AD curve
LR: economic growth can be achieved through increase in capital goods as increase in
capital shifts aggregate production function upward
3. What is interest?
the cost of using money over a period of time
4. How do you calculate compound growth?
A= P(1+(interest rate))^n
Grows 3% a year; to calculate amount for 5 years starting with 1000$
A = 1000*(1.03)^5
5. How and why do we discount future $ values?
Present value = future value / (1+interest rate)^n
where n = number of periods
discount to find value today
6. What affects the present value of a future amount?
interest rate and number of periods
higher interest rate or longer number of periods leads to lower present value
7. How are real and financial capital related?
financial capital is used to acquire real capital
real capital is an asset, financial capital is a liability or equity
8. How does an increase in capital affect labor?
An increase in the capital stock decreases the marginal product of capital and increases
the marginal product of labor. As a result, real returns to capital decrease and real
returns to labor (wages) increase.
INFLATION
Define inflation.
A general increase in prices and fall in the purchasing value of money.
2. How do we measure the level of prices (what indices-CPI, Implicit GDP
deflator)?
CPI, PPI, GDP deflator
3. How do we measure inflation?
percentage change in some price index, often the CPI or the GDP deflator
4. What can cause inflation in the short-run?
business cycle and exchange rates, also demand shocks
5. What can cause inflation in the long-run?
Money supply Growth, expectations
6. What harm does anticipated inflation cause?
Shoe leather - people inefficiently reducing their holding of money, which earns no
interest and loses purchasing power with inflation so the economy will waste resources
going back and forth to the bank to reduce their money holding
menu costs - businesses must constantly reprice)
7. What harm does unanticipated inflation cause?
Distortion of signaling function of prices, distortions in tax system, lenders lose to
borrowers (real rate falls with inflation) and thus reduced desire to lend
Bracket creep - tax system can be distorted as nominal incomes increase, increasing tax
brackets and taxes with no increase in real incomes (the alternative minimum tax)
8. What is deflation and what harm does it cause?
Possible vicious cycle in which falling demand lowers prices, causing consumers and
business to postpone purchases reducing demand further. Also deflation RAISES the
real interest rate (real = nominal - inflation but deflation is - so -- = +) and further reduces
investment
9. What is hyperinflation? What causes it? What are the consequences?
inflation rate in excess of 200 percent per year.
Cause: excessive rise in money supply
consequence - money loses role as medium of exchange, begin bartering or using other
currencies
10. What’s the short-run Phillip’s curve? What policy does it imply?
According to the Phillips curve, the lower an economy's rate of unemployment, the more
rapidly wages paid to labor increase in that economy.
There is a trade off between inflation and unemployment therefore graph is downward
sloping
The theory states that with economic growth comes inflation, which in turn should lead to
more jobs and less unemployment.
11. What causes the short-run Phillip’s curve to shift up?
when inflationary expectations rise
12. What’s the long-run Phillip’s curve? What’s the implication of the slope of the
long-run Phillip’s curve.
The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment
(NRU). Shows no relation between inflation and unemployment in long-run; no trade-off-
at natural (full) rate of unemployment, cannot lower unemployment and attempts to do
so will only lead to long-run inflation
13. What’s the relation between Fed credibility and inflation? Between inflation
expectations and inflation? Between unemployment and inflation?
rational expectations - people use all available information to make forecasts about
future economic activity and adjust their behavior to these forecasts.
inflation depends on expected inflation. credibility, meaning the Fed will do what it takes
to keep inflation, will keep expected inflation low and thus inflation low

UNEMPLOYMENT

What does it take to be counted as unemployed?

currently may not have a job but are actively seeking and capable
2. How do we define the unemployment rate?
unemployment rate = unemployed/(emp + unemp) aka unemployed/labor force
3. What is hidden unemployment, discouraged workers?
not included in the count (such as those in the military)
Person who has given up looking for a job
4. What are three causes or types of unemployment?
STRUCTURAL: mismatch of jobs and services
FRICTIONAL: qualified individuals with transferrable skills who change jobs
CYCLICAL: contractions in the economy result from low levels of AD in context of sticky
wages and prices
5. What is Okun’s law?
unemployment and GDP rates are inversely related
6. Define the natural rate of unemployment (NAIRU). Why does it matter?
the 'full employment' rate at which inflation does not increase; only structural and
frictional, not cyclical
7. What does JOLTS show?
The use of statistical techniques on economic data to investigate how economic
variables are related

INTERNATIONAL MACRO

Why are some benefits of international trade?

comparative advantage
increase economic growth
Each Country can utilize its resources best
2. What is the idea of comparative advantage?
that even a country with absolute advantage can benefit
specialization in lowest opportunity cost
more output/production possible for all
transmission of ideas, technology develops
international competition
Comparative advantage: produce the good for which you have a lower opportunity cost.
3. How do exports and imports affect the economy?
Exports --> increase aggregate demand, CREDIT-money into U.S.
Imports --> decrease aggregate demand, DEBIT-money flowing out of U.S.
4. What impact does an open economy have on the effectiveness of monetary policy? Of
fiscal policy?
monetary: strengthened
fiscal: weakened -- exchange rates
5. What are the determinants of exchange rates in the short-run? In the long-run?
SR: supply and demand for currency
LR: purchasing power parity—REAL exchange rate
6. What is purchasing power parity theory?
in the long run, exchange rates equilibrium adjusts
things will have the same cost everywhere, but different amounts
7. Why do we have a current account deficit, and what does it imply?
means that the balance on current account is negative, spending for goods and services
that flows in (net exports are negative)
this implies that our agg demand is going down
8. Why do we have a capital/financial account surplus and what does it imply?
If M >X, means current account deficit. It weakens AD, slows econ, and selling assets or
going into debt
9. What is the ‘twin deficit problem’? The ‘tri-lemma’?
The twin deficit problem says that the government deficit (G-T) increases and leads to
the current account deficit (imports > exports)
The tri lemma says you can only have two out of three: Fixed exchange rates, Control of
Ms, or Capital mobility
10. What are the advantages of floating exchange rates? Fixed exchange rates?
Floating exchange rates --> automatic adjust to economic conditions.
Fixed exchange rates --> international business purposes.
11. How does a strong currency affect the domestic economy?
A strong currency decreases Net Exports b/c foreign currencies can buy less,
decreasing AD & shifting it left.
12. Why does China’s fixed exchange rate system present dangers to China?
prevents a government from using domestic monetary policy in order to achieve
macroeconomic stability

FINANCIAL CRISIS, EVOLUTION OF MACROECONOMICS,

CONTROVERSIES

1. What was the role of each of the following in the financial crisis and great recession?
o Easy money policies: contributed to the recession as subprime lending
occurred (lending to people with bad credit quality)
o Deregulation (laissez-faire): Run on the Shadow, banking system,
Systemic problems with funding mismatch, Too big to fail Credit
CrunchRecession*
o Leverage: maxes returns, but also risk (losses)
o De-leveraging:
o Securitization: Converting a security that doesn't trade, like a mortgage,
into a tradeable security, like a bond
o Financial engineering: promoted use of derivatives, which are often
highly leveraged and unregulated (risky)
o Derivatives: the widespread use of derivatives greatly magnified and
spread the impact of losses on sub-prime mortgages
o Shadow Banking system:losely regulated with funding mismatch (Could
not roll over short-term debt which they had used to fund long term investments);caused
run on shadow banking system - AIG, Lehman fell
o Runs on shadow banks: leds to collapse of financial institutions
(Lehman Brothers fell, AIG went to government control)
o Fiscal policy:
o Monetary policy:
2. Briefly identify:
o Classical Macro
long run:
sayes law: supply creates own demand
loanable funds theory: real interest rate determined by savings and investment
Flexible wages & prices: vertical aggregate supply curve
Quantity theory of money: MV-P
o Keynesian Macro
Short run
sticky wages
agg supply curve upward
economy unstable and needs govt intervention - fiscal policy
can be below full employment
o Neo-Classical Synthesis
Starting Point for rigorous economic models. These assumptions are oversimplification
according to political scientists.
o Monetarism
A set of views based on the belief that inflation depends on how much money the
government prints. It is closely associated with Milton Friedman, who argued, based on
the quantity theory of money, that the government should keep the money supply fairly
steady, expanding it slightly each year mainly to allow for the natural growth of the
economy.
o New Classical macro
using monetary policy will change real GDP only if the policy takes people by surprise
emphasizes aggregate supply and wage and price flexibility.
view economy as essentially stable and self-correcting
o New Keynesian Macro
Provides microeconomic foundations for Keynesian economics
2 main assumptions:
households & firms have rational expectations, variety of market failures (imperfect
competition in price & wage setting; become sticky) also, implies that economy may fail
to attain full employment.
fiscal and monetary policy can higher efficiency
o Supply-Side Economics
A school; the school of economic theory that stresses the costs of production as a
means of stimulating the economy; advocates policies that raise capital and labor output
by increasing the incentive to produce
o Real Business Cycle Theory
claims that fluctuations in the rate of growth of total factor productivity cause the
business cycle
3. What was tulip mania? The South Seas bubble?
tulip mania - example of speculative bubble, in the Netherlands, tulip prices rose to 10x
annual incomes, then collapsed
South Seas Bubble - stock speculation in British stock company, Company established
to fund gov’t debt, 10 fold increase in stock price in year
4. What is a speculative bubble?
When stock values rise beyond any reasonable expectations for future profits.

OTHER
1. What is the index of leading economic indicators and what is it used for? Will not be
on
exam
A composite of economic variables used by analysts to predict future economic
conditions.
2. What caused the great depression? The current recession?
DECLINE IN AD
1920s: yo-yo years
stock market went up, people speculated when they couldn't afford to
spent on credid
Now: housing market: people bought houses on the margin, couldn't affort
both cases: people spending imaginary money
3. What is the Black-Scholes formula and why does it matter?
It is a revolutionary formula (40 years ago) for valuing/pricing options;
opened up door for all sorts of new financial instruments and quantitative finance/
financial engineering
4. Who was Adam Smith? Milton Friedman? Malthus? Schumpeter? Keynes? Adam
Smith?
adam smith: often touted as the world's first free-market capitalist. father of econ
Milton Friedman: An American economist and statistician best known for his strong belief
in free-market capitalism. Milton Friedman strongly opposed the views of Keynesian
economists, encouraging governments to minimize their involvement in the economy by
reducing taxes and ceasing inflationary policies.
Schumpeter
Wrote about history of economic thought
Creative destruction- free markets self correction
Innovation improves society
Invention holds or advances society a little
John Maynard Keynes believed wages and prices were relatively inflexible and interest
rate would not fall fast enough to restore full employment
Malthus: Economist. Work used by Darwin
Said populations will grow exponentially and something keeps them in check.
Wrote "Essay on the Principles of Population"
5. What is Dodd-Frank? The Volcker Rule?
Bar banks from proprietary trading — or making trades for their own benefit — using
customer funds.
Banks limited in the extent of their trading with their own money, and allowed to own only
a small percentage of hedge and private equity funds
6. What is econometrics?
The use of statistical techniques on economic data to investigate how economic
variables are related

FORMULAS AND CALCULATIONS

Consumption=a+b Income mpc = b

government expenditure multiplier 1/(1-mpc)
PV=FV/(1+i)^n
FV=PV*(1+i)^n
72/i=years to double
i nominal = ireal + expected inflation
i nominal=i risk free+ risk premium
Money Supply=1/rr x Reserves
Real GDP = nominal GDP/(P/100)
UR=U/LF LF=U+E
%change(XY)=%changeX + %changeY