Classical theory of economics (self correcting economy)

Level of Output exceeds Level of Potential Output (Boom)=inflationary gap

Low unemployment
Wages increase
Aggregate supply shifts left (increase in wages)
Level of output decreases
Level of Potential Output exceeds Level of Output (Bust)=recessionary gap
High unemployment
Wages decrease
Aggregate supply shifts right (decrease in wages)
Level of output increases
Keynesian theory of economics
Level of Potential Output exceeds Level of Output (Bust)=recessionary gap will not
self correct
High unemployment
Wages decrease
Aggregate demand curve shifts right (increased government spending)
Level of output increases (side effect is inflationary gap)
Supply Side theory of economics=Reaganomics
Level of Potential Output exceeds Level of Output (Bust)=recessionary gap
High unemployment
Wages decrease
Aggregate supply curve shifts right (taxes decreased and disinflation) but Aggregate
demand will also shift right due to increase in demand
Level of output increases (side effect is the price change unknown due to shift of both
curves)
Arthur Laffler and the Laffler Curve
Higher tax rates disincentivizes people to work;
there is an optimum tax rate for optimum tax revenue

Long term growth theory of economics

Shift long run aggregate supply curve to the right causing long term growth
1. Increase labor force
1. Increase technology
1. Increase capitol for labor forces use
GDP
cyclical unemployment
Unemployment rates
Decreasing
positive
 Actual > natural
Increasing
Negative
Actual < natural
Full employment
zero
Actual = natural
4-6%

Marginal Propensity to Consume (MPC) =additional spent/additional income x 100%

Marginal Propensity to Save (MPS) = additional saved/additional income x 100%
Spending multiplier= 1/1-MPC = 1/MPS, tells government how much to spend in
recessionary gap
1-MPC=MPS
consumption function = autonomous consumption spending (C(a)) + (MPC)(level of
income)

Labor force = employed + unemployed

Unemployment rate = unemployed / labor force x 100
Labor force participation rate = labor force / population greater than 16 yo x 100
Not in labor force = population greater than 16 yo – labor force
CPI in year K = cost year K/cost in base year x 100 aka inflation rate
Inflation rate = large – small / small x 100
nominal rate = real rate + inflation rate
Change in output by change in taxes=
(change in tax)(-MPC)/1-MPC
M1=travelers checks+currency+demand deposits+other checkable deposits
M2=M1+small time deposits+savings deposits+money market

Money Multiplier = 1/minimal reserve ratio

Change in output by change in spending=
change in spending/1-MPC
GDP = C + I + G + NX; C = Consumption ;
I = Investment ;
G = Government Purchases ;
NX = Net Exports
also equals income
Q*=economies potential GDP with full employment including the frictional and
structural unemployed but no cyclical unemployment
GDP deflator = nominal GDP/real GDP x 100%
Fiscal Policy-Fiscal policy affects output directly though increasing consumption and
government spending and indirectly through the tax and government spending
multipliers.
Expansionary Fiscal Policy
1. Keynesian and Supply Sided economics
2. recessionary gap
3. can include deficit spending
 4. causes Crowding Out of Consumers
Contractionary Fiscal Policy
1. inflationary gap
Increasing government spending
Decreasing government spending
Decreasing taxes
Increasing taxes
Factors that shift aggregate demand
Components of aggregate demand (GDP):
Increase aggregate demand
(Expansionary Fiscal Policy)
Decrease aggregate demand (Contractionary Fiscal Policy)
Consumption
Decrease in taxes
Increase in taxes
Business Investment
Increase in government spending

Decrease in government spending

Government Expenditures
Increase in the money supply
Decrease in the money supply
Net Exports
Increase in demand
Decrease in demand
Optimism in business
Pessimism in business

Monetary Supply Policy

Minimum Reserve ratio
Federal Funds Rate
Open Market
Discount Rate
Percentage of deposits bank hold
Interest rate on loans between banks
Buying and selling government securities
Interest rate on loans from the Fed
Increase Money Supply
(Expansionary)
Decrease minimum reserve ratio
Decrease discount rate
Decrease federal funds rate
Decreases interest rate
buy government securities
shifts supply to right
Increases GDP
Increases Loans
Increases Spending
Decrease Money Supply
(Contractionary)
Increase minimum reserve ratio
Increase discount rate
Increase federal funds rate
increase interest rates
Sell government securities
shifts money supply left
Decreases GDP
Decreases Loans
Decreases Spending

Monetary Policy (Expansionary)

Open Market Bond Purchases
Increase in Money Supply
Decrease in Interest Rates
Increase in Investment Spending
Increase in GDP
Increase in Aggregate Demand shifting the curve to the right
Prices increase in the Short Run
Decrease in Exchange Rate, depreciates currency
Increase in Net Exports
Monetary Policy(Contractionary)
Open Market Bond Sale
Decrease in Money Supply
Increase in Interest Rates
Decrease in Investment Spending
Decrease in GDP
Decrease in Aggregate Demand shifting the curve to the left
Prices decrease in the Short run
Increase in Exchange Rate, appreciation of currency
Decrease in Net Exports

Chapter 11
Gross Domestic Product (GDP) : The total market value of final goods and services
produced within an economy in a given year, only newly produced products are included
in GDP
Real GDP: A measure of GDP that controls for changes in price
Nominal GDP: The value of GDP in current dollars
National Income : The total income earned by a nation's residents both domestically and
abroad in the the production of goods and services:
GDP + net income by US firms and residents abroad – depreciation from GDP +-
statistical discrepancies = NNP +- statistical discrepancies
Gross National Product: GDP plus Net Income earned abroad
Net National Product (NNP): GDP + net income by US firms and residents abroad –
depreciation from GDP = GNP – depreciation
Okun's law: for every 1% increase in unemployment, GDP falls by 2.5%
Chapter 12
Alternative Measures of Unemployment:
discouraged workers-Workers who left the labor force because they could not find jobs
marginally attached workers-discouraged workers and workers who are not looking for
jobs for other reasons
individuals working part time for economic reasons-Workers who would like to be
employed full time but hold part time jobs
officially unemployed
Unemployment:
Seasonal Unemployment: The component of unemployment attributed to seasonal
factors
Cyclical Unemployment: Unemployment that occurs during fluctuations in real GDP
Frictional Unemployment: Unemployment that occurs with the normal workings of the
economy, such as workers taking time to search for suitable jobs and firms taking time to
search for qualified employees
Structural Unemployment: Unemployment that occurs when there is a mismatch of
skills and jobs
Inflation Rate: The percentage rate of change in the price level aka CPI
Deflation: Negative inflation or falling prices of goods and services
Anticipated Inflation: Inflation that is expected
Unanticipated Inflation: Inflation that is not expected
Menu Costs: The costs associated with changing prices and printing new price lists when
there is inflation
Shoe Leather Costs: Costs of inflations that arise from trying to reduce holdings of cash
Hyperinflation: An inflation rate exceeding 50 percent per month, monetizing too much
debt
Monetization-Printing money to pay debt
Chapter 14 & 15
1. Automatic Stabilizers: Taxes and transfer payments that stabilize
GDP without requiring policymakers to take explicit action
Deficit role in stabilizing the economy:
increased transfer payments such as unemployment insurance, food stamps, and other
welfare payments
Other households whose incomes are falling
Taxes on businesses fall
1. Supply shock: External events that shift the aggregate supply curve
A supply shock is an event that suddenly changes the equilibrium price of a commodity
or service. It may be caused by a sudden increase or decrease in the supply of a particular
good.
Supply Shock
Supply
Prices
Shift of aggregate supply curve
Examples and Consequences
Negative
decrease
increase
left
Stagflation
increase in oil prices during the 1973 energy crisis
Positive
Increase
Decrease
Right
Advance in technology
1. Stagflation: A decrease in real output with increasing prices
Stagflation occurs when a country's inflation rate is high and unemployment rate is
high. It is an economic condition in which inflation and economic stagnation are
occurring simultaneously and have remained unchecked for a significant period of time
First, stagflation can result when an economy is slowed by an unfavorable supply shock,
such as an increase in the price of oil in an oil importing country, which tends to raise
prices at the same time that it slows the economy by making production less profitable.
This type of stagflation presents a policy dilemma because actions that are meant to assist
with fighting inflation might worsen economic stagnation and vice versa.
Second, both stagnation and inflation can result from inappropriate macroeconomic
policies.
Crowding out effect-any reduction in private consumption or investment that occurs
because of an increase in government spending.
If the increase in government spending is financed by a tax increase, the tax increase
would tend to reduce private consumption.
If instead the increase in government spending is not accompanied by a tax increase,
government borrowing to finance the increased government spending would increase
interest rates, leading to a reduction in private investment.
Chapter 16&17
1. Money: Any items that are regularly used in economic transactions
or exchanges and accepted by buyers and sellers
Three Properties of Money
Medium of Exchange-Any item that buyers give to sellers when they purchase goods
and services
Unit of Account-A standard unit in which prices can be stated and the value of goods and
services can be compared
Store of Value-The property of money that holds that money preserves value until it is
used in an exchange
Double Coincidence of Wants: The problem in a system of barter that one person may not
have what the other desires
Functions of the Federal Reserve:
1. Supply currency to the economy
2. Provide a system of check collection and clearing
3. Holds reserves from banks and other depository institutions
and regulates banks
 4. Conducts monetary policy
Demand for Money:
1. Interest rates affect money demand
2. price level and GDP affect money demand
3. other components of money demand
Monetary Systems
1. Commodity Money: A monetary system in which the actual
money is a commodity, such as gold or silver
2. Gold Standard: A monetary system in which gold backs up
paper money
3. Fiat Money: A monetary system in which money has no
intrinsic value but is backed by the government
Lags in Monetary Policy:
1. Inside Lags: time it takes for policymakers to recognize and
implement changes
2. Outside Lags: time it takes for policy to work
Chapter 18
1. Comparative Advantage: The ability of one person or nation to
produce a good at a lower opportunity cost than another person or nation
2. Absolute Advantage: The ability of one person or nation to produce
a product at a lower resource cost than another person or nation
3. Import: A good or service produced in a foreign country and
purchased by residents of the home country
4. Export: A good or service produced in the home country and sold
in another country
Protectionist Policies:
1. Import bans-
2. Import Quota-A government-imposed limit in the quantity
of a good that can be imported
3. Tariffs-A tax on imported goods
4. Voluntary Export Restraint-A scheme under which an
exporting country voluntarily decreases its exports
5. Import licenses-Rights, issued by a government, to import
goods
Distinct effects of fixed and flexible exchange rates
Appreciation-increase in value-increase in demand
Increased value of the exchange rate makes imports less expensive for the residents of
the country where the exchange rate appreciated
Increased value of the exchange rate makes US goods more expensive on world
markets, net exports decrease
Depreciation-decrease in value-decrease in demand
Decreased value of the exchange rate makes imports more expensive for the residents of
the country where the exchange rate depreciated
Decreased value of the exchange rate makes US goods less expensive on world markets,
net exports increase
1.