Test Review II: Understanding Total Economic Activity
Economics Test Review Notes has all six free economics reviews. Updates 10/17/16
Please I. Measuring Total Economic Activity
II. The Business Cycle
III. Macro Equilibrium
IV. Competing Macro Theories and Issues
V. Keynesian Economics: An Expanded Review
VI. Money, Banking, and the Creation of Money
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Measuring Total Economic Activity Review
View Entire Chapter 8
B. Interpreting national income account data
1. Comparing data over time requires adjusting for inflation, population increases, and number of people working.
2. National income accounts do not consider leisure time.
3. Positive and negative effects of economic activity upon the environment are not measured by national income accounts.
C. Money vs. real GDP (taking inflation out of financial data)
1. A Price Index measures price changes for a basket of commonly used goods over a period of years.
a. One year is chosen as a base year, set equal to 100 and years before and after are expressed as a percent of the base year.
b. For convenience all index calculations are multiplied by 100 allowing the percent sign to be dropped.
c. Two important indexes are the Consumer Price Index (CPI) and the Producer Price Index (PPI) which respectively
measure the inflation associated with consumer and producer goods.
2. An index can be used to determine whether someone's salary, a consumer good, and other items of interest have changed
more or less than inflation.
a. Nominal salary is salary measured in current dollars.
b. Real salary is salary adjusted for inflation.
3. This example uses actual consumer price changes and 1982 as the base year (PB). The item of interest could be
someone's salary, the price of a new car, etc. (PC is price in current year).
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II. The Business Cycle Review
describe the business
activity over time.
View Entire Chapter 9
A. Recession: commonly accepted definition is two consecutive quarters of negative
growth in Real GDP.
B. Why business activity fluctuates
1. Inventory Recession: Excessive optimism causes inventories to over expand and
eventually they must be worked down causing a recession.
2. Rolling Recessions: Economic downturn is limited to areas or sectors of the economy.
3. Innovation Cycle: railroads, computers, bio-technology
4. Political Events: wars, international trade
5. Misuse of Monetary and Fiscal Policy: government creates and/or borrows an
incorrect amount of money
6. Non-cyclical Fluctuations
a. Seasonal variation: Christmas buying rush, spring construction
b. Long-Term Secular Trends: the expansion or contraction in the level of economic
activity over a long period of years (the dark ages, the industrial revolution)
7. Durable Goods have a long useful life (houses, equipment, etc.) Sale of durable goods
contract substantially during a recession as their purchase may be easily postponed.
C. Leading, coincidental, and lagging indicators are measures such as the unemployment
rate, which respectively change before, with or after general economic activity. Economists
use to predict future economic activity.
D. Unemployment Types and special topics
1. Frictional is caused by time lags in the operation of labor markets.
a. Workers are between employment because they have been fired, are changing
careers, are seasonal workers, have been temporarily laid off, etc.
b. Short-term, inevitable, temporary, and is eliminated with time.
2. Structural is caused by changes in consumer demand and technology.
a. Result is an oversupply of workers with a particular skill.
b. This unemployment is often concentrated in a particular area, associated with a
particular industry, and is often permanent.
c. Increased economic activity will not decrease this type of unemployment as training
and/or relocation are required.
d. Happened in the 1970's and early 1980's as consumers decided to buy small foreign
built cars and other products produced in the Rust Belt. Now it is happening because
NAFTA and foreign competition are causing industries
to restructuring is needed because of foreign competition.
a. Caused by a lack of total demand at the end of an economic expansion
c. Recession of the early 1990's was due to a drop in demand caused by a debt
buildup in the 1980's by individuals, businesses, and the federal government.
Apprehension caused by high structural unemployment of both blue and white collar
workers slowed the recovery.
d. Recession of 2001 was caused by debt build up of individuals resulting from the
long period of prosperity and the stock market bubble, excess capital investment
caused by Y2K and internet optimism, and September 11.
e. Great Recession of 2008-09 was caused by the end of an excessive building
boom compounded by a banking and stock market crisis.
4. Special topics
a. Natural unemployment (frictional + structural unemployment) is usually 4% to 6%
of the labor force
b. Full employment is when cyclical unemployment equals zero
c Okun's Law: a 1% increase in cyclical unemployment will cause a 1% increase in
cyclical unemployment will cause given a 2.5% annual drop in GNP
1) GNP change = 2.5 (unemployment rate change)
2) If unemployment goes up 2% as it did in the 1990-91 recession then the drop in
GNP would be 2.5 X 2% or 5%.
3). Cost to a 6 trillion dollar economy of 250 million people
(5% X $6,000,000,000,000) / 250,000,000 = $1,200/person/year.
E. Inflation is an increase in prices
as measured by a price index such as the
4. Causes of inflation
the demand and supply variables affecting total economic
activity are in balance and under no pressure to change. View Entire Chapter 10
A. Macro equilibrium exists even though the more slowly changing variables affecting long-term activity are still
in flux. Said long-term activity is called a long-term secular trend.
B. Aggregate demand, AD, is a schedule matching the Real Gross Domestic Product a country purchases at
various price levels.
1. As prices drop, the amount of real gross domestic product purchased (AD) increases. AD = C + I + G + XN
2. Like all demand curves, AD increases to the right and decreases to the left
3. Price level is the key determinate of aggregate demand. Holding non-price level determinants constant
yields the following analysis of why price levels and aggregate demand are inversely related.
a. Interest rate effect
1. If the price (inflation) is low, interest rates will be low causing consumption and investment to be high
2. This is especially true now that home mortgages are easily refinanced at lower interest rates.
b. Real asset balance effect as low inflationary expectations cause people think their past accumulations
(savings) will maintain their value. causing people to spend more which increases AD.
c. Low domestic inflation relative to foreign inflation results in low-priced exports selling better which
d. High price levels will bring opposite results
4. Non-price level determinants of aggregate demand and their determining characteristics
a. Consumption (C). Increased expectation of wealth caused by more overtime, debt decreasing by
refinancing a home at lower interest and taxes going down all increase consumption.
b. Investment (I) Increased profit expectations, decreased business taxes, low excess capacity, and
positive technology outlook all increase investment. .
c. Government Spending (G)
d. Net Exports (XN) (exports minus imports) are determined by economic activity abroad and exchange rates
5. Price level and non-price level factors together determine aggregate demand which interacts with aggregate
supply to determine total economic activity.
C. Aggregate Supply is a schedule of the amounts of Real Gross Domestic Product companies are willing to
produce at various price levels.
1. Holding non-price determinants constant yields the following analysis of how different price levels affect AS.
2. Keynesian Range: increases in AD increase real GDP and prices do not change
3. Intermediate Range: both prices and real GDP change
4. Classical Range: increases in AD increases prices and real GDP does not change because full
5. Non-price factors affecting aggregate supply factor price decrease, productivity increases and
increased domestic and foreign tranquility all will increase AS
Note: This section belongs at the end of the next section but I can't make
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described three key
problems causing slow economic growth.
2. Lowering the tax rate from X to X' would increase
a. Lower tax rate would lessen avoidance of taxes.
b. Fewer transfer payments due to tougher welfare
would result in more people working and paying taxes.
c. Overall effect of the program would be higher
productivity. This would increase AS causing GDP
and tax revenue to increase.
IV. Competing Macro Theories and Issues
View Entire Chapter 11
A. Classical economics
1. Dominated philosophically during the late 18th, 19th and early 20th centuries.
2. First defined by Adam Smith its primary beliefs were full employment was a norm of capitalism and
Laissez-faire (hands-off) government policy was best.
3. Say's Law
a. Supply created enough factor income to clear the market so inventories will not accumulate and
a slow down to use excess inventory, which causes unemployment, was not necessary.
b. Savings is not a leakage because interest rates adjust to insure saving is borrowed and invested (spent).
1) Leakage describes the loss of a variable required to maintain a state of equilibrium (stable level
of economic activity).
2) Interest rates drop when savings increase to insure savings is invested and there isn't leakage.
2. Price-Wage flexibility
a. During periods of slow economic activity wage rates would fall and everyone wanting to work could find work.
b. All factor prices, not just wages, would adjust downward and all factors would be fully employed.
"Real" factor prices would therefore remain constant.
B. Keynesian economics
1. Macro equilibrium could settle at an unacceptable level of unemployed resources and government intervention
was needed to fully employ resources.
2. To some, The Great Depression discredited classical economics.
3. John Maynard Keynes wrote The General Theory of Employment, Interest, and Money (1936).
a. Disagreed with Say's Law: savings may not be invested.
1. Interest rates are not the sole determinate of savings and investing.
2. Saving and investment are done by different people with different motives, may not be equal causing
goods to go unsold and inventories to increase.
3. Saving is based upon "liquidity preference," the need to hold money
a) Transactionary Motives: for every day use.
b) Speculative Motives: save because prices may drop (Japan in late 1990's).
c) Precautionary Motives: save due to uncertainty (when a recession is expected).
4. Investment decisions are based upon profit expectations and interest rates
5. Money balances (savings) are also important in determining aggregate demand.
b. Disagreed with price-wage flexibility: prices would adjust downward insuring all resources are fully employed.
1. Resource prices are inflexible downward meaning resource prices may not adjust and unemployment may persist.
2. Wages are sticky downward because of unions, monopoly power of corporations, and government policies.
c. As a result, government involvement may be required to keep AD high enough to maintain full employment.
4. Manipulating equilibrium
a. Classical economists didn't see a need as Real GDP was fixed..
b. Keynesian economists want to manipulate AD by changing C + I + G + XN to maintain noninflationary full employment.
The quantity theory of money
1. Represents the basic theory behind macroeconomics prior to the Keynesian Revolution
2. Believed that changes in the money supply would only affect price and not economic activity.
3. The equation of exchange
MV = PT
Money Supply X Velocity of Money = Average Price Level X Number of Transactions
a. Velocity of money is how often the money supply is spent.
b. Number of transactions is real economic activity
c. The equation is an identity
1. Dollars spent = dollars received
2. MV = Aggregate Demand and PT = Nominal GDP = C + I + G + XN = GDP
d. Classical theory stated that V was basically stable and that there existed some natural level of
growth for T.
1. This natural level was a function of individual and business interaction.
2. V and T were essentially unalterable which meant changes in M would change P and not the natural
level of T.
3. Government should therefore refrain from interfering with market activity by adjusting the money
4. Came into disfavor in the 1930's with the popularity of Keynesian economics which stated that real
output could be
changed by affecting aggregate demand.
1. Monetarists believe that changes in the money supply are both a
necessary and sufficient condition to cause inflation.
2. If AD was low, increasing the money supply would only increase
short-run economic activity.
a Eventually short-term expansion stops and increasing M only
adds to inflation.
b. Public anticipation stops the process from being repeated.
c. Monetarists believe that government involvement in the economy,
especially monetary intervention, increases the magnitude of the
3. Keynes believed changing the money supply would affect interest
rates affecting investment affecting Real GDP
4. To some degree monetarism is an extension of classical economics.
Advocates believe that a competitive market, free of government inter-
ference, causing economic stability and a reasonable growth rate
E. New Classical economics states market forces and not government.
manipulation of aggregate demand and the money supply control
Keynesian Economics: An Expanded Review C+ I + G + EN
View Entire Chapter 12
Part 1 of chapter 12
A. Consumption and Saving
1. Average Propensity to Consume (APC) is consumption (C)
divided by income (Y).
a. APC = C/Y
b. APC decreases as income increases as people can afford
2. Marginal Propensity to Consume (MPC) is the change in
consumption divided by the change in income.
a. MPC decreases as income increases.
b. This makes sense because when an average is falling, what is
happening on the margin must be less.
1) Suppose your test average after one test is 90 and after
2 tests its 80.
2) Your second test had to be below 80 to pull the average
down. Test 2 was a 70 and (90 + 70) / 2 = 80.
Note: Points on a 45-degree line equate values on the x and y axes
(S) is income minus consumption. S = Y - C
B. Investment is business spending on capital
goods, inventory, and research &
1. The level of investment is a function of
expected profit, interest rates, and the level
of technology required to maintain a desired
2. Investment spending tends to be somewhat
C. Government Spending is assumed to be
D. Net Exports, exports minus imports, are also
assumed to be constant for this simplified
Part 2 of Chapter 14
Aggregate Demand and Equilibrium
A. Equilibrium (E) is where planned and actual AD and AS are equal.
1. Equilibrium is where all goods produced for sale are sold.
2. At points below equilibrium, AD < AS, inventories are
building and business activity is contracting. This level of
economic activity was depicted by the horizontal (Keynesian)
range of AS explained in the previous model.
3. At points above equilibrium AD > AS, inventories are
decreasing and business activity is expanding as depicted
by the intermediate range and eventually the classical range
4. Economic activity (Real GDP) will be wherever AD
intersects AS. Equilibrium seldom exists as economic
activity is usually in one stage or another of the business
B. If economic activity is not in balance, a dynamic situation
exists and will continue until equilibrium is reached.
C. Keynes believed that E could settle at a level of
economic activity with large amounts of unemployment.
1. If potential Real GDP is greater than what actual AD
yields, a recessionary gap exists and may persist
indefinitely. The solution is to increase AD.
2. If potential Real GDP is less than what actual AD
yields, an inflationary gap exists and the inflation
may persist indefinitely. The solution to this
unacceptable level of economic activity is to
Multiplier Affect (K) is important to
determining the change in AD needed to
reach equilibrium E.
1. Changes in AD will result in larger changes in
NNP as increases are not spent and respent.
2. Decreases in AD have a similar but opposite
3. K = 1/MPS = 1?(1-MPC) Note: As MPS
increases, K decreases.
4. A MPS is 20%, Multiplier is 5 as 1/20% =
1/(1/5) = 1X 5 = 5
VI. Money, Banking, and the
Creation of Money
View Entire Chapter 13
A. Functions of money
1. Medium of exchange: facilitate exchange eliminating barter
2. Standard of value: allows for the pricing of heterogeneous goods.
3. Store of value: maintains value and provides liquidity so extra spending power
is available as needed.
4. Standard of deferred payment: makes credit contracts possible so credit
transactions are possible.
B. The supply and demand for money
1. Three categories of the supply of money
a. M1 = Currency, coins, and demand deposits (checking accounts).
b M2 = M1 plus near monies such as small time deposits (savings accounts) and
short-term government securities.
c. M3 = M2 plus large time deposits (over $100,000)
2. What backs the dollar?
a. It is a debt of the federal government.
b. Backed by faith in the government's ability to control inflation.
c. Value is determined by acceptability (it is legal tender and scarce).
d. It's fiat (by decree of the government) money.
e. Coins have little intrinsic value (a small % of face value), it's called token money.
f. Commodity money such as tobacco used as money in the Virginia colony has
intrinsic value of its own.
The Demand for Money
1. Transaction D, Dt, results because people hold money,
often in a money market account,
to use as a medium of exchange.
2. Asset Demand, Da, results because people accumulate money,
often held in an investment account, to buy assets.
3. The demand for money Dm= D t + Da
4. Interest rates are set in the money market.
Maintaining money's value requires
2. A sound monetary policy (not using inflation to pay the federal debt)
E. United States private banking system
1. Two kinds of banks
a. Commercial banks offer demand deposits (checking accounts)
b. Savings and loan associations used to specialize in time deposits
(saving accounts) and home mortgages. Now, because of dereg-
ulation during the early 1980's, they are similar to commercial banks.
2. Federal deregulation contributed to banking difficulties in the 1980's.
F. The Federal Reserve
A Board of Governors oversee the Federal Reserve System
1. Seven governors
2. Governors are appointed by the President and confirmed by the Senate.
3. The chair is appointed by the President for a four-year term.
a) To foster independence, the term does not coincide with the President's term.
b) Other board members are appointed to 14-year terms on a staggered basis
to insure an experienced board.
B. Federal Open Market Committee
1. Membership consists of the Board of Governors and 5 of the 12 Federal Reserve
bank presidents with the N.Y. president always a member because N.Y. City is the
financial center for U.S. international trade.
2. The Committee tries to affect interest rates by affecting the supply of money by
buying and selling U.S. government bonds (See Chapter 15).
C. Federal Advisory Council 12 prominent commercial bankers, one from each district,
who advise the Board of Governors
D. Twelve Federal Reserve Banks
a. The United States is divided into 12 homogenous districts and each has its own bank