HCCS 2011 REVIEW FOR TEST II Covering chapters from Case, Fair, Oster text. GDP and the Standard of Living

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1 HCCS 2011 REVIEW FOR TEST II Covering chapters from Case, Fair, Oster text GDP and the Standard of Living What is Gross Domestic Product and how is it measured? Expenditure Approach (C+I+G+NX) Income Approach What is the distinction between Final Goods and Intermediate Goods? Understand what is meant by value added. Understand that Government Expenditures include both Purchases of Goods and Services and Transfer Payments. But in measuring GDP, we only include the purchases, not transfer payments. Thus, be sure you understand what a transfer payment is. (Social security payment, welfare payment, etc. These are transfers of money but they are not equated with a good or service; hence they don t help us measure GDP. They do, however, have large impacts on the government budget.) Know the distinction between Gross Domestic Product and Net Domestic Product; The difference is depreciation (sometimes called capital consumption). What is National Income? (wages, rents, net interest, corporate income, and proprietor income) Relate GDP to the business cycle, and understand the phases of contraction and recovery and expansion of the cycle, as well as the peak and the trough of the cycle. Know that Real GDP is Nominal GDP adjusted for inflation; that is, it is measured in constant dollars, not current dollars. Constant dollars are base-year dollars. Comparing the NOMINAL to the deemed base year allows us to measure inflation, and by excluding the inflation, we can discern REAL. REAL and NOMINAL are applied to everything we measure with dollars. Real wage, real income, real GDP, real interest, etc. We must distinguish between REAL and NOMINAL since to measure things in dollars is to measure with a rubber yardstick since the dollar is subject to inflation and deflation. Jobs and Unemployment o Understand the types of unemployment (This is important because different policies might be necessary and appropriate for one type and not another; e.g. job training programs) -- Frictional --Seasonal --Structural --Cyclical o It is very important to understand the meaning of THE NATURAL RATE OF UNEMPLOYMENT. (includes the first 3 types. I.e. all but cyclical.) We consider the economy is at FULL EMPLOYMENT when we have only the natural rate of unemployment. While it is debated among economists, in this course we can consider the natural rate of

2 unemployment to be 5%. So if we have 5% unemployment, we are at full employment. Cyclical unemployment (i.e. the unemployment above the natural rate) varies with the business cycle. Understand how the unemployment rate is calculated What constitutes official unemployment rate: The number of officially unemployed The Labor Force What constitutes the Labor force? Understand what is meant by a discouraged worker What is under employment? How is it treated in the official calculations? (e.g. The laid off aerospace engineer who is working at an entry level job at McDonalds) The CPI and The Cost of Living Understand the purpose and uses of the Consumer Price Index (CPI) (Wage contracts, adjustments to Social Security, etc.) Know that a COLA clause is a Cost Of Living Adjustment clause Understand the basics of how the CPI is calculated --Determine a market basket (Thousands of separate goods and services in 8 categories food, clothing, housing, medical, education, transportation, recreation, and other) --Price the market basket --determine a base time period and index the market basket price in the base period at 100 (U.S. uses ) -- Now all years can be compared to the base year and measured against the base of 100. Or any other period cold be measured. Thus, nominal prices can be restated as real prices as inflation is stripped out. O Realize how the following factors must be considered in comparing CPI indicators from year to year -- The nature of the market basket (how many DVD s were in the 1990 basket?) -- Even if we include a gallon of gasoline in 1950 or 1990 and in 2004, the quality of the gasoline may have changed. (We took the lead out.) -- There may be distortions with a fixed basket if substitutions are not considered. -- There can be wide distortions over time and over different markets (E.g. New York City prices vs. Dime Box, Texas, prices) o Review the difference between REAL and NOMINAL. We will apply these distinctions to Prices, the GDP, to wages, to everything we measure in dollars, since the purchasing power of the dollar will change with inflation and deflation.

3 O Who might be economically hurt by inflation? : Lenders if lending at fixed rates; people on fixed income, merchants who can t adjust prices with inflating costs. O Who might be benefited by inflation? : Borrowers if paying back at fixed interest rates; merchants who can over-adjust. Inflation distorts investments. O If you can adjust commensurately with inflation you can stay neutral. However, few people can stay even with inflation. Scrambling to stay even results in shoe leather costs and menu costs wasting society s scarce resources. O Understand that inflation reflects lower purchasing power of the dollar, and deflation reflects higher purchasing power. Aggregate Supply-Aggregate Demand Model and Potential GDP (Full Employment GDP) In earlier chapters we spent considerable time with the basics of supply and demand, and we developed the fundamental graphical tools of the scissors : the downward sloping demand curve and the upward sloping supply curve. As we move deeper into Macroeconomics, we focus on supply and demand at a different level: the Macro level. We can use the fundamental tools, but now we are considering Aggregate Demand and Aggregate Supply. Be comfortable with the AS AD tools of analysis. Understand the components of Aggregate Demand: C + I + G + (X-M) Understand what affects each component. E.G. What moves Consumption? What moves Investment? What moves Exports and Imports? As you understand the forces moving Aggregate Supply and Aggregate Demand, you will understand that they move toward equilibrium. Economics always wants equilibrium. SO: If we are at a short term equilibrium with more than the natural rate of unemployment, (say 7%) we experience a RECESSIONARY GAP. If we reach a short term equilibrium with less than the natural rate (say 3%), we are experiencing an INFLATIONARY GAP. It is very important to understand this to diagnose imbalances in the macro economy. We must be able to diagnose problems with the economy before we can apply policy to reach solutions. As we move forward in studying Macroeconomics, we confront a fork in the road. An activist approach and a non-activist approach. As in most things, policy applications will be a blend rather than a stark either/or. A. Activist policy applications Fiscal Policies and Monetary Policies. An active Congress dealing with Fiscal policy, and an active Federal Reserve dealing with Monetary policy.

4 B. Laissez Faire the classical economic philosophy that argued that imbalances in the economy would self-correct. Much of this is rooted in organic, naturalistic philosophy. The economy like much of nature moves pendulum-like with a natural force to return to the center: A regression to the mean. Thus, excesses contain self-correcting forces and government activist policies are not necessary or desirable. The classical, Laissez-faire belief is that the economy will self-regulate. O Understand the Laissez faire arguments and how they might be applied to prices, wages, overvalued currency, etc. I.e. how would excesses in one direction contain the force to self-correct? O Jean Baptise Say is one classical economist who would be very comfortable with the circular flow diagram. He argued that Supply creates its own demand. Understand why he might argue this. Overall: Develop a grasp of the following models and analytical tools and see how they interrelate: a. The Circular Flow Diagram: and how it pulsates as GDP increases and decreases. b. The AS-AD curves what moves each, and how these also relate to the pulsations in the circular flow diagram c. How all of these relate to the Business Cycle which depicts these pulsations the expansions and contractions in GDP over time d. And how the production-possibility curve indicates efficiency (full employment) and inefficiency (within the p-p curve), and future aspirations (beyond the p-p curve) d. How we can measure these recessionary gaps and inflationary gaps? (Visualize where we may be in our short run equilibriums compared to where we need to be to ensure full employment.) e. How can we close a recessionary gap or an inflationary gap? Investment and Savings o Understand the distinction between Physical Capital and Financial Capital, and understand that when an economist uses the term capital, the meaning is usually physical capital. When a financial advisor or investment banker uses the term capital, the meaning is usually financial capital. Either of us is generally comfortable in the other s neighborhood. In the context of the Circular Flow Diagram we looked at Leakages and Injections. Consider Savings as leakage; Investment as Injection. Thus when S = I we stay at equilibrium When S > I we have net leakage When S < I we have net injection

5 In the classical, Laissez Faire view interest rates changed to bring S and I into balance. We discussed the relationship between Consumption and Investment, and how a change in C can cause a greater change in I. Know the difference between wealth and income Know the difference between a stock and a bond Know that physical capital depreciates. (Machines wear out.) Realize that Gross investment less depreciation = net investment. See the whole discussion of S and I in the macro context by seeing S and I in the context of the circular flow diagram a. Leakages and Injections b. C + I + G + NX c. Crowding Out. Especially, as public sector borrowing uses available funds from the savings pool, the upward demand for these funds increases the interest rate. (i.e. it raises the cost of money.) Government borrowing makes private borrowing more costly and may crowd out private investment. The government and Exxon may be competing for the same loanable dollars, and government borrowing raises Exxon s cost of borrowing and hence may affect its Investment. O Know what is meant by discretionary fiscal policy and non-discretionary fiscal policy. We discussed two examples of non-discretionary policy that served as automatic stabilizers : A progressive income tax and unemployment compensation. How do these serve as automatic stabilizers? O Know what is meant by discretionary fiscal policy and non-discretionary fiscal policy. We discussed two examples of non-discretionary policy that served as automatic stabilizers : A progressive income tax and unemployment compensation. How do these serve as automatic stabilizers? Know what is meant by an Expansionary Fiscal policy and a Contractionary Fiscal Policy. The Art of Macroeconomics is managing the economy to meet the goals of sustainable growth, stable prices, and full employment. Understand how any addition or reduction to the Macro economy has a multiplied effect. The Income Multiplier: 1/ MPS or 1/1-MPC One divided by the Marginal Propensity to Save One divided by One less the Marginal Propensity to Consume (These are two expressions of the same thing since the MPS + MPC always = 1). As the Marginal Propensity to Save increases, the multiplier declines. As the Marginal Propensity to Save decreases, the multiplier expands The amount of consumption drives the whirl that is the multiplier.

6 Consider the effects of these policy options: A. Government spends $1000 B. Government gives tax cut or tax refund of $1000 C. Government spends $1000 but maintains a balanced budget by raising taxes by $1000 to cover the increased expenditures. REVIEW OF FISCAL POLICY Why does A have the most effect on the economy? B less; and C much less???? A. THE POLICIES: TAXING GOVERNMENT SPENDING MANAGING BORROWING MANAGING TRANSFER PAYMENTS MANAGING THE NATIONAL DEBT (Note that transfer payments and the national debt are derived from the fundamental taxing and spending policies granted to Congress by Constitution.) B. An EXPANSIONARY FISCAL POLICY involves cutting taxes and increasing government spending. A CONTRACTIONARY FISCAL POLICY involves raising taxes and reducing government spending. C. The fiscal policy doctor might prescribe an EXPANSIONARY policy to correct a recessionary gap and a CONTRACTIONARY policy to correct an inflationary gap. The marginal additions to or the subtractions from the economy are subject to the income multiplier 1/MPS see above. D. If Government spending > Government Tax revenue, we have a budget deficit. If Tax revenue > Spending we have a budget surplus. A budget deficit may be used to correct a recession, while a budget surplus may be useful in correcting inflation. E. The annual budget deficit now is about $1.3 trillion. Annual Budget deficits add to the National Debt which now is approximately $13 trillion about 85% of GDP. The U.S. government must borrow to meet the shortfall in the budget. F. Fiscal Policies can be discretionary or non-discretionary. DISCRETIONARY fiscal policies are determined on an ad hoc basis by the Congress Congress considers each bill and passes or rejects that bill at its discretion. An example would be Hurricane relief for Katrina victims. NON-DISCRETIONARY fiscal policy includes spending that is pursuant to a system Congress has passed, not a particular, specific ad hoc case. An example is Social Security which includes the conditions that must be met for a recipient to collect. If one meets those conditions, that person is entitled to receive benefits. Such spending is often referred to as entitlements. Entitlements

7 as well as paying interest on the national debt are examples of NON- DISCRETIONARY spending. G. TAXES. Be familiar with Progressive, Regressive, and Proportional Taxes. Progressive Tax: The rate of the tax increases as income increases. The US personal income tax (our Number One source of federal revenue) is a good example. Regressive Tax: The rate of the tax decreases as income increases OR the rate increases as income decreases. Excise taxes (such as a gasoline tax) and sales taxes are good examples. Proportional Taxes: The rate of the tax neither increases nor decreases as income changes. (Stephen Forbes ran for the US Presidency twice with the flat tax as his main platform position. Candidate Cain now advocates this in his program.) Understand why Social Security (taken as a whole) is regressive. (One pays on the first $110,000 --approximately. So it is proportional up to that amount; then it become very regressive.) Understand what is depicted by a Laffer curve: How can lower Tax rates raise total tax revenue? And Higher rates reduce revenue. H. NATIONAL DEBT. Understand the issues associate with: The size of the debt To whom do we owe that debt Shifting resources from the future to the present Shifting resources among income groups