ECO403-Marcoeconomics New Lecturewise Questions and Answers for Final term Prepared By Virtualians.pk Lecture No.23

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1 Lecture No.23 Benefits of Economic Growth: Economic growth means an increase in real GDP. This increase in real GDP means there is an increase in the value of national output / national expenditure. The benefits of economic growth include: 1. Higher Incomes. This enables consumers to enjoy more goods and services and enjoy better standards of living. 2. Lower unemployment With higher output firms tend to employ more workers creating more employment. 3. Lower Government borrowing. Economic growth creates higher tax revenues and there is less need to spend money on benefits such as unemployment benefit. Therefore economic growth helps to reduce borrowing. Economic growth also plays a role in reducing debt to GDP ratios 4. Improved public services. With increased tax revenues the government can spend more on the NHS and education e.t.c. 5. Money can be spent on protecting the environment. With higher real GDP a society can devote more resources to promoting recycling and the use of renewable resources 6. Investment. Economic growth encourages investment and therefore encourages a virtuous cycle of economic growth. Lecture No.24 Definition of 'Aggregate Demand' The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending". Definition of 'Aggregate Supply' Page 1

2 The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand. Lecture No.25 What are shocks? A shock is an unexpected or unpredictable event that affects an economy, either positively or negatively. Technically, it refers to an unpredictable change in exogenous factors that is, factors unexplained by economics which may have an impact on endogenous economic variables. Definition of 'Supply Shock' An unexpected event that changes the supply of a product or commodity, resulting in a sudden change in its price. Supply shocks can be negative (decreased supply) or positive (increased supply); however, they are almost always negative and rarely positive. Assuming aggregate demand is unchanged, a negative supply shock in a product or commodity will cause its price to spike upward, while a positive supply shock will exert downward pressure on its price. Page 2

3 Definition of 'Demand Shock' A sudden surprise event that temporarily increases or decreases demand for goods or services. A positive demand shock increases demand, while a negative demand shock decreases demand. Both positive and negative demand shock have an effect on the prices of goods and services. Lecture No.26 What is Keynesian cross? It is the simple closed economy model in which income is determined by expenditure. This model is presented by J.M. Keynes. Notations: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure What is the difference between actual expenditure and planned expenditure? Actual expenditure is the amount that households, firms and the government spend on goods and services; it equals the economy s gross domestic product (GDP). Planned expenditure is the amount households, firms and the government would like to spend on goods and services Page 3

4 What is govt. purchases multiplier? The increase in income resulting from Rs.1 increase in G is known as government purchases multiplier. In this model, the G multiplier equals: Y/ G = 1 / 1 - MPC Lecture No.27 Definition of 'ISLM Model' A macroeconomic model that graphically represents two intersecting curves, called the IS and LM curves. The investment/saving (IS) curve is a variation of the income-expenditure model incorporating market interest rates (demand for this model), while the liquidity preference/money supply equilibrium (LM) curve represents the amount of money available for investing (supply for this model). Lecture No.28 IS curve Formula The IS curve is defined by the equation where Y represents income, represents consumer spending as an increasing function of disposable income (income, Y, minus taxes, T(Y), which themselves depend positively on income), represents investment as a decreasing function of the real interest rate, G represents government spending, and NX(Y) represents net exports (exports minus imports) as a decreasing function of income Page 4

5 (decreasing because imports are an increasing function of income). In this equation, the level of G (government spending) is presumed to be exogenous meaning that it is taken as a given. LM frame work: LM curve. For the liquidity preference and money supply curve, the independent variable is "income" and the dependent variable is "the interest rate." The LM curve shows the combinations of interest rates and levels of real income for which the money market is in equilibrium. It is an upwardsloping curve representing the role of finance and money. Lecture No.29, The Firm vs. the Industry's Short-Run Supply Curve A company will continue to produce output until marginal revenue (MR) is equal to marginal cost (MC). In other words, the condition for maximum profit occurs where: MR = MC Another condition for profit to be maximized, because it is possible that MR=MC at a point where MC is falling, is that the marginal cost curve must be rising. Therefore, the supply curve for a competitive firm will be that part of the marginal cost curve which lies above the low point of the average cost curve. The supply curve slopes upward because marginal costs increase with the greater quantity supplied in the short run. With a competitive market, the supply curve will be a summation of the individual firms' supply curves. Long-Run Effects on Equilibrium In the short-run, increases (decreases) in demand in a competitive market will cause prices and output to increase (decrease). Page 5

6 In the long-run, increases (decreases) in demand in a competitive market will cause increases (decreases) in output. Initially, markets with an increase (decrease) in demand will have firms experiencing economic profits (losses). Over time, markets with firms experiencing economic profits (losses) will have additional firms enter (existing firms will exit) the market, and prices will decrease (increase) towards previous levels. If cost conditions remain the same, then prices will revert to what they were before the increase (decrease) in demand. Lecture No.30 Mundell Flaming Model: The Mundell Fleming model, also known as the IS-LM-Bop model, The model is an extension of the IS-LM model. The Mundell Fleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closedeconomy IS-LM model, which focuses only on the relationship between the interest rate and output). The Mundell Fleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy Difference between Flexible and Fixed exchange rate system: A system of international exchange rates in which the countries agree to maintain a predetermined value of their currencies in terms of other currencies is called fixed exchange rate system. An international monetary system in which exchange rates are determined in foreign exchange markets and governments do not agree to fix them is called flexible exchange rate system. Lecture No.31 Country Risk: The risk that the country s borrowers will default on their loan repayments because of political or economic turmoil. Lenders require a higher interest rate to compensate them for this risk. Page 6

7 Definition of 'Fiscal Policy' Government spending policies that influence macroeconomic conditions. Through fiscal policy, regulators attempt to improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy. Fiscal policy is largely based on the ideas of British economist John Maynard Keynes ( ), who believed governments could change economic performance by adjusting tax rates and government spending Definition of 'Monetary Policy' The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves). Lecture No.32 What Is an Exchange Rate? An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other. Page 7

8 Fixed Exchange Rates There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. Floating Exchange Rates Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing. Lecture No.33 Three Model of Aggregate supply. Definition of 'Sticky Wage Theory' An economic hypothesis that the pay of employed workers tends to respond slowly to the changes in a company's or the broader economy's performance. When unemployment rises, the wages of those workers that remain employed tend to stay the same or grow at a slower rate than before rather than falling with the decrease in demand for labor. Specifically, wages are said to be "sticky-down" since they can move up easily but move down only with difficulty. Page 8

9 Imperfact-InformationalModel: This paper surveys the research in the past decade on imperfect information models of aggregate supply and the Phillips curve. This new work has emphasized that information is dispersed and disseminates slowly across a population of agents who strategically interact in their use of information. We discuss the foundations on which models of aggregate supply rest, as well as the micro-foundations for two classes of imperfect information models: models with partial information, where agents observe economic conditions with noise, and models with delayed information, where they observe economic conditions with a lag. We derive the implications of these two classes of models for: the existence of a non-vertical aggregate supply, the persistence of the real effects of monetary policy, the difference between idiosyncratic and aggregate shocks, the dynamics of disagreement, and the role of transparency in policy. Finally, we present some of the topics on the research frontier in this area. Sticky Price Model: The resistance of a price (or set of prices) to change, despite changes in the broad economy that suggest a different price is optimal. "Sticky" is a general economics term that can apply to any financial variable that is resistant to change. When applied to prices, it means that the prices charged for certain goods are reluctant to change despite changes in input cost or demand patterns. Price stickiness can also occur in just one direction, as in "sticky-up" or "sticky-down". A price that is sticky-up, for instance, can move up rather easily but will only will move down with pronounced effort. Lecture No.34 Page 9

10 Phillips Curve Model: An economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. According to the Phillips curve, the lower an economy's rate of unemployment, the more rapidly wages paid to labor increase in that economy. Lecture No.35 Debt Definition: Debt is a liability you must repay. It may also be a financial guarantee or commitment that you must honor on time. A short-term debt is a loan you must repay within 12 months. A long-term liability has a maturity date exceeding one year. Examples include loans, taxes and bills. Domestic Debt Definition: Domestic debt, otherwise known as national debt, consists of liabilities that a country's citizens and government owe. For example, the United States domestic debt includes Treasury notes, bonds and bills. The U.S. debt also includes credit card debts, student loans, mortgages and business loans that individuals and corporations owe. Definition of 'Floating-Rate Note - FRN' A debt instrument with a variable interest rate. Also known as a floater or FRN," a floating rate notes interest rate is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the fed funds or the prime rate. Floaters are mainly issued by financial institutions and governments, and they typically have a two- to five-year term to maturity. What is capital Assets? A type of asset that is not easily sold in the regular course of a business's operations for cash and is generally owned for its role in contributing to the business's ability to generate profit. Furthermore, it is expected that the benefits gained from the asset will extend beyond a time span of one year. On a business's balance sheet, capital assets are represented by the property, plant and equipment figure. Page 10

11 Lecture No.36 What is Tax cut? A series of temporary income tax relief measures enacted by President George W. Bush in 2001 and The tax cuts lowered federal income tax rates for everyone, decreased the marriage penalty, lowered capital gains taxes, lowered the tax rate on dividend income, increased the child tax credit from $500 to $1,000 per child, eliminated the phaseout on personal exemptions for higher-income taxpayers and eliminated the phaseout on itemized deductions and eliminated the estate tax. Lecture No.37 What is consumption? The Process in which the substance of a thing is completely destroyed, used up, or incorporated or transformed into something else. Consumption of goods and services is the amount of them used in a particular time period. What is budget constraint? A budget constraint is an accounting identity that describes the consumption options available to an agent with a limited income (or wealth) to allocate among various goods. Lecture No.38 What is consumer preferences? Customer preference refers to how customers select goods and services in relation to factors like taste, preference and individual choices. Factors such as the consumer's income and price of the goods do not influence the customer's preferred products or services. Definition of 'Optimization' In the context of technical analysis, it is the process of adjusting one's trading system in an Page 11

12 attempt to make it more effective. These adjustments include changing the number of periods used in moving averages, changing the number of indicators used, or simply taking away what doesn't work. LectureNo.39 What is LCH? The Life-Cycle Hypothesis (LCH) is an economic theory that pertains to the spending and saving habits of people over the course of a lifetime. The concept was developed by Franco Modigliani and his student Richard Bromberg. LCH presumes that individuals base consumption on a constant percentage of their anticipated life income. An example supporting the hypothesis is that people save for retirement while they are earning a regular income (rather than spending it all when it is earned). Lecture No.40 what is capital investment? Assets or capital investments that are needed to start up and conduct business, even at a minimal stage. These assets are considered fixed in that they are not used up in the actual production of a good or service, but have a reusable value. Fixed-capital investments are typically depreciated on the company's accounting statements over a long period of time, up to 20 years or more. The rental price of capital is? The rental price of capital is A) the price paid to use capital for a limited time period B) the price paid for ownership of capital C) always more than the purchase price D) determined outside the realm of factor markets Page 12

13 Economists claim that a resale price maintenance agreement isn't anti-competitive because A) suppliers are never able to exercise noncompetitive market power B) retail markets are inherently noncompetitive C) retail cartel agreements can't increase retail profits D) a supplier with market power is likely to exert that power through wholesales price rather than retail price. What is cobb-dougles Production function? Definition: A standard production function which is applied to describe much output two inputs into a production process make. It is used commonly in both macro and micro examples. For capital K, labor input L, and constants a, b, and c, the Cobb-Douglas production function is: f(k,n) = bk a n c Lecture No.41 What is Investment Funcation? The investment function is negatively sloped with respect to interest rates. More investment occurs when interest rates are lower and less investment occurs when interest rates are higher. Lower interest rates make all capital projects more profitable and higher interest rates make all capital projects less profitable. Businesses buy more profitable capital before they buy less profitable capital. So, as interest rates decrease, investment increases and as interest rates increase, investment decreases. Lecture No.42 What is stock market? The market in which shares of publicly held companies are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, the stock market is Page 13

14 one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership in the company. The stock market makes it possible to grow small initial sums of money into large ones, and to become wealthy without taking the risk of starting a business or making the sacrifices that often accompany a high-paying career. Lecture No.43 What is Inventory? The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets that are ready or will be ready for sale. Inventory represents one of the most important assets that most businesses possess, because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders/owners. What is Accelerator Model? An economic theory that suggests that as demand or income increases in an economy, so does the investment made by firms. Furthermore, accelerator theory suggests that when demand levels result in an excess in demand, firms have two choices of how to meet demand. Lecture No.44 What is money supply? The entire stock of currency and other liquid instruments in a country's economy as of a particular time. The money supply can include cash, coins and balances held in checking and savings accounts. Economists analyze the money supply and develop policies revolving around it through controlling interest rates and increasing or decreasing the amount of money flowing in the economy. Money supply data is collected, recorded and published periodically, typically by the country's government or central bank. Public and private sector analysis is performed because of the money supply's possible impacts on price level, inflation and the business cycle. In the United States, the Federal Reserve policy is the most important deciding factor in the Page 14

15 money supply. Also called money stock. Lecture No. 45 What is money Demanded? The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. Page 15

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