Economics Dr.

Sauer

Principles of Macroeconomics - online Exam 2 Information Time and Place The exam is given online and can be taken any time between 3/11 at 11pm and 3/18 at 11pm. The exam is timed you will have 2 hours to complete it. The wise thing to do is to block off some time before and after you plan to take the exam just for the unexpected circumstances of life. What to Expect This exam will be similar in format to Exam 1. This exam contains 50 multiple choice questions; each question is worth 2 points. Exam Content This exam assesses material from chapters 5-11. This exam test your understanding of economic concepts. This means I rarely ask you a question about a definition of a term itself, but I will ask you questions where you apply a definition or pick out an example which illustrates a definition/concept. Making sure you know the definitions is a good first step. The application and understanding of definitions/concepts is what you will be tested on in the exam. Additionally, there are many calculations contained in these chapters.

Exam Purpose:

Assess your ability to meet the following course learning objectives

Apply supply and demand analysis in a variety of macroeconomic contexts (ch 8) Describe the construction of fundamental macroeconomic variables and interpret changes in them. (ch 5, 6, 7, 8, 9, 10) Describe the US monetary system. (ch 11)

____________________________________________________________________________________ Studying for the Exam You should study for this exam as if you would not have any course resources to rely on. If you try to look up each answer, you will run out of time. A note on studying economics in general: Most brains process economics best in small doses. Studying frequently for short periods of time is usually more much more effective than an all-night cram session the night before the exam. For example, when you have 10 extra minutes, use that time to review your notes for one chapter. Suggested materials to review (in no particular order): - Review the text chapter summaries / material you highlighted. - Complete the extra practice problems that are generated for each chapter on which you scored less than 80%. - Complete the end-of-chapter problems in the text. - Review the homework problems.

Summary of Chapters 5 - 11 Chapter 5 Key Points Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross domestic product (GDP) measures an economys total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households purchases of new housing. Government purchases include spending on goods and services by local, state, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports). Nominal GDP uses current prices to value the economys production of goods and services. Real GDP uses constant base-year prices to value the economys production of goods and services. The GDP deflatorcalculated from the ratio of nominal to real GDPmeasures the level of prices in the economy. GDP is a good measure of economic well-being because people prefer higher incomes to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment. After learning the material from this chapter, you should understand: why an economys total income equals its total expenditure. how gross domestic product (GDP) is defined and calculated. the breakdown of GDP into its four major components. the distinction between real GDP and nominal GDP. whether GDP is a good measure of economic well-being. ____________________________________________________________________________________ Chapter 6 Key Points The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates annual inflation by about one percentage point. Like the consumer price index, the GDP deflator also measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Dollar figures from different times do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index. Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation. A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation. After learning the material from this chapter, you should understand: how the consumer price index (CPI) is constructed. why the CPI is an imperfect measure of the cost of living. how to compare the CPI and the GDP deflator as measures of the overall price level. how to use a price index to compare dollar figures from different times. the distinction between real and nominal interest rates. _________________________________________________________________________________ Chapter 7 Key Points Economic prosperity, as measured by GDP per person, varies substantially around the world. The average income in the worlds richest countries is more than ten times that in the worlds poorest countries. Because growth rates of real GDP also vary substantially, the relative positions of countries can change dramatically over time. The standard of living in an economy depends on the economys ability to produce goods and services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources, and technological knowledge available to workers. Government policies can try to influence the economys growth rate in many ways: encouraging saving and investment, encouraging investment from abroad, fostering education, promoting good health, maintaining property rights and political stability, allowing free trade, and promoting the research and development of new technologies. The accumulation of capital is subject to diminishing returns: The more capital an economy has, the less additional output the economy gets from an extra unit of capital. As a result, while higher saving leads to higher growth for a period of time, growth eventually slows down as the economy approaches a higher level of capital, productivity, and income. Also because of diminishing returns, the return to capital is especially high in poor countries. Other things being equal, these countries can grow faster because of the catch-up effect. Population growth has a variety of effects on economic growth. On the one hand, more rapid population growth may lower productivity by stretching the supply of natural resources and by reducing the amount of capital available for each worker. On the other hand, a larger population may enhance the rate of technological progress because there are more scientists and engineers. After learning the material from this chapter, you should understand: how much economic growth differs around the world. why productivity is the key determinant of a countrys standard of living. the factors that determine a countrys productivity. how a countrys policies influence its productivity growth. ____________________________________________________________________________________

Chapter 8 Key Points The U.S. financial system is made up of many types of financial institutions, such as the bond market, the stock market, banks, and mutual funds. All of these institutions act to direct the resources of households that want to save some of their income into the hands of households and firms who want to borrow. National income accounting identities reveal some important relationships among macroeconomic variables. In particular, for a closed economy, national saving must equal investment. Financial institutions are the mechanism through which the economy matches one persons saving with another persons investment. The interest rate is determined by the supply and demand for loanable funds. The supply of loanable funds comes from households who want to save some of their income and lend it out. The demand for loanable funds comes from households and firms who want to borrow for investment. To analyze how any policy or event affects the interest rate, one must consider how it affects the supply and demand for loanable funds. National saving equals private saving plus public saving. A government budget deficit represents negative public saving and, therefore, reduces national saving and the supply of loanable funds available to finance investment. When a government budget deficit crowds out investment, it reduces the growth of productivity and GDP. After learning the material from this chapter, you should understand: some of the important financial institutions in the U.S. economy. how the financial system is related to key macroeconomic variables. the model of the supply and demand for loanable funds in financial markets. how to use the loanable-funds model to analyze various government policies. how government budget deficits affect the U.S. economy. ____________________________________________________________________________________ Chapter 9 Key Points Because savings can earn interest, a sum of money today is more valuable than the same sum of money in the future. A person can compare sums from different times using the concept of present value. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum. Because of diminishing marginal utility, most people are risk averse. Risk-averse people can reduce risk by buying insurance, diversifying their holdings, and choosing a portfolio with lower risk and lower return. The value of an asset equals the present value of the cash flows the owner of the share will receive. For a share of stock, cash flows include the stream of dividends and the final share price. According to the efficient markets hypothesis, financial markets process valuable information rationally, so a stock price always equals the best estimate of the value of the underlying business. Some economists question the efficient markets hypothesis, however, and believe that irrational psychological factors also influence asset prices. After learning the material from this chapter, you should understand: the relationship between present value and future value. the effects of compound growth. how risk-averse people reduce the risk they face. how asset prices are determined. ____________________________________________________________________________________

Chapter 10 Key Points The unemployment rate is the percentage of those who would like to work but do not have jobs. The Bureau of Labor Statistics calculates this statistic monthly based on a survey of thousands of households. The unemployment rate is an imperfect measure of joblessness. Some people who call themselves unemployed may actually not want to work, and some people who would like to work have left the labor force after an unsuccessful search and therefore are not counted as employed. In the U.S. economy, most people who become unemployed find work within a short period of time. Nonetheless, most unemployment observed at any given time is attributable to the few people who are unemployed for long periods of time. One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. This frictional unemployment is increased as a result of unemployment insurance, a government policy designed to protect workers incomes. A second reason why our economy always has some unemployment is minimum-wage laws. By raising the wage of unskilled and inexperienced workers above the equilibrium level, minimum-wage laws raise the quantity of labor supplied and reduce the quantity demanded. The resulting surplus of labor represents unemployment. A third reason for unemployment is the market power of unions. When unions push the wages in unionized industries above the equilibrium level, they create a surplus of labor. A fourth reason for unemployment is suggested by the theory of efficiency wages. According to this theory, firms find it profitable to pay wages above the equilibrium level. High wages can improve worker health, lower worker turnover, raise worker quality, and increase worker effort. After learning the material from this chapter, you should understand: the data used to measure the amount of unemployment. how unemployment can result from minimum-wage laws. how unemployment can arise from bargaining between firms and unions. how unemployment results when firms choose to pay efficiency wages. ___________________________________________________________________________________________ Chapter 11 Key Points The term money refers to assets that people regularly use to buy goods and services. Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future. Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money. In the U.S. economy, money takes the form of currency and various types of bank deposits, such as checking accounts. The Federal Reserve, the central bank of the United States, is responsible for regulating the U.S. monetary system. The Fed chairman is appointed by the president and confirmed by Congress every four years. The

chairman is the lead member of the Federal Open Market Committee, which meets about every six weeks to consider changes in monetary policy. Bank depositors provide resources to banks by depositing their funds into bank accounts. These deposits are part of a banks liabilities. Bank owners also provide resources (called bank capital) for the bank. Because of leverage (the use of borrowed funds for investment), a small change in the value of a banks assets can lead to a large change in the value of the banks capital. To protect depositors, bank regulators require banks to hold a certain minimum amount of capital. The Fed controls the money supply primarily through open-market operations. The purchase of government bonds increases the money supply, and the sale of government bonds decreases the money supply. The Fed also uses other tools to control the money supply. It can expand the money supply by decreasing the discount rate, increasing its lending to banks, lowering reserve requirements, or decreasing the interest rate on reserves. It can contract the money supply by increasing the discount rate, decreasing its lending to banks, raising reserve requirements or increasing the interest rate on reserves. When individuals deposit money in banks and banks loan out some of these deposits, the quantity of money in the economy increases. Because the banking system influences the money supply in this way, the Feds control of the money supply is imperfect. The Federal Reserve has in recent years set monetary policy by choosing a target for the federal funds rate, a short-term interest rate at which banks make loans to one another. As the Fed achieves its target, it adjusts the money supply. After learning the material from this chapter, you should understand: what money is and what functions money has in the economy. what the Federal Reserve System is. how the banking system helps determine the supply of money. what tools the Federal Reserve uses to alter the supply of money.