SAMPLE Macroeconomics
THE ULTIMATE CREDIT-BY-EXAM STUDY GUIDE FOR: Macroeconomics 1 st Edition
2/01/2024
Acknowledgements We would like to thank the author for their patience, support, and expertise in contributing to this study guide; and our editors for their invaluable efforts in reading and editing the text. We would also like to thank those at Achieve Test Prep whose hard work and dedication to fulfilling this project did not go unnoticed. Lastly, we would like to thank the Achieve Test Prep students who have contributed to the growth of these materials over the years.
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Contents Chapter 1: Basic Economic Concepts
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A. Basic Definitions of Economic Principles
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B. The Economy
C. Factors of Production
D. Scarcity, Choice, and Opportunity Costs E. Production Possibilities Curve (PPC)
F. Comparative Advantage, Specialization, and Exchange
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G. Gains from Trade
H. Demand, Supply, and Market Equilibrium
Chapter 1: Review Questions
Chapter 2: Measurement of Economic Performance
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A. Introduction to Economic Performance
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B. National Income Accounts
C. Inflation Measurement and Adjustment
D. Unemployment
Chapter 2: Review Questions
Chapter 3: National Income and Price Determination
A. Aggregate Demand (AD)
B. Business Cycles and Economic Fluctuations
C. Multiplier and Crowding-Out Effects
D. Aggregate Supply (AS)
E. Macroeconomic Equilibrium F. Self-Correction of Output Gaps
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G. Long-Run Self-Adjustments in the AD-AS Model
Chapter 3: Review Questions
Chapter 4: Financial Sector
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A. Definition of Financial Assets: Money, Stocks, and Bonds B. Time Value of Money (Present and Future Value)
111 116 117 119 122 125 128 131 133
C. Measures of Money Supply
D. Financial Institutions
E. Banks and Creation of Money
F. Money Demand G. Money Market
H. Real vs. Nominal Interest Rates
I. Loanable Funds Market
J. Central Bank and Control of the Money Supply
139 140 146 146 148 151 152 155 156 157 158 161 166 169 170 175 179 180 183 186 189 190 192 195 197 200 201 202 204 206 208 214 216 218 151 186 206
K. Tools of Central Bank Policy L. Limitations of Monetary Policy M. Quantity Theory of Money Chapter 4: Review Questions
Chapter 5: Inflation, Unemployment, and StabilizationPolicies
A. Fiscal Policy
B. Demand-Side Effects of Fiscal Policy C. Government Deficits and Debt
D. Crowding out
E. Automatic Stabilizers
F. The Reserve Market Model
G. Monetary Policy
H. Supply-Side Effects and Policies
I. Policy Mix
J. Inflation and Unemployment
K. Changes in the AD-AS and Phillips Curve Models
L. Role of Expectations M. Economic Philosophies Chapter 5: Review Questions
Chapter 6: Economic Growth and Productivity
A. Economic Growth and Real GDP per Capita B. Economic Growth vs. Economic Expansion
C. Sources of Economic Growth
D. Labor Productivity
E. Research and Development and Technological Progress
F. The Aggregate Production Function
G. Benefits and Drawbacks of Economic Growth
H. Growth Policy
I. Additional Reading: The Trajectory of Productivity Since the 1950s
Chapter 6: Review Questions
Chapter 7: Open Economy: International Trade and Finance
A. Closed Economy vs. Open Economy B. Balance of Payments Accounts C. How and Why the BOP is Balanced
D. Exchange Rates
E. Demand for Foreign Exchange
F. Supply of Foreign Exchange G. Exchange Rate Determination
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H. Exchange Rate Effects on the Economy
I. Exchange Rate Policies Chapter 7: Review Questions
Glossary
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Chapter 1: Basic Economic Concepts Overview
This chapter introduces core macroeconomics concepts, laying the groundwork for understanding complexnationaleconomies.Fundamentalprincipleslikescarcityandopportunitycostguideindividual and national resource allocation decisions. Chapter 1 discusses thefactorsofproduction(land,labor, capital, entrepreneurship) that drive economic activity and explore the Production Possibilities Curve (PPC) as a tool for understanding trade-offs and growth. Furthermore, this chapter will examine comparative advantage andspecialization,revealingthebasisformutuallybeneficialtrade.Lastly,this chapter analyzes demand and supply, the invisible forces shaping market prices and resource allocation. Learning Objectives ● Define key economic principles such as scarcity, opportunity cost, and different economic systems. ● Distinguish macroeconomics from microeconomics. ● Recognize factors of production and define land, labor, capital, and entrepreneurship, and how they combine for production. ● Navigate scarcity and choices by understanding how to apply opportunity cost calculations to understand trade-offs in economic decisions. ● Master market dynamics through the comprehension of demand, supply, and macroeconomic equilibrium to analyze market responses. A. Basic Definitions of Economic Principles Economics isasocialsciencethatstudieshowindividuals,firms,societies,andnationsmake choices to use scarceresources .Itexaminestheallocationofresources,thebehaviorofmarkets,andtheimpact of various factors on economic outcomes. The fundamentaleconomicproblem arisesbecause resources ,whicharethe“inputs”usedtoproduce goods and services, are scarce (meaning they are limited) and may not be enough to fulfill people’s basic needs as well as society’s essentially unlimitedwants . Study Tip In economics, needs are limited and representanythingthatisnecessaryforsurvivalsuchasfood, water, shelter, and clothing. Wants , on the otherhand,arenotessentialforlivingbutareunlimited desires that make lifemoreenjoyableandcomfortable.Forexample,ahumanbeing needs waterto drink, but may want juice or soda. By the end of this chapter, you should be able to:
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Economicsisdividedintotwomainbranches,macroeconomicsandmicroeconomics,eachwithitsown distinct focus. Macroeconomics vs. Microeconomics Macroeconomics isthebranchofeconomicsthatfocusesonthe overallbehaviorandperformanceof an economy . It examines large-scale economic phenomena such as economic growth, inflation, unemployment, and national income. At its core, macroeconomics aims to establish not justefficient production and exchange , but also overall economicstability . Microeconomics ,ontheotherhand, analyzesindividualcomponentsoftheeconomy ,likeconsumers, firms, and markets, to understand how they make decisions and interact to determine prices and quantities of goods and services while considering resource constraints. It helps derive useful conclusionsabouthowresourcesareallocatedandhowmarketswork.Inotherwords,microeconomics deals with individual decisions, whereas macroeconomics deals with the sum of theseindividuals.In macroeconomics, sums are referred to as “ aggregate .” Complementary Insights: Recognizing the intricate interplay between microeconomics and macroeconomics is crucial.Bothfieldstogetherformthebedrockofunderstandingeconomics holistically. Microeconomics provides a keen insight into individual behaviors and smaller interactions , which is invaluable forunderstandingthenutsandboltsoftheeconomy.Onthe otherhand, macroeconomicsequipsuswiththetoolsneeded todecipherbroadertrendsand influences that shape the economy's larger tapestry.
Key Macroeconomic Concepts
Key Microeconomic Concepts
Economics indicators: Gross Domestic Product, inflation, unemployment Aggregate demand, aggregate supply, and macroeconomic equilibrium
Elasticity
Marginal analysis
Fiscal and monetary policies
Production theory
Economic growth
Forms of market competition
Balance of payments
Market failure
Checkpoint Quiz 1: Classify each of the following topics under macroeconomics or microeconomics . a. The unemployment rate recorded in an economy in a given time period. b. The price that a single firm should set for its product in order to maximize profit.
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c. A consumer’s decision to substitute a product with a cheaper one.
(Checkpoint answers are located at the end of the chapter under the review question answers.)
Economic Models The fundamental economic problem forcesalleconomiestoanswerthefollowing resourceallocation questions :
1. What to produce? 2. How to produce? 3. For whom to produce?
To deduce how individuals and entities can be incentivized to make choices that lead to the best possible outcomes forsociety,economistsbuildanduseformal models thatsimplifyrealityandmake simplifyingassumptions.Thishelpsthem predictoutcomes bothatindividualandcollectivelevels(i.e., howdifferenteconomicagentsanswerthe3abovequestions)andtherefore recommendpolicies that maximize efficiency and utility . The Production Possibilities Curve, that will be explained later in this chapter, is an example of an economic model used by economists to construct generalizations. The Method of Economics: Positive vs. Normative Statements In economics, you will come across two types of economic statements and questions: positive and normative.
Positive statements describe what exists in an economy and how it works withoutmakinganyjudgments .Theyare objective andinvolve factsthatcan be tested . Example: The unemployment rate in 2022 is 2%.
This statement states a fact that can be verified by looking at the data.
Normative statements , on the other hand, consist of opinions since they analyze economic behaviorand evaluatewhethertheyaregoodorbad .They may also suggest courses of action. Normative statements cannot be tested since they are subjective . Example: The government should cut taxes in half to increase disposable incomes. This statement expresses a value judgment that cannot be proven right or wrong. The key word in this statement is “should.” Whenever a statement in economics has terms such as “should” and “ought”, it can be classified as normative.
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B. The Economy The economy refers to the system through which goods and services are produced, distributed, exchanged,andconsumedwithinasociety.Itencompassesalleconomicactivitiesandinteractionsthat occur, involving individuals, firms, markets, and governments.
An economy can be a representation of various scopes, ranging from a nation or region to a singular industry or even a household unit.
An economic system or structure refers to the way in which production is organized andchoicesare made in an economy. It identifies the means by which households, firms, and governments make decisionsrelatingtothethreeresourceallocationquestionsofwhattoproduce,howtoproduce,andfor whom to produce.
There are 3 main economic systems:
● Market Economy (also known as Laissez-Faire orFreeMarketEconomyandCapitalism): In thiseconomicsystem,resourcesareallocatedthroughthe pricemechanism whichisbasedon the forcesofdemandandsupply .Thismeansthathouseholdsandfirmsinteractasbuyersand sellers and make decisionsonhowtoallocateresourcestosatisfytheirwantsandneeds.The government has little to no control over the process of resource allocation. In addition, productive resources and assets are owned by individualsand private firms . For example, when excess supply exists because too much is being produced compared to demand,goodsstockpileinshopsandwarehouses.Inanattempttoencouragepeopletobuyand clearthestock,firmsreduceprices.Thismaycleartheexcesssupply;however,somefirmsmight choose to stop producing at lower prices. With less suppliers in the market, the price rises. Assumingnochangeindemandoccurs,firmsmaydecidetore-enterthemarketleadingtoafall in price and the whole process will continue. This shows that prices and the self-interest of individuals and firmsguidethedecisionsinamarketeconomywithouttheneedforgovernment intervention.
The United States is one of the closest examples of a market economy globally.
● CommandEconomy(alsoknownasaPlannedorCentrallyPlannedeconomy): Contrarytoa market economy, in a planned economy the government has a significant role in making decisions related to resource allocation. In principle, all choices made in terms of what to
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produce,howtoproduce,andforwhomtoproducearecontrolledbythestate.Inaddition,the statehasownershipofproductiveresourcesandproperty,meaningthatthemarkethasnoreal role in the allocation of resources.
North Korea and Cuba are as close to planned economies as the theory suggests.
Itisimportanttoavoidthecommonmisconceptionthattheclassificationofeconomiesisexactbecause bothmarketandplannedeconomiesintheirtrueformsonlyexistintheory.Instead,amixedeconomyis the typical economic system. ● Mixed Economy: In a mixed economic system, both the private sector (individuals and private firms) and the public sector (the government) have a role in allocating resources. Decisionsconsistofaninteractionbetweenindividuals,private firms,labor,andthegovernment.Thereisprivateownershipof assets as well as some public ownership. C. Factors of Production When defining economics, there is always a mention of the allocation of scarce resources to satisfy needs and unlimited wants; but what are these resources? Theresourcesavailableinaneconomyarereferredtoasthe factorsofproduction .Theyarethemeans by which an economy produces goods and services.
There are 4 main types of factors of production:
Land: Thisreferstoall naturalresources usedinproduction,suchasminerals, forests, water bodies,andagriculturalland,aswellasotherresourceslikeoil andnaturalgas.Land,asafactorofproduction,playsavitalroleinthecreation ofgoodsandservices.Itprovidesthe rawmaterials necessaryforproduction, serving as the foundation upon which economic activities are built. Natural resources derived from land are transformed into intermediate or finished goods through various production processes.
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From an economic viewpoint, "land" takes on a specialized definition beyond its literal meaning. In economics, "land" is not limited to physical terrain but encompasses all natural resources used in production . For example, water used in corn farms to grow crops is an example ofland,whereasan office building is not. Land rewards its owner with rent , which is thepaymentmadefortheuseoflandanditsassociated natural resources.
Labor: Labor represents the human effort and work that goesinto production.Itincludesboth physicalandmentalcontributions from workers.Laborencompassesnotonlythequantityofworkersbutalso their skills, education, intellectual contributions, and expertise.
Thecompensationindividualsreceivefortheirlaborisareflectionof thevaluetheycontributetotheproductionofgoodsandservices.The reward for labor is the wage or earnings paid for their services. Theefficiencyandproductivityoflabor arecriticalconsiderationsin economics.Howefficientlylaborisutilizedimpactstheoveralloutput and economic growth. Factors such as education, training, and technologicaladvancements caninfluencetheproductivityandqualityoflabor,enablingindividualsto produce more output with the same amount of effort. Labor also plays a role in determining wages and income distribution within an economy. The demand for different types of labor, influenced by factors like skill level and demand for specific jobs, affects wage levels. The supply of labor, influenced by factors such as population and participation rates, also contributes to wage dynamics. Capital: Capital refers to any physicalproductmadebyhumans tohelpwiththeproductionofother goodsandservicessuchasthetools,equipment,machinery,informationtechnology,andinfrastructure used in the production process. It helps generate income, increase the value of a business, and/or increase the efficiency and output of labor.
There are 2 different types of capital:
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Chapter 2: Measurement of Economic Performance Overview
This chapter introduces the world of national income accounting by providing the tools to analyze and understand a nation’s economic performance. It uses the circular flowmodelto illustrate how money and products move between different economic agents such as households, firms, governments, and foreign sectors.Thenthestageformeasuringthesizeof an economy using the gross domestic product (GDP).
This chapter also delves into understanding economic fluctuations through two crucial indicators: inflation and unemployment. Learning Objectives
By the end of this chapter, you should be able to:
● Understand how economic activity is measured through national income accounting. ● Understand how money and products move in an economy using the circular flow model. ● Define and calculate GDP using different approaches. ● Define, calculate, and analyze inflation and unemployment as indicators of economic performance. ● Distinguish nominal from real economic values. A. Introduction to Economic Performance
A fundamental question that often arises in economics pertains to the relationshipbetweena nation'seconomicactivity andthe well-beingof itsindividuals .Specifically,doestheoverallriseinacountry'seconomic activity,accompaniedbyan increasedcapacityforpeopletopurchase goods and services , translate into greater happiness among its citizens?Thisquerylooksintotheintricateinterplaybetweeneconomic indicators and the subjective experience of well-being. To addressthis question,economistsmustnavigatethechallengeofmeasuringboththe intangible concept of "happiness" and the quantifiable metrics of a nation's economic performance. In this exploration, we will delve into
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the complexities of this connection, considering how economic factors and individual satisfaction intertwine to shape our understanding of human prosperity. Macroeconomics, the study of an economy as a whole, studies the various aspects that collectively defineanation'seconomichealth. Economicperformancecanbemeasuredusingdifferentindicators suchasgrossdomesticproduct,theinflationrate,andtheunemploymentrate. ThestudyofGDPis part of national income accounting that measures a country’s total output to assess its economy’s performance. B. National Income Accounts Circular Flow Oneofthemethodsusedtoassessaneconomy’sperformanceismeasuringeconomicactivityinterms of the country’s output. This is referred to as nationalincome accounting . In macroeconomics, gross domestic product (GDP) is the most widely used measure of national income anditstandsasacornerstoneindicatorofeconomicperformance.Itrepresentsthe total value ofallfinishedgoodsandservicesproducedwithinacountry'sbordersoveraspecificperiodoftime . When defining GDP, always remember the following: “ G ross” means total “ D omestic” refers to the home economy “‘ P roduct” means output Forexample,Argentina’sGDPin2022measuresthetotalvalueofoutput(goodsandservices)produced by the factors of production (land, labor, capital, enterprise) based in Argentina in 2022. TobeabletomeasureGDP,wemustfirstunderstandhowgoods,services,andmoneymovearoundin an economy. The Simple Circular Flow Diagram A simple circular flow of incomes and expenditures diagram illustrates the flows of goods and services, money, and factors of production between only two economic agents: households and firms. Macroeconomicsconsidersthiscircularflowasafoundationalmodeltounderstandthebroader dynamics of economic transactions and the connections between various economic agents. Thesimplecircularflowdiagramreflectsthe interdependencebetweenhouseholdsandfirms inwhat isknownasa two-sectoreconomy .Householdssupplyfactorsofproduction(suchaslabor)tofirmsin returnforrewards(suchaswages).Firmsusethesefactorsofproductiontoproducegoodsandservices and sell them to households in return for revenue, creating a circular flow of income and expenditure.
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Chapter 3: National Income and Price Determination Overview
This chapter explores aggregate demand andaggregatesupplyascoremechanisms shaping economic fluctuations. Factors influencing them, such as consumer spending, business investment, government policies, and international influences, are examined.
The aggregate demand-aggregate supply (AD-AS) model providesakeyframework for analyzing these interactions. Shifts in the AD and AS curves reveal how changes in different determinants impact output and price levels. Further, the chapterdivesintothebusinesscycle,characterizedbyrecurringperiodsofexpansionand contraction. The multiplier effect, amplifying the impact of initial spending changes, is analyzed. The chapter distinguishes between inflationary gaps and recessionary gaps, introducing insights into potential policy responses. Finally, the concept of long-run self-adjustment,thetendencyofaneconomytoreturntoitspotential outputlevelafterashock,isexplored.Thisprovidesadeeperperspectiveonthelong-termdynamicsof
economic fluctuations. Learning Objectives
By the end of this chapter, you should be able to:
● Understand aggregate demand, short-run aggregate supply, long-run aggregate supply, and their determinants. ● Use the AD-AS model to analyze changes in the economy.
● Analyze the different stages of a business cycle. ● Identify inflationary and recessionary output gaps. ● Understand how the self-adjustment mechanism works.
Oneofthemostcommonlyusedmodelsineconomicsistheaggregatedemand-aggregatesupplymodel (AD-ASmodel).Thismodelrepresentstherelationshipbetweenthepricelevelandaggregateoutputin an economy and illustrates how output, employment, and the price level respond to macroeconomic changes and shocks. To understand this model, let’s start by breaking down its components.
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A. Aggregate Demand (AD) In economics, the term “aggregate” refers to total . While demand is a microeconomic concept, aggregate demand (AD) is a macroeconomic concept that describes the relationship between the general price level and the total spending or aggregate output demanded by households, firms, governments, and the foreign sector. Inotherwords,aggregatedemandisthe totaldemandforaneconomy’sgoodsandservicesatagiven price level in a given period of time . It is made up of four components: consumption, investment, governmentspending,andnetexports.Thisshouldsoundfamiliarsincethesearethesamecomponents usedtocalculaterealGDPusingtheexpenditureapproach!(RecallChapter2SectionB:Componentsof Gross Domestic Product and Approaches to Measure it ). Therefore, AD = C + I + G + (X − M) . Aggregate Demand Curve (AD Curve) The aggregate demand curve (AD curve) illustrates the different quantities of total demand for an economy’sproductsatdifferentpricelevels.Thepricelevelisplottedonthey-axisandtherealGDPis plottedonthex-axis.Notethat realGDP and realoutput canbeusedinterchangeablyasalabelonthe x-axis.
TheADcurveis downwardsloping indicatingan inverserelationship betweenthepricelevelandreal output.
Study Tip All demand and supply curves can be drawn as straight lines or curves.
The inverse relationship between the price level and real GDP can be attributed tothree main effects:
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Chapter 4: Financial Sector Overview This chapter delves into the core building blocks of the financial system, exploring various types and functionsof money,stocks,andbonds.Wedissecttheconceptoftime value of money, understanding how its present value differs from its future worth. Thechapterdistinguishesbetweencommercialandcentral banks, analyzing their roles and structures. It further examinesthefractionalreservesbankingsystem,revealing how banks create credit, impacting the money supply.
Financial markets like the money market and loanable funds market are introduced, highlighting their functions in facilitating the flow of funds between borrowers and lenders. Finally,thechapterexaminesmonetarypolicy,thetoolsusedbycentralbankstoinfluenceinterestrates and the money supply, aiming to achieve macroeconomic objectives like price stabilityandeconomic growth. Learning Objectives ● Differentiate between barter, stocks, bonds, and the different types and functions of money. ● Understand and calculate the time value of money. ● Distinguish commercial from central banks and understand how the fractional-reserves banking system works. ● Understand and analyze changes in the money market and the loanable funds market. ● Identify the meaning, tools, and limitations of monetary policy and understand the quantity theory of money. A. Definition of Financial Assets: Money, Stocks, and Bonds Howdidpeopleexchangegoodsandservicesbeforemoneyexisted?Whywereshellbeadsacceptedas ameansofpaymentsincertaincultures?Inthissection,wewillexaminewhatqualifiesanassettobe considered as “money” and define other types of financial assets. Barter vs. Money Before the money asweknowittodayexisted,people“bartered”goodsandservices. Barter refersto thedirectexchangeofgoodsandserviceswithoutusingmoneyasanintermediary . Forexample,a By the end of this chapter, you should be able to:
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farmermightexchange10orangesforfivepencils. Thissystemservedasanalternativetothemonetary economy we have today. However, it had limitations that ultimately ledtothecreationofmoney.The mainlimitationtobarteristheneedfora doublecoincidenceofwants :Inabartertrade,bothparties needtohavewhattheotherwants,andbothmustdesirewhattheotherhas.Incomplexsocietieswitha widevarietyofgoodsandservices,barterexchangesbecomealmostimpossibleduetothesubstantial effort required to find a perfect match. Consider the challenge of trading 3 red shirts and a coffee machineforachickenandaplant.Theoddsoffindingsomeonewhonotonlyhasachickenandaplant but also wants exactly 3 red shirts and a coffee machine are extremely low! Associetiesbecamemorecomplexandeconomiesgrew,peopleunderstoodtheneedforamediumof exchange that eliminates the problem of the double coincidence of wants. This medium of exchange evolved throughout history, from beads to crops, stones, animals, and even tobacco, until humans adopted today’s monetary system that relies on the use of various financial assets. Money is not only about coins and bills. It refers to any asset that can serve the three following functions :
1. Medium of Exchange: The primary function of money is its ability to be used to buy something else. For instance, one can use a $100 bill to buy a concert ticket. 2. Store of Value: Another function of money is transporting purchasingpowerfromonetimeperiodtoanother,allowing it to becomeamediumofexchangelater .Inotherwords,it shouldallowitsholderstosaveforlater. Forinstance,onemay decide to save the $100 in a safe tobuyaconcertticketnext year.
Peoplecanstoremoneyandaccumulatewealthinvariousforms,suchasgold,realestate,and otherassets.However,afinancialassethasanadvantageoverotherformsofmoneywhenitis more liquid . Liquidity refers to the ease with which an asset can be converted into cash without losing purchasing power . Cash and demand deposits are the most liquid form of money. Cash can be used immediately , and demand deposits , also referred to as bank deposits,referto moneykeptinabank, likecheckingaccounts.Banksareusuallyrequiredto provide access to this money immediately on demand ;therefore, they are highly liquid too. 3. Unit of account (also known as a measure of value): Money should enable comparisons between the value of different items that are expressed in money terms . For instance, a concert ticket that sells for $100 is said to be worth 10 times as much as a book that sells for $10. Types of Money The forms of money used throughout history varied across time periods and cultures; however, economists usually classify the types of money under three main categories:
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● Commoditymoney: Thisreferstoitemsusedas moneywhilealsohavinganintrinsicvaluein some other use . Gold is a form of commodity money and itwasusedforyearstodirectlybuy things, while also having other uses, such as making jewelry and dental fillings. Cigarettesare another form of commodity money used by prisoners of war who used topurchasegoodswith cigarettes, quote prices in terms ofcigarettes,andholdtheirwealthintheformofaccumulated cigarettes .However,theproblemwithcommoditymoneyisthat itsvaluecanchangewhenthe demand for it as an item falls . For example, if no one intheprisonsmoked,cigaretteswould have been useless. ● Fiatmoney: Bycontrast,fiatmoney,alsoknownas tokenmoney ,isintrinsicallyworthless.The money used in the U.S. today (i.e., cash money) is mostly fiat money, but what is the actual value of$1,$20,or$50bills?Zero.Howelsecanweusesmallgreenpiecesofpaper?Whydo people accept them? Because thegovernmentdeclaresitsmoneyas legaltender .Thatis,the governmentensuresthat thismoneyisacceptedbydeclaringitasanacceptablemediumof debt settlement . This is achieved through passing laws that define certain pieces of paper, printed using certain ink and certain plates, as legal tender. Itisimportanttounderstandthat fiatmoneyisnot backed by any commodity , such as gold or silver. That is another type of money referred to as commodity-backed money. Fiat money is the outcome of a measure taken by the government through the Fed (central bank). In addition, the supplyoffiatmoneyhastobecontrolledwiselyto avoid risking its value in what is known as currency debasement . For instance, excessive printing/supply of money to finance government expenditure makes money lose its value and leads to inflation (will be discussed later). ● Commodity-backedmoney: Thisis moneythathasnoinherentvaluebutcanbesecuredbya promise that it can be converted into something of value . For instance, the U.S. dollarwas backedbygolduntil1973.Anyformofcurrency,suchaspeanuts,thatcanbeexchangedforits equivalent value in a valuable commodity, such as silver, would be considered as commodity-backed money. Stocks and Bonds Financial assets other than cash and demand deposits, exist and earn a return. Under financial economics,whichthischapterisallabout,investmentreferstothepurchaseoffinancialassets,suchas stocks and bonds. A stock represents asliceofownershipinacompanyandpaysdividends (aportionofthecompany’s profits) to its owner. For instance, if individual A owns 10 sharesofacompanythathas1,000stocks, individualAowns1%ofthatcompany. Stocks,sometimesreferredtoasequity,areissuedbycompanies to exchangecashforownershipstakeinthecompany .Anotherwayforastockholdertomakeareturn
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Chapter 5: Inflation, Unemployment, and Stabilization Policies Overview
In intertwined phenomenaofinflationandunemploymentlie at the heart of economicpolicyandanalysis. These two economic indicators often appear to beatodds,andmanagingthemeffectively is a key challenge for policymakers worldwide.UnliketheNewClassicalviewthat perceives government intervention to close output gaps as not necessary, Keynesians believe that in this complex economic landscape,stabilizationpoliciesplayapivotal role in steering an economy towards sustainable growth and stability. In this exploration of inflation, unemployment, and stabilization policies, this chapter will delve macroeconomics, the
into the definitions, causes, consequences, and policy tools related to these critical macroeconomic factors. Understanding how these elements interact is essential for crafting demand-side and/or supply-side policies that promote economic well-beingand prosperity for societies around the globe. Learning Objectives
By the end of this chapter, you should be able to:
● Understand the tools and effects of fiscal, supply-side, and monetary policies, as well as the role of automatic stabilizers. ● Define the government budget and national debt and understand how government borrowing leads to crowding out. ● Analyze the reserve market model, the Laffer curve, and the Phillips curve model. ● Interpret the macroeconomic policy mix and illustrate economic changes on the PPC, AD-AS, and Phillips curve models. ● Understand different economic philosophies. A. Fiscal Policy Government policies, including fiscal policy, were listed as one of the indirect components affecting aggregatedemandAD(Chapter3SectionA).ThisimpliesthatfiscalpolicyaffectstheAD-ASmodeland can therefore be used as a stabilization policy to affect macroeconomic equilibrium. Governments implementfiscalpoliciestoachievemacroeconomicgoals suchasfullemploymentorpricestability
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by influencing macroeconomic aggregates that include aggregate demand, real output, and the price level. Since fiscalpolicyimpactsaggregatedemand ,itisconsidereda demand-sidepolicy . Itstools includegovernmentspendingandtaxes(ortransfers). Itisalsoreferredtoasa discretionarypolicy , meaning that it is one actively implemented by the government to affect AD. For example, the U.S. Federal Government needs the approval of the Congress to use fiscal policy tools to achieve macroeconomic objectives. Government Spending and Taxes Recall that government spending (or government expenditure) is an injection into the economy that directly affects AD (component of AD), whereas taxes areleakagesoutoftheeconomythatindirectly affect AD by influencing consumption (C), a component of AD.
The following table lists the various areas and items of government spending and taxes in the U.S.
Table 1: The Tools of Fiscal Policy in the U.S. Areas of Government Spending
Types of Tax
Education
Personal income tax which affects disposable income by reducing consumption. Corporate tax imposed on firms’ profits, reducing their investment spending. Sales tax imposed on goods or services and collected from their suppliers.
National defense
Healthcare coverage for those who are 65 years old and above
Social security such as retirement pensions
Property tax imposed on the value of privately-owned property.
Other transfer payments such as unemployment benefits
Social insurance tax collected from self-employed individuals and payrolls to support those who are 65 years old and above. This affects wages and the costs of production.
B. Demand-Side Effects of Fiscal Policy Outputgapsoccurwhentheeconomyisoperatingintheshort-runequilibriumeitherbeloworabovethe level of full employment (below or above LRAS).Intheshortrun,fiscalpolicycanbeimplementedto affect real GDP and the price level by influencing AD. Expansionary Fiscal Policy As observedinthebusinesscycle,arecessionisaneconomicdownturnassociatedwithadecreasein the price level, real output, and an increase in unemployment. This indicates that the economy is experiencingarecessionarygap,wheretheshort-runequilibrium(intersectionofAD-SRAS)isbelowthe fullemploymentoutput(LRAS).Toaddressthis,thegovernmentmayimplementan expansionaryfiscal
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