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

semester)

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 -

Y=C+I+G+X-M

YOU SHOULD LIKELY STUDY THIS FROM THE BOTTOM TO THE TOP – THAT

IS, FROM MATERIAL COVERED LATE IN THE COURSE, BACK TO THE

BEGINNING.

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

providence”

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

produced?

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

services

• 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

management

CIRCULAR FLOW, NATIONAL INCOME ACCOUNTING AND OTHER

MEASUREMENTS

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,

C+I+G+NX

3. 3 Ways to calculate GDP (Value Added 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 GDP after changes in inflation have been taken

into account

• 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?

• Surveys

9. What are Discouraged Workers and Hidden Unemployment

• Discouraged workers – those who gave up on their job hunt, a part of

hidden unemployment

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?

• A statistical 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

being?

• Does not take into account nonmarket transactions, fails to account

for improved product quality, underground economy not included

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, credit provision, risk management

2. What is Stock?

• A type 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

borrowed

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?

• A spike in asset values within a particular industry, commodity, or

asset class. A speculative 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

round)

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 –

LESS RISK

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,

Muni/S&L 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 

risk

• Treasury bonds – government issued debt

• Corporate bonds – bond issued by a corporation

• Municipal/S&L bonds – interest income is exempt from federal 

income tax

12. What are Mutual Funds?

• A collection 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 – 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. ETFs

experience price changes throughout the day as they are bought and

sold

14. What is a stock index mutual fund, and why should you likely use it for long-run

investing?

• 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?

• A security 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? A futures contract? A call 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-

determined price

• Call Option – the option to buy a given stock at a given price before a

given date

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,

insurance companies

MONEY AND THE FED

1. What is Money? Wealth? Income? How are they different?

• Money – the circulating medium of exchange as defined by a

government

• 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 

them 

• Board of Governors, fed open market committee, federal reserve 

banks, member banks, advisory councils; 12 banks divide nations into 

12 districts

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

• S table 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,

technology/productivity

9. How does the stock market affect the economy?

• Significantly adds to the wealth effect – if people feel wealthier,

consumption increases

10. What are the ‘types’ of unemployment?

• Structural unemployment – mismatch between skilled workers and

employers’ needs

• Frictional unemployment – moving from one job to another (time in

between)

• 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

growth

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

elections

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

income

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

Model)

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

(MV=Py)

7. What is the natural rate of unemployment (NAIRU)?

• The equilibrium rate of unemployment; vertical AS curve

8. What is the relation between the nominal and real interest rates and inflation?

Formula

• i real = i nominal – expected inflation

• i nominal = i real + expected inflation

• Real interest is the amount you receive for lending or pay for

borrowing in terms of what you can buy with it; nominal interest is

the $ you receive for lending or pay for borrowing

9. What causes inflation in the long run?

• Increases in the money supply growth

10. What causes unemployment in the long run?

• Only frictional & structural facors

11. What is crowding out?

• Reduction in private C or I because of government spending

12. How does fiscal policy affect the economy in the long run?

• Not needed; G crowds out I, no changes in D

13. How does monetary policy affect the economy in the long run?

• Only affects P; Money supply 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, VERTICAL

• SR: shifts to the right because of increasing inflationary expectations

(when AS shifts left)

15. What role do inflationary expectations play in inflation and the Phillips curve?

• Inflationary expectations cause the short run Phillips curve to move to

the right (downward)

16. What is the debate between rules and discretion in monetary policy?

• Active vs. Passive policy

17. What is the time-inconsistency problem as related to monetary policy?

• The problem that arises when a decision/policy maker prefers one

policy in advance, but a different one when the time to implement

arrives

18. What is meant by the classical dichotomy/neutrality of money?

• Classical dichotomy – real variables measure actual goods, while

nominal variables measure money and prices of goods. Real variables

are more accurate because nominal variables can fluctuate based on

the quantity of money in the economy.

• Money neutrality – a change in money stock affects only nominal

variables like wages, inflation rate, and prices

19. What monetary growth rule has been suggested by Friedman and others, and

why?

• Friedman favors replacing monetary policy with a monetary growth

rule: increase the money supply at a constant rate independent of

economic conditions (recession/expansion).

20. What is meant by rational expectations? What does it imply about business

cycles? About fiscal and monetary policy?

• Rational expectations – assumption that individuals make reasonable

forecasts

• Implies that fiscal & monetary policies have no impact in classical

model

ECONOMIC GROWTH

1. What is the long-run average rate of growth in real GDP? Real GDP per capita?

• Real GDP – 3%

• Per capita – 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 the role of each of the following in economic growth:

• Political structure – invisible hand is the most efficient

• Property rights – most likely cause growth

• Human capital – more is better

• Capital – more is better

• Savings – necessary for investments in capital, which increases

productivity

• Education – increases human capital & productivity

• Natural resources – better for production

• Industrial policy – no growth, invisible hand is better

• Population growth – should be controlled for growth

• Research and development – essential for productivity gains

• Taxes – less likely better

• Free trade – probably increase, comparative advantage

• Trickle down economics – good, pro-business and pro-rich policies will

benefit the non-rich

• Government budget deficits – may reduce growth since I can be

negative

4. How do you calculate growth rates?

• (Value at beginning – value at end) / value at end

5. What is the rule of 72? (Or 70)? How do you use it?

• Rule of 72 # of years to double = 72/interest rate

6. How does an increase in saving affect the economy in the long run? (short-run?)

• Increases investment in the long run

7. Explain the idea (1 sentence) of each of the following theories of economic

growth:

• Classical/Malthusian – limited resources leads to diminishing returns

and no growth

• NeoClassical – Solow Model – steady state economy – grows along LR;

growth because of determinants of technological change

• Endogenous or New Growth Theory – focuses on determinants of

technological change

• Creative Destruction – continuous progress and improved standards of

living for everyone

8. What’s wrong with Malthus’ law? (Why hasn’t it held for developed countries?)

• Said that population grows geometrically and food grows

arithmetically; did not take into account the idea of increases in

capital and technology, as well as population limits

INTEREST ETC

1. What is capital?

• Financial assets or the financial value of assets, such as cash

2. What role does capital play in the macroeconomy in the SR (hint investment and

agg D)? LR (output and growth)?

•

3. What is interest?

• The charge for the privilege of borrowing money, typically expressed

as an annual percentage rate

4. How do you calculate compound growth?

• The compound annual growth rate is calculated by taking the nth root

of the total percentage growth rate, where n is the number of years in

the period being considered.

5. How and why do we discount future $ values?

• To estimate the money you'd receive from an investment and to adjust 

for the time value of money

6. What affects the present value of a future amount?

• The higher the discount rate, the lower the present value of the future 

cash flows

7. How are real and financial capital related?

• Real capital – comprises physical goods that assist in the production 

of other goods and services, e.g. shovels for gravediggers, sewing 

machines for tailors, or machinery and tooling for factories.

• Financial capital – the funds provided by lenders (and investors) to 

businesses to purchase real capital equipment for producing 

goods/services

8. How does an increase in capital affect labor?

• Increases output per worker

INFLATION

1. Define inflation.

• A process of ongoing increases in the general level of prices

2. How do we measure the level of prices (what indices-CPI, Implicit GDP

deflator)?

• Using the CPI (consumer price index) – can be used as an index of the

rate of change in overall prices faced by consumers

3. How do we measure inflation?

• Using the CPI (consumer price index) – can be used as an index of the

rate of change in overall prices faced by consumers

4. What can cause inflation in the short-run?

• Demand and/or supply shifts/shocks – demand pull; cost push

5. What can cause inflation in the long-run?

• Increases in the money supply

6. What harm does anticipated inflation cause? (menu and shoe leather costs)

• One can index against it – salaries, prices, tax rates can all

automatically increase with inflation

• Shoe leather cost – people inefficiently reducing their holding of

money, which earns no interest and loses purchasing power with

inflation. Thus the economy will waste resources ‘going back and

forth to the bank’ to reduce their money holding.

• Menu costs – incurred as businesses must constantly reprice etc.

7. What harm does unanticipated inflation cause?

• Distortion of the price system and resulting economic inefficiency. We

are used to seeing price increases in a good as signaling that we should

substitute other goods for it. Yet with inflation, we confuse the

increase in the general level of prices with increases in the price of

individual items relative to others

• Lenders lose to borrowers since borrowers pay back in ‘cheaper’

dollars (the real interest rate falls with inflation and thus lenders lend

less and the financial system works inefficiently)

• Bracket Creep – The tax system can be distorted as nominal incomes

8. What is deflation and what harm does it cause?

• Sustained decrease in general level of prices; can be caused by a

decrease in government, personal or investment spending.

• Harm caused: increased unemployment; increased real interest rates;

increased burden of debt; deflationary spiral

9. What is hyperinflation? What causes it? What are the consequences?

• Extreme inflation

• Causes: supply shocks, money shocks

• Consequences: eliminates confidence in money

10. What’s the short-run Phillip’s curve? What policy does it imply?

• Inflation is inversely related to unemployment (increase

unemployment as inflation decreases); downward sloping

11. What causes the short-run Phillip’s curve to shift up?

• Wage costs rise / price levels increase

12. What’s the long-run Phillip’s curve? What’s the implication of the slope of the

long-run Phillip’s curve.

• Represents the relationship between inflation and unemployment

• Slope = vertical; implies that there is no trade off between inflation

and unemployment

13. What’s the relation between Fed credibility and inflation? Between inflation

expectations and inflation? Between unemployment and inflation?

• Fed credibility & inflation: high inflation = lack of credibility; to

increase credibility, must create a “target” inflation rate and achieve

it, possibly with monetary action

• Inflation expectations & inflation: expectations cause nominal interest

rates to adjust

• Unemployment & inflation: trade off in short run (decrease in

unemployment = increase in inflation), not long run

UNEMPLOYMENT

1. What does it take to be counted as unemployed?

• Must be jobless, looking for jobs, and available to work

2. How do we define the unemployment rate?

• The percentage of the work force that is unemployed at any given date

3. What is hidden unemployment, discouraged workers?

• Hidden unemployment – group of unemployed individuals who are

not counted in the unemployment figures compiled by the government

they are not actively seeking employment

• Discouraged workers – believe no job is available to them in their line

of work or area. Had previously been unable to find work. Lack the

necessary schooling, training, skills, or experience

4. What are three causes or types of unemployment?

• Structural unemployment – comes from there being an absence of

demand for the workers that are available

• Frictional unemployment – comes from people moving between jobs,

careers, and locations

• Cyclical unemployment – occurs when the unemployment rate moves

in the opposite direction as the GDP growth rate

5. What does Okun’s law say?

• The relationship between an economy's unemployment rate and its

GDP; GDP gap decreases by 2% for every 1% increase in

unemployment rate

6. Define the natural rate of unemployment (NAIRU). Why does it matter?

• The lowest rate of unemployment that an economy can sustain over

the long run

• Matters because it is the equilibrium rate that we are always trying to

achieve & make it stable at 0

INTERNATIONAL MACRO

1. Why are some benefits of international trade?

• Comparative advantage;

2. What is the idea of comparative advantage?

• Specialization in low opportunity cost; more output and production is

possible for all; international competition

3. How do exports and imports affect the economy?

• PPP and exchange rates; Current Account deficits/surplus

4. What impact does an open economy have on the effectiveness of monetary

policy? Of fiscal policy?

• Monetary policy – strengthened

• Fiscal policy – weakened

5. What are the determinants of exchange rates in the short-run? In the long run?

• SR – derived from supply and demand for goods and services, and

real and financial assets (flexible)

• LR – adjust to equalize prices (PPP)

6. What is purchasing power parity theory?

• Exchange rates adjust in long run to equalize prices

7. Why do we have a current account deficit, and what does it imply?

• CAD – imports are greater than exports; implies that we are a net

debtor to the rest of the world

8. Why do we have a capital/financial account surplus and what does it imply?

• If imports are greater than exports, it means there is a CAD. It

weakens agg. Demand, slows economy, and selling assets or going into

debt.

9. What is the ‘twin deficit problem’? The ‘tri-lemma’?

• Twin deficit problem – Government Budget Deficit MAY lead to

current account (trade) deficit

• Tri-lemma – can only get 2 of the following 3: capital mobility,

monetary policy control, fixed exchange rates

10. What are the advantages of floating exchange rates? Fixed exchange rates?

• Floating exchange rates – automatic adjustments; not many

advantages because there is considerable uncertainty

• Fixed exchange rates – eases international business trade; there is

certainty and eventual revaluations

11. How does a strong currency affect the domestic economy?

• Be able to get foreign goods and services at lower prices

12. Why does China’s fixed exchange rate system present danger to China?

• If too high – outflow of official reserves deflation

• If too low – X up, M down government demand for financial assets

FINANCIAL CRISIS, EVOLUTION OF MACROECONOMICS,

CONTROVERSIES

1. What was the role of each of the following in the financial crisis and great

recession?

• Easy money policies – stimulated an already­booming housing market; 

resulted in double­digit increases in housing prices for six years

• Deregulation (laissez-faire) – government & policies not regulated

• Leverage – led to a sharp relative decline in durable consumption

• Securitization – there was an explosion in the issuance of bonds backed

by mortgages

• Financial engineering – spread diverse risks over multitudes of 

participants

• Derivatives – AIG Financial Products had been participating the in

traditionally stomping ground of investment banks by issuing

derivatives

• Shadow Banking system – were not subject to the same strict 

regulations as banks, and thus could use high leverage to gain quick 

and large profits in good times but also huge losses in bad times

• Runs on shadow banks – allowed to take on as much debt as their 

internal risk management analyses deemed prudent

2. Briefly identify:

• Classical Macro – self regulating, little room for government

intervention

• Keynesian Macro – Inherently unstable, role of expectations, focus on

aggregate demand and need for government to fill gap

• Neo-Classical Synthesis – Keynesian for SR, classical for LR

• Monetarism – A set of views based on the belief that inflation depends

on how much money the government prints

• New Classical Macro – An approach to economics that relates supply

and demand to an individual's rationality and his or her ability to

maximize utility or profit

• New Keynesian Macro – Same framework as New Classical with

microfoundations; micro-based rigidities – price stickiness

(monopolistic competition)

• Supply-Side Economics – SR incentive to shift supply rather than

demand; likely not effective in the short run

• Real Business Cycle Theory – The recurring and fluctuating levels of

economic activity that an economy experiences over a long period of

time. The five stages of the business cycle are growth (expansion),

peak, recession (contraction), trough and recovery

3. What was tulip mania? The South Seas bubble?

• Tulip mania –the first major financial bubble. Investors began to

madly purchase tulips, pushing their prices to unprecedented highs;

the average price of a single flower exceeded the annual income of a

skilled workers. Tulips sold for over 4000 florins, the currency of the

Netherlands at the time. As prices drastically collapsed over the

course of a week, many tulip holders instantly went bankrupt

• South Seas bubble – One of the largest stock scams of all time. The

U.K.-based South Sea Company's shares saw a huge appreciation

based on rumor, speculation and false claims before plummeting and

eventually becoming worthless

4. What is a speculative bubble?

• A spike in asset values within a particular industry, commodity, or

asset class. A speculative bubble is usually caused by exaggerated

expectations of future growth, price appreciation, or other events that

could cause an increase in asset values

OTHER

1. What is the index of leading economic indicators and what is it used for?

• An index published monthly by the Conference Board used to predict

the direction of the economy's movements in the months to come

2. What caused the great depression? The current recession?

• Great Depression – Stock market crash of 1929, bank failures,

reduction in purchasing across the board, American economic policy

with Europe, drought conditions

• Current recession – collapse of housing bubble, decline in housing

market, labor force peaked & then began to decline

3. What is the Black-Scholes formula and why does it matter?

• A model of price variation over time of financial instruments such as

stocks that can, among other things, be used to determine the price of

a European call option

4. Who was Adam Smith? Milton Friedman? Malthus? Schumpeter? Keynes?

• Adam Smith – “The Father of Economics” – world's first free market

capitalist, major proponent of laissez faire economic policies

• Milton Friedman – An American economist and statistician best

known for his strong belief in free-market capitalism; strongly

opposed the views of Keynesian economists, encouraging governments

to minimize their involvement in the economy by reducing taxes and

ceasing inflationary policies

• Thomas Malthus – theorized that populations will continue to grow

until growth is stopped or reversed by disease, famine, war or

calamity; developed the Malthusian growth model, an exponential

formula used to forecast population growth

• Joseph Schumpeter – argues that competition among market

participants leads to a desire to seek out new ways to improve

technology, new ways to do business and other types of advantages

that would increase profit margins and directly impact the

entrepreneur's standard of living

• John Maynard Keynes – well-known for his stance that national

governments should attempt to smooth out the effects of expansion

and contraction in the business cycle by using fiscal and monetary

policy

5. What is Dodd-Frank? The Volcker Rule?

• Dodd-Frank – supposed to lower risk in various parts of the U.S.

financial system

• Volcker Rule – trading restrictions placed on financial institutions.

The Volcker rule separates investment banking, private equity and

proprietary trading (hedge fund) sections of financial institutions

from their consumer lending arms

6. What is econometrics?

• The application of statistical and mathematical theories to economics

for the purpose of testing hypotheses and forecasting future trends

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