Chapter Eight
Gross Domestic Product (GDP) -the market value of all final goods and services produced domestically during the year. GDP includes domestic production by foreigners and excludes foreign production by citizens.
final goods and services- goods and services which are purchased by their ultimate consumers.
intermediate goods- goods purchased for resale or used to produce other goods.
expenditure approach- determining GDP by summing the expenditures on final goods and services.
resource cost-income approach- determining GDP by summing the costs of producing goods and services.
transfer payments- gifts or payments that are not for production of goods and services; transfer payments do not count in GDP.
GDP=C+I+G+(X-M) expresses that GDP is the sum of the spending of consumers, businesses, government and foreigners on domestic current output; used to calculate GDP using the expenditure approach.
*Gross National Product (GNP) -the market value of all final goods and services produced by citizens of a country during the year. GNP excludes domestic production of foreigners and includes foreign production by citizens.
nominal values- values expressed in current dollar amounts. Also called money values.
real values- values that have been adjusted to remove the effects of inflation, or expressed in the prices (money) of another year.
base year- the year used as the source of price information when real values are computed.
inflation rate-the rate of change in prices over time, on an annual basis.
price index- a number which is calculated from the economy’s price and output data, and which will allow estimation of the inflation rate over time. Generally, a price index is constructed by determining the sums of money that would be necessary to purchase the same combination of goods at two different time periods (and at two sets of prices), taking a ratio of these sums, and multiplying by 100. The percentage change in a price index over time can be used as a measure of inflation. By the way, the plural of index is "indices."
Consumer Price Index (CPI)- a price index which is calculated using a combination of items which consumers are likely to buy. This index is one of those most commonly used by government and business to determine inflation at the retail level.
GDP deflator- a price index which is calculated using the goods comprising GDP.
nominal (current) GDP - GDP computed using current year’s prices.
real (constant) GDP- GDP that has been adjusted for inflation by use of a price index or price ratio (ratio of price indices). Real GDP is essentially GDP for one year, as it would be evaluated in some other year's prices (the other year is referred to as the "base year"). Real GDP is also sometimes called ?real output.?
*real value calculation- any nominal or money value can be converted into the equivalent amount of money of some other year. The converted amount is called the real value. To convert an amount from one year (the "nominal year") to another year (the "real year") the formula is
*price ratio -the ratio of price indices, this can also be a ratio of nominal to real GDP
(personal) consumption (C)-household (consumer) spending on goods and services. It is the largest component of GDP expenditure in the United States economy.
(private) investment (I)-business spending on goods and services.
*capital- a man-made resource, such as machines, tools, and equipment. Capital usually lasts a long time, and can be used without being used up.
inventory investment- changes in goods produced but not sold and in resources purchased but not used. These are counted in GDP for the year they are produced.
government spending (G) - purchases by the government of goods and services (consumption and investment); the second largest component of GDP.
exports (X)- goods produced domestically but sold to people in other countries.
imports (M)- goods produced in other countries but purchased domestically.
net exports (X-M)- goods produced domestically but purchased by foreigners minus goods purchased from foreigners.
GDP per capita- GDP of a country divided by the country's population
Chapter Nine
*percentage change or percentage difference- this is not really an economic tool, but it is a mathematical one. It is the change in some variable, divided by the initial value of the variable. Often, it is calculated from one year to the next. It is also known as the "rate of change." The shorthand used in class for this is % followed by a triangle.
growth rate- the percentage change or percentage difference in some variable, such as real GDP; also known as the "rate of change."
inflation rate-the rate of change in prices over time, on an annual basis; the percentage change in the price index from one year to the next.
economic growth rate- the growth rate in real GDP on an annual basis
stagflation- inflation with slow economic growth (or a recession).
business cycle- term used to describe that the economy has ups and downs; a fairly useless term (normatively speaking).
recession- a downturn in the economy; sometimes used to describe a fall in real GDP lasting six months or more.
depression- a prolonged recession.
unanticipated inflation- inflation that was not expected by decision-makers.
anticipated inflation- the level of inflation that is expected by decision-makers.
net monetary debtor- a person who owes more money than he is owed by others. Such a person will gain from an unanticipated inflation.
net monetary creditor- a person who is owed more money by others than she owes to others. Such a person is harmed by an unanticipated inflation.
(nominal) money interest rate-the percentage difference between the amount of money borrowed at one time and the amount repaid at another, on an annual basis.
inflationary premium- component of the money interest rate that compensates a lender for the effects of inflation.
real interest rate- the interest rate in terms of purchasing power, that is, when changes in prices have been accounted for. The real interest rate is approximately the nominal interest rate minus the inflation rate. One way to think of it is as the interest rate in terms of things rather than money.
Chapter Ten
nominal) money interest rate-the percentage difference between the amount of money borrowed at one time and the amount repaid at another, on an annual basis.
inflationary premium- component of the money interest rate that compensates a lender for the effects of inflation.
real interest rate- the interest rate in terms of purchasing power, that is, when changes in prices have been accounted for. The real interest rate is approximately the nominal interest rate minus the inflation rate. One way to think of it is as the interest rate in terms of things rather than money.
bond -a promise to pay a certain amount in the future. The promise might also involve paying interest between the current time and the future big payoff. By selling a bond, a government or business is borrowing money. The interest rate on the loan is determined by the difference between the price the bond sells for (basically, the borrowed money) and the payoff or "face value" of the bond (the repayment of the loan).
*asset- something of value that pays money or provides benefits over time
*security- an asset, such as a bond, often issued by the government
principal -the amount deposited or lent and that will earn interest
present value -the amount that one has now, or its equivalent. This is the same as the principal.
future value -the amount that one will have in the future, based on the principal earning interest
asset value -the present value or expected current price of a piece of real estate, a bond, or other property that might pay its owner money or produce benefits over time. The value of an asset is always inversely related to the interest rate; it represents the present value of the expected net benefits of owning the asset. As an extreme, if we assume the asset will last (virtually) forever, asset value is the annual net income from the asset divided by the interest rate; Asset value = Annual net income/ interest rate
in perpetuity- forever. When an asset will give benefits "in perpetuity," its current value or price is its annual income divided by the interest rate. Otherwise, its value will be less than that amount (but is still inversely related to the interest rate).
(civilian) labor force- persons who are either employed or unemployed (see unemployment); persons who are over 16, free to work, and willing to work (either they are working or looking for work).
unemployed- the situation in which one is either actively looking for work or waiting to start work (such as during a temporary layoff) but does not have a job currently. A person in such a situation is unemployed. Most unemployment is due in some way to information costs, unless there is a price floor of some kind at work.
labor force participation rate- the percentage of the population that is in the labor force.
rate of unemployment - the percentage of persons in the labor force who are unemployed; also called the "unemployment rate."
frictional unemployment- unemployment that is caused by the job search process and the costs involved in getting information on available jobs. One kind of unemployment caused by information costs.
structural unemployment- unemployment caused by changes in the economy which will require some workers to get retrained before they can find a job. The longer it takes the worker to learn that he needs training and how it can be obtained, the longer the worker will be unemployed. This is another kind of unemployment caused by information costs.
cyclical unemployment- unemployment resulting from cycles in the economy affecting the demand for labor; it takes buyers and sellers in the labor market to adjust to new realities concerning wages, especially if the labor market is frequently changing. It simply expresses that changes in demand for labor will make information about the labor markets more difficult to obtain for a while.
full employment- the level of employment that exists when only "natural" unavoidable unemployment exists; employment of all resources that are not frictionally or structurally unemployed.
natural rate of unemployment- the unemployment that, on average, normally exists due to information costs in the economy. The long term average amounts of frictional and structural unemployment make up the natural rate.
*discouraged workers- potential workers who have left the labor force because finding a job is hard for them.
employment/population ratio- the percentage of people in the labor force who have jobs out of those who could be in the labor force (over 16 and not in the military).
potential output- the output of the economy if it is at full employment.
Chapter Eleven
resource markets- also called "factor markets" or "input markets", these are where labor, capital and natural resources are bought and sold; the market for inputs that are used to produce goods and services. Resource markets (and the demand for various resources) are affected by the demand for goods and services.
wage- the price of labor resources. Wages and other resource prices affect the cost of goods and services, and thus their supply.
loanable funds market (money market, capital market) - the market in which borrowing and lending of households, businesses, and governments are coordinated, loans are made, and interest rates are determined. The "buyers" of loans (capital) are borrowers, the ?sellers? are lenders, and the ?price? is the interest rate. Financial institutions, such as banks, serve as middlemen in this market.
interest rate-the percentage difference between the amount of money borrowed at one time and the amount repaid at another, on an annual basis. The interest rate enables comparisons of values in the future to values in the present.
foreign exchange market- market in which money of different countries is bought and sold to enable international trade.
exchange rate- the value (or price) of one country's money in terms of another country's money. Exchange rates determine what the prices of one country's goods will be in other countries.appreciation- a country's currency becoming more valuable (higher value or price) in foreign exchange markets.
depreciation- a country's currency becoming less valuable (lower value or price) in foreign exchange markets.
trade deficit- when imports are greater than exports, so that money is leaving the country to pay for imported goods and services.
trade surplus -when exports are greater than imports, so money is entering the country as other countries pay for goods and services being shipped to them
goods and services market- a combination of all of the markets in which goods and services are traded.
long run -a time period sufficient to enable decision-makers to adjust to market changes.
short run -a time period in which decision-makers have not yet adjusted to market changes.
aggregate demand curve (AD)-the downward-sloping graphical representation of the inverse relationship between the price level and the quantity of goods and services desired by buyers (consumers, businesses, government, and foreigners) from the economy. The relationship is inverse because the purchasing power of money rises as price level decreases, lower price levels tend to lower real interest rates (making it easier to borrow), and lower price levels reduce buyers' tendency to substitute foreign goods for domestic purchases.
real balance effect- the inverse relationship between the price level and the value (purchasing power) of assets held as cash.
aggregate supply curve- the graphical representation of the relationship between the price level and the quantity of goods and services produced in the economy. In the short run, the aggregate supply is thought to be a positive relationship (shown as an upward sloping curve). In the long run, aggregate supply is represented by a vertical line indicating that output does not depend on the price level.
short run aggregate supply (SRAS)- in the short run, the output of the economy is directly related to the price level because, as prices rise, resource costs (based on long-term contracts) will not increase as fast, so profits (and incentives to expand production) will increase.
long run aggregate supply (LRAS)- in the long run, the output of the economy is not related to the price level because, as prices rise, resource costs will eventually increase, removing incentives to expand production as a response to the price level. Output is based on technology and the resources available at full employment.
short run macroeconomic equilibrium -the real GDP and price level at which the short-run aggregate supply and the aggregate demand curve are equal.
long run macroeconomic equilibrium -the real GDP and price level at which the short-run aggregate supply, the long run aggregate supply, and the aggregate demand curve are equal. In long-run equilibrium, resource markets, goods/services markets, and loanable funds markets must all be in equilibrium. This implies that the actual inflation rate is equal to the expected inflation rate, that the prices of goods are equal to their costs of production, and that interest rates reflect the normal long run return on capital investments.
full employment equilibrium -the long run macroeconomic equilibrium, so called because all resources are being used to their full capacity.
natural rate of unemployment- the level of unemployment at full employment equilibrium; some unemployment (frictional unemployment) is considered unavoidable or natural.
anticipated change- a change that is predicted by decision-makers.
unanticipated change- an unexpected change.
unanticipated increase in aggregate demand- a movement of the aggregate demand curve to the right, as would be caused by an increase in domestic buyers' real wealth, a fall in real interest rates, an increase in optimism, an increase in anticipated inflation, higher real incomes of buyers in other countries, or a fall in the exchange rate. (The opposites of these would cause a decrease in aggregate demand, which would move the aggregate demand curve to the left.)
*unanticipated increase in long-run aggregate supply- a movement to the right of the long run aggregate supply curve, as would be caused by an increase in the supply of resources, increases in technology, or institutional changes. (The opposites of these would cause a decrease in long run aggregate supply, which would move the long run aggregate supply curve to the left.)
productivity- the average output of labor divided by the number of worker hours; the amount of product produced per hour worked
*unanticipated increase in short-run aggregate supply- a movement to the right of the short run aggregate supply curve, as would be caused by an decrease in the prices of resources, favorable conditions for production, or temporary institutional changes. (The opposites of these would cause a decrease in short run aggregate supply, which would move the short run aggregate supply curve to the left.)
*self-correcting mechanism-when an economy is not operating full employment, changes in wages, resource prices, and interest rates will eventually restore long run equilibrium without government intervention. Specifically, if output is below full employment, resource prices fall, due to the low resource demand, thus increasing SRAS. Also, if output is below full employment levels, businesses will want to invest less which will result in less borrowing, lowering real interest rates and increasing AD. Opposites of these things will occur if output is above full employment.
permanent income hypothesis- consumption spending by households depends on how households view their long term income. Consumption spending will increase only if households expect income to rise permanently; wealth (a long-term measure of accumulated income) will affect consumption whereas temporary fluctuations in short-term income will not . Thus, the consumption component of aggregate demand is fairly stable (at least as far as the effect of income).
Chapter Twelve
central bank- authority that controls the banking industry and money supply of a country.
money- anything commonly used and generally accepted as final payment of debts. in the United States, money includes bank deposits, travelers' checks, and currency. Credit cards are not money.
liquid asset- anything that can be quickly transformed into purchasing power without loss of value.
medium of exchange- an asset used to buy goods or services. One of the functions of money.
accounting unit- a way of measuring the relative value of goods and services. One of the functions of money.
store of value- a way of preserving value or purchasing power over time. One of the functions of money.
standard of deferred payment- something used to make payments over time. A function of money.
fiat money- money whose principal value to people is that it is accepted in exchanges and issued by some authority; it is not "backed up" by any valuable asset.
currency- money in the form of cash (per money) and coin
money supply- the amount of money available for people to spend. Also called the "stock of money."
M1- one of the main measures of money, M1 consists of currency, demand deposits, interest-earning checkable deposits, and travelers' checks.
transactions accounts- any account from which funds can be drawn to make a payment.
demand deposits- checking account money; money which can be transferred by check, but which does not generally earn interest.
other checkable deposits- money in accounts that earn interest but which are accessed by check writing. Also called "interest-earning checkable deposits."
M2 -consists of M1 plus savings accounts, time deposits (see below), money market mutual funds, and various short-term loans and deposits.
time deposits- savings account balances of less than $100,000, often earning some interest.
banking or depository institutions- businesses that accept deposits and make loans; these include banks, savings and loans, and credit unions. For convenience, we will just call them all "banks."
money market mutual funds- checkable, interest-earning accounts with brokerage houses.
credit- money acquired by borrowing.
Federal Reserve System (Federal Reserve Bank)-the central bank of the United States, it has control over the banking industry and the money supply in the U. S.
"The Fed" -nickname for the Federal Reserve System.
*savings and loan associations- institutions that openly accept deposits, make loans, and pay dividends on deposits made (shares). In most ways, similar to commercial banks, except that depositors are considered "owners."
*credit unions- associations or cooperatives that accept deposits, pay interest or dividends on the deposits, and make loans to members. Sort of like a bank that you join. Usually, you must be an employee or somehow affiliated with a particular employer or occupation to join.
*commercial banks- financial institutions that operate for profit, are owned by stockholders, accept many different kinds of deposits, and make loans of various sorts.
banking system (industry)- commercial banks, savings and loan associations and credit unions taken as a whole. All are controlled by the Federal Reserve.
actual (bank) reserves- vault cash plus bank deposits at the Fed
vault cash- coins and cash held by banks. Vault cash is not money; instead, it is actual reserves.
fractional reserve banking system-a system in which banks keep only a portion of their deposits to back up those deposits.
required reserves- reserves which banks are must have to secure their deposits. They are equal to the demand
deposits in the bank times the required reserve ratio.
required reserve ratio (r)- the fraction of deposits that banks must hold in the form of actual reserves. The ratio is set by the Fed. If the Fed reduces the required reserve ratio, excess reserves will rise, thus enabling banks to lend more, create demand deposits and thus expand the money supply.
excess reserves- the amount by which actual reserves exceed required reserves. Excess reserves can safely be lent out, as they are not legally needed to secure deposits in the bank.
bank expansion- the act by depository institutions of creating money by making new loans.
deposit expansion multiplier- the number used to determine how many dollars will actually be added to the money supply for each one dollar addition to bank reserves. It is inversely related to the required reserve ratio. The expansion multiplier will be reduced if the public increases its holding of cash or if banks voluntarily keep excess reserves rather than maximizing their loans.
potential deposit expansion multiplier (1/ r)- the number used to determine how many dollars might, at most, be added to the money supply for each one dollar addition to bank reserves. It is the inverse of the required reserve ratio.
*potential bank expansion equation -the formula relating additional excess reserves in the banking system to the maximum amount of money that can be eventually generated by banks in the form of new loans. This is in addition to any money directly created when actual reserves are created by the Fed. Specifically, new loans= (new ER)/r , where ER is excess reserves and r is the required reserve ratio.
cash drain or cash (currency) leakage- when the public increases its holding of cash while reducing its bank deposits.
Federal Open Market Committee- a board that sets Fed policy concerning the buying and selling of bonds.
securities -bonds
government securities- government issued bonds and "bills" (short term bonds); sold by the government to borrow money.
open market operations- the most frequently used tool of the Fed, these are purchases or sales of bonds by the Fed. Purchase of bonds by the Fed will raise bank actual reserves and thus increase demand deposit creation and the money supply. Sale of bonds by the Fed will have the opposite effect.
monetary base- the sum of currency in circulation (in the hands of the public) and bank reserves.
discount rate- the interest rate that the Fed charges banks when they borrow reserves. This is the only interest rate that the Fed directly sets. if the Fed lowers the discount rate, it tends to encourage banks to borrow reserves, enabling them to extend more loans, increase demand deposits and thus increase the money supply.
Federal Funds market- a market where banks in need of reserves can borrow them from other banks (who have an excess).
Federal Funds Rate- the interest rate banks charge one another for borrowed reserves. It reflects the discount rate, but need not be the same. As is true of all interest rates, it is determined in a market (the Federal Funds market, to be exact).
U. S. Treasury- the government agency responsible for handling the Federal government's finances, including borrowing money (by selling bonds). It is not part of the Federal Reserve System.
bank run- when people go to their bank to withdraw money due to fear that their deposits are not secure.
Federal Deposit Insurance Corporation (FDIC)- a government corporation established to insure bank deposits and instill confidence in the banking system, preventing bank runs. Unlike a private insurance company, premiums paid by a financial institution to the FDIC do not reflect the risks of insuring the institution, thus producing a moral hazard problem.
moral hazard problem- when a person with insurance behaves recklessly, assuming that the insurance will cover the results of his decisions. In the banking industry, the moral hazard problem results in financial institutions making riskier loans than they otherwise might (or than they would if the premiums on deposit insurance reflected risk). This is why so many banking institutions went bankrupt in the 1980's.
Chapter Thirteen
monetary policy- using the supply of money issued and in circulation to influence GDP, interest rates, inflation and unemployment.
demand for money- the (inverse) relationship between the nominal interest rate and the amount of wealth people want to hold as money assets (rather than other kinds of liquid assets). Graphically, money demand is shown as a downward-sloping curve.
supply of money- the stock or quantity of money in the economy, set by the Fed. Since the amount of money is not dependent on interest rates, a graphical representation of the relationship between nominal interest rates and the quantity of money would be a vertical line at the amount of money set by the Fed.
expansionary monetary policy- an increase in the growth rate of the money supply, usually intended to increase aggregate demand. As the money supply is increased, nominal interest rates will fall to equate the quantity demanded with the higher quantity supplied. As people increase their money holdings, deposits in banks increase (remember also that an increase in bank deposits is part of the process of increasing the money supply- that's the form it takes). As banks lend these new deposits, the supply of loanable funds increases, reducing the real interest rate. The reduction in the real interest rate will increase aggregate demand.
*effects of lower interest rates- Lower interest rates increase aggregate demand by making borrowing more attractive thus increasing spending (for businesses and households). In addition, investors will respond to the lower U.S. interest rates by investing more in other countries, thus lowering the value of the dollar (which also increases aggregate demand). Further, as the interest rate falls, the value of non-money assets increases, thus increasing people's wealth (further increasing aggregate demand).
restrictive monetary policy- reductions in the growth rate of the money supply to restrict the growth of the economy (often to avoid inflation).
quantity theory of money- the theory that increases in the money supply will affect economic variables, such as the price level (and, perhaps, the level of real output). Long term, the theory predicts that the effects of faster money supply growth will be mostly on the price level.
velocity of money- the number of times each dollar in existence changes hands in a year.
Equation of Exchange-the equation relating the money supply to other economic variables. Specifically, MxV=GDP=PxQ where M is the money supply, V is velocity, P is the price level, and Q is real output or real GDP.
In terms of growth rates, [% change in M] + [% change in V] = [% change in P] + [% change in Q]
where [% change in M] is the growth rate of the money supply,
[% change inV] is the growth rate of velocity,
[% change in P] is the inflation rate, and
[ % change in Q] is the growth rate of real GDP or the growth rate of real output.
*quantity equation of money- another name for the equation of exchange
*time and the effects of increasing growth in the money supply- Most of the time, velocity changes is very little (if at all) from one year to another. In the very short run (how long that is depends on the economy), the first effects of an increase in the money supply growth rate will be a decrease in [% change in V]. Very soon, velocity will return to its normal level (% change in V will be zero). With time (perhaps a year or more later), the effects of the increase in the money supply growth rate will be felt on [% change in Q] (growth in real output will rise, and unemployment will fall). Eventually (18 months to three years after the initial change in money growth), the growth in real output will return to zero (or may even become negative), as [% change in P] grows (resulting in inflation).
escalator clause- contract provision that raises wages and salaries to keep up with inflation automatically. Also called COLAs for cost of living adjustments.
*using monetary policy to keep interest rates low- while expansionary monetary policy may reduce interest rates in the short run, eventually higher inflation rates will push interest rates up. Thus, long term reductions in interest rates will not be possible through monetary expansion.
*overall conclusions about monetary policy- The effects of monetary policy on real output and unemployment are temporary. The time it takes for these effects to be felt and to vanish depends on the state of the economy when the monetary policy is begun. Persistent money supply growth will lead, in the long run, to inflation. Money interest rates and inflation are directly related. Since it takes time for monetary policy changes to be felt in the economy, there are time delays (often greater than a year) between a policy and its effects on output and even longer time delays before the effect is seen on inflation.
activist - the view that monetary and fiscal policy can be used to “fine tune” and stabilize the economy.
nonactivist - the view that the economy would be more stable is the monetary and fiscal policy makers followed consistent policy rules instead of changing policy as conditions change.
Monetarist - theory "school" based on the observation that fluctuations in the money supply are a major cause of changes in GDP and that fast growth of the money supply is a major cause of inflation.
*index of leading indicators- a statistic that tends to predict the direction of the economy. It involves such things as new factory orders, M2, average number of hours worked per week, and stock prices.
recognition lag- the length of time it takes policy makers to realize a policy change is needed.
administrative lag- the time it takes for a policy to be implemented after its need is recognized.
impact lag- the length of time it takes for a policy to have its desired effect after it is implemented.
adaptive expectations-the view that private sector decision makers will base decisions on the past, with the most recent past having the biggest influence on current decisions.
rational expectations-the view that changes in government spending will affect private spending, as those in the private sector anticipate higher or lower future taxes. The implication is that fiscal policy will be largely ineffective.
policy-ineffectiveness theorem- idea that decision makers will anticipate the effects of any policy. In so doing, they will counteract its effects.
consensus view on policy- Regarding policy, economists are in agreement that (1) a monetary policy that has the goal of keeping inflation low will be workable if pursued long-term, (2) increasing aggregate demand to reduce unemployment will not work long-term, (3) large changes in monetary or fiscal policy will greatly disrupt the economy, even if the intentions are noble, and (4) fiscal policy will not work to stabilize the economy
Chapter Fourteen
*government purchases- spending by government on the purchase of goods and services, not including transfer payments.
*transfer payments- payments by the government to individuals, businesses or others which are not due to the purchase of any good or service. Examples include welfare programs, Social Security payments, pension payments, and similar programs.
*government spending-the total spent by the government, including government purchases and transfer payments. This spending must be paid for by tax revenues or borrowing (selling bonds and Treasury notes).
fiscal policy- using government taxing and spending to affect GDP, inflation and unemployment.
balanced (government) budget-a situation in which the government is taking in exactly the same amount of tax revenue as it is spending
(government) budget deficit-a situation in which the government raises less in tax revenues than it spends.
(government) budget surplus-a situation in which the government raises more in tax revenues than it spends.
*national debt or government debt- the sum of the government budget surpluses and deficits; the total owed by the government
discretionary fiscal policy- changes in tax laws or spending programs that affect government purchases or tax revenues.
Keynesian model-the view of the economy as relationships between expenditure and income. These relationships are that consumption depends on income, while income depends on consumption, government spending, and investment. The Keynesian view is that increased government spending will put income in the hands of the public, which would stimulate additional consumption spending by individuals and investment by businesses, thus increasing aggregate demand and GDP. The Keynesian model is responsible for the acceptance on the part of policy makers that the government budget can (and, in the opinion of some, should) be used to influence the economy.
autonomous spending- spending that occurs regardless of income
induced spending- spending (primarily on consumption) that depends on the level of income in the economy.
permanent income hypothesis- consumption spending by households depends on how households view their long term income. Consumption spending will increase only if households expect income to rise permanently; wealth (a long-term measure of accumulated income) will affect consumption whereas temporary fluctuations in short-term income will not . Thus, the consumption component of aggregate demand is fairly stable (at least as far as the effect of income).
expansionary fiscal policy- increase in government spending or reduction in taxes intended to increase the budget deficit and cause the economy to grow.
restrictive fiscal policy- reductions in government spending or increases in taxes to restrict the growth of the economy (often to avoid inflation).
countercyclical policy- a policy that attempts to stabilize the economy by offsetting whatever changes the economy is experiencing naturally.
automatic stabilizers-programs that will increase government spending (or reduce taxes) during recessions and reduce government spending (or increase taxes) during growth periods in the economy, without special action by government officials. They are automatically countercyclical. These programs include unemployment insurance, corporate taxes and the progressive income tax.
crowding out effect- when reductions in private consumer and business spending occur because government deficits raise real interest rates.
new classical economics- the controversial school of thought that markets tend to long run equilibrium without government action. The implication is that fiscal policy will be largely ineffective, due to Ricardian equivalence.
*Ricardian equivalence- the idea that government deficits will not affect the economy, since people will expect higher future taxes due to the government's deficit spending. Government deficits have no effect on aggregate demand or on the interest rate.
*Ricardian equivalence with higher government spending- If a deficit is used to finance higher government spending, people will reduce current consumption just as much as if higher taxes were applied immediately (they do this in order to stabilize their standard of living and to be able to pay the higher taxes they will face in the future). Thus, the government spending will not move the aggregate demand curve. The higher savings of people will prevent the government's borrowing from raising interest rates. In all, the deficit has no effect.
*Ricardian equivalence with a tax cut- If a deficit is used to finance lower taxes, people will maintain their current consumption and save the tax cut money (they do this in order to stabilize their standard of living and to be able to pay the higher taxes they will face in the future). Thus, the tax cut will not move the aggregate demand curve. The higher savings of people will prevent the government's borrowing from raising interest rates. In all, the deficit has no effect.
*marginal tax rate- the additional tax that must be paid divided by additional income (see chap. 6).
supply side economics- economic view that marginal tax rates strongly influence aggregate supply. Lower marginal tax rates move both the long run and the short run aggregate supply curves to the right by increasing the incentives to provide labor and capital to resource markets. The major effects of changing marginal tax rates will be seen in the long run.
Chapter Fifteen
comparative advantage-the ability to produce at lowest opportunity cost; the basis for trade and specialization.
absolute advantage-the ability to produce a greater amount with the same resources
*production possibilities curve (PPC)-a graphical depiction of all of the possible and (productive) efficient combinations of two goods which can be produced by an individual or group. Shows the maximum amounts of two goods that can be produced with a given set of resources and technology. Combinations (amounts) on the curve are efficient. Those below the curve are not.
tariff-a tax on imported goods.
import quota- a restriction on the quantity of goods that can be imported.
voluntary export restrictions (VER)- a sort of self-imposed quota.
dumping- selling a good in a foreign country for a lower price than it is sold domestically.
foreign exchange market- market in which money of different countries is bought and sold to enable international trade.
exchange rate- the price of one country's money in terms of another country's money.
appreciation-becoming more valuable (higher value or price).
depreciation-becoming less valuable (lower value or price).
flexible exchange rates- exchange rates that are determined in a foreign exchange market rather than being set by law. Also called "floating exchange rates."
fixed exchange rate- an exchange rate that is set by laws rather than in the foreign exchange market.
pegged exchange rate- exchange rate that is maintained at a particular level or in a particular range through use of monetary or fiscal policy.
balance of payments- a way to measure imports and exports of goods, services and loans.
current account- the flow of money used to pay for goods and services exchanged internationally.
balance of (merchandise) trade- difference between the value of goods exported and the value of goods imported.
balance on goods and services- difference between the value of goods and services exported and the value of goods and services imported.
balance on current account- overall, the flow of money coming into the country to pay for exports and as returns on foreign investments minus the flow of money going out of the country to pay for imports and as payments to foreign investors.
*current account deficit- on net, money is leaving the country to pay for imported goods and services and investments. Also called a "trade deficit."
*current account surplus -on net, money is entering the country as other countries pay for goods and services being shipped to them. Also called a "trade surplus."
(balance on) capital account- the flow of money lent internationally (and capital purchases); the flow of international credit.
*capital account deficit-money is leaving the country as it is lent internationally.
*capital account surplus -money is entering the country as other countries lend to people or governments in this country.
International Monetary Fund (IMF)- an international bank set up to facilitate trade. It makes loans to central banks of various nations.