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Midterm Review
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Macroeconomic Concerns
Three of the major concerns of macroeconomics are
Output or output growth
Unemployment
Overall price level or its increase/decrease (i.e.
Inflation/deflation)
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Output Growth
business cycle The cycle of short-term ups and downs in the
economy.
aggregate output The total quantity of goods and services produced
in an economy in a given period.
recession A period during which aggregate output declines.
Conventionally, a period in which aggregate output declines for two
consecutive quarters.
depression A prolonged and deep recession.
expansion or boom The period in the business cycle from a trough up
to a peak during which output and employment grow.
contraction, recession, or slump The period in the business cycle
from a peak down to a trough during which output and employment fall.
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Typical Business Cycle
Expansion/boom The economy expands as it moves from a trough to a
peak.
Recession/slump The economy moves from a peak down to a trough.
Depression Large and long recession
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Unemployment
unemployment rate The percentage of the labor force that is
unemployed.
Inflation and Deflation and Stagflation
inflation An increase in the overall price level.
hyperinflation A period of very rapid increases in the overall
price level.
deflation A decrease in the overall price level.
stagflation A situation of both high inflation and high
unemployment.
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The Components of the Macroeconomy
The participants in the economy can be divided into four broad groups:
(1) Households.
(2)Firms.
(3)The government.
(4)The rest of the world.
Households and firms make up the private sector, the government is
the public sector, and the rest of the world is the foreign/external
sector.
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The Circular Flow Diagram
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The Role of the Government in the
Macroeconomy
fiscal policy Government policies concerning taxes and
spending.
monetary policy The tools used by the Federal Reserve to
control the short-term interest rate.
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Gross Domestic Product
gross domestic product (GDP) The total market value of all
final goods and services produced within a given period by
factors of production located within a country.
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Final Goods and Services
final goods and services Goods and services produced for
final use.
Example: eggs you buy, cook and then eat at home
intermediate goods Goods that are produced by one firm for
use in further processing by another firm.
Example: eggs S&P buys, bakes and it sells the cakes
made of eggs
value added The difference between the value of goods as they
leave a stage of production and the cost of the goods as they
entered that stage.
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Exclusion of
Used Goods and Paper Transactions
GDP is concerned only with new, or current, production.
• Old output is not counted in current GDP because it was
already counted when it was produced.
GDP does not count transactions in which money or goods
changes hands but in which no new goods and services are
produced.
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Exclusion of Output Produced Abroad by
Domestically Owned Production Factors
GDP is the value of output produced by factors of production
located within a country.
gross national product (GNP) The total market value of all final
goods and services produced within a given period by factors of
production owned by a country’s citizens (or a country’s factors
of production), regardless of where the output is produced.
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Calculating GDP
expenditure approach A method of computing GDP that
measures the total amount spent on all final goods and services
during a given period.
income approach A method of computing GDP that measures
the income—wages, rents, interest, and profits—received by all
factors of production in producing final goods and services.
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The Expenditure Approach
Four main categories of expenditure:
Personal consumption expenditures (C): household spending
on consumer goods
Gross private domestic investment (I): spending by firms and
households on new capital, that is, plant, equipment,
inventory, and new residential structures
Government consumption and gross investment (G)
Net exports (EX − IM): net spending by the rest of the world,
or exports (EX) minus imports (IM)
GDP = C + I + G + (EX − IM)
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Personal Consumption Expenditures (C)
personal consumption expenditures (C) Expenditures by
consumers on goods and services.
• durable goods Goods that last a relatively long time, such
as cars and household appliances.
• nondurable goods Goods that are used up fairly quickly,
such as food and clothing.
• services The things we buy that do not involve the
production of physical things, such as legal and medical
services and education.
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Gross Private Domestic Investment (I)
gross private domestic investment (I) Total investment in
capital—that is, the purchase of new housing, plants, equipment,
and inventory by the private (or nongovernment) sector.
• nonresidential investment Expenditures by firms for
machines, tools, plants, and so on.
• residential investment Expenditures by households and
firms on new houses and apartment buildings.
• change in business inventories The amount by which
firms’ inventories change during a period. Inventories are the
goods that firms produce now but intend to sell later.
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The Income Approach
national income The total income earned by the factors of
production owned by a country’s citizens.
• compensation of employees Includes wages, salaries, and
various supplements
• rental income The income received by property owners in
the form of rent.
• net interest The interest paid by business.
• proprietors’ income The income of unincorporated
businesses.
• corporate profits The income of corporations.
• surplus of government enterprises Income of government
enterprises.
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• indirect taxes minus subsidies Taxes such as sales taxes,
customs duties, and license fees less subsidies that the
government pays for which it receives no goods or services in
return.
• net business transfer payments Net transfer payments by
businesses to others.
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National Income versus Personal Income
personal income The total income of households.
disposable (personal) income Personal income minus
personal income taxes.
• The amount that households have to spend or save.
personal saving The amount of disposable income that is left
after total personal spending in a given period.
personal saving rate The percentage of disposable income
that is saved.
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Nominal GDP versus Real GDP
nominal GDP Gross domestic product measured in current
dollars/prices.
• Current dollars/prices The current prices that we pay for
goods and services.
real GDP Gross domestic product measured in base-year
dollars/prices.
• Base-year dollars/prices The prices that take place in the
(selected) base year.
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Calculating the GDP Deflator
Policy makers not only need good measures of how real output
is changing but also good measures of how the overall price
level is changing.
The GDP deflator is one measure of the overall price level.
NGDP
GDP deflator =
´100
RGDP
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Unemployment
Measuring Unemployment
employed Any person 16 years old or older (1) who works for pay, either for
someone else or in his or her own business for 1 or more hours per week, (2)
who works without pay for 15 or more hours per week in a family enterprise, or
(3) who has a job but has been temporarily absent with or without pay (such as
maternity leave).
unemployed A person 16 years old or older who is not working, is available for
work, and has made specific efforts to find work during the previous 4 weeks.
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not in the labor force A person who is not looking for work because he or
she does not want a job or has given up looking.
labor force The number of people employed plus the number of unemployed.
labor force = employed + unemployed
adult population = labor force + not in labor force
population = adult population + population below 16 years old
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unemployment rate The ratio of the number of people unemployed to the total
number of people in the labor force.
unemployment rate =
unemployed
employed + unemployed
labor force participation rate The ratio of the labor force to the total
population 16 years old or older.
labor force participation rate =
labor force
adult population
discouraged-worker effect The decline in the measured unemployment rate
that results when people who want to work but cannot find jobs grow
discouraged and stop looking, thus dropping out of the ranks of the
unemployed and the labor force.
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Frictional, Structural, and Cyclical Unemployment
frictional unemployment The portion of unemployment that is due to the
normal turnover in the labor market; used to denote short-run job/skill-matching
problems.
structural unemployment The portion of unemployment that is due to
changes in the structure of the economy that result in a significant loss of jobs
in certain industries.
natural rate of unemployment The unemployment rate that occurs as a
normal part of the functioning of the economy. Sometimes taken as the sum of
the frictional unemployment rate and the structural unemployment rate.
cyclical unemployment Unemployment that is above frictional plus structural
unemployment.
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The Consumer Price Index
A price index computed using a bundle that is meant to represent the “market
basket” purchased monthly by the typical urban consumer.
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The Costs of Inflation
Inflation May Change the Distribution of Income
One way of thinking about the effects of inflation on the distribution of income is
to distinguish between anticipated and unanticipated inflation.
The effects of anticipated inflation on the distribution of income are likely to be
fairly small, since people and institutions will adjust to the anticipated inflation.
Unanticipated inflation, on the other hand, may have large effects, depending,
among other things, on how much indexing to inflation there is.
real interest rate The difference between the interest rate on a loan and the
inflation rate.
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The Keynesian Theory of Consumption
consumption function The relationship between consumption and income.
We can use the following equation to describe the curve:
C = a + bY
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marginal propensity to consume (MPC) That fraction of a change in income
that is consumed, or spent.
b = marginal propensity to consume º slope of consumption function º
DC
DY
The triple equal sign means that this equation is an identity, or something that
is always true by definition.
a = autonamous consumption º consumption when income is 0
aggregate saving (S) The part of aggregate income that is not consumed.
S≡Y–C
marginal propensity to save (MPS) That fraction of a change in income that
is saved.
MPC + MPS ≡ 1
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Planned Investment (I) versus Actual Investment
A firm’s inventory is the stock of goods that it has awaiting sale.
planned investment (I) Those additions to capital stock and inventory
that are planned by firms.
actual investment The actual amount of investment that takes place; it
includes items such as unplanned changes in inventories.
If a firm overestimates how much it will sell in a period, it will end up with more
in inventory than it planned to have.
We will use I to refer to planned investment, not necessarily actual investment.
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The Determination of Equilibrium Output (Income)
equilibrium Occurs when there is no tendency for change. In the
macroeconomic goods market, equilibrium occurs when planned aggregate
expenditure is equal to aggregate output.
planned aggregate expenditure (AE) The total amount the economy plans to
spend in a given period. Equal to consumption plus planned investment:
AE ≡ C + I.
Because AE is, by definition, C + I, equilibrium can also be written:
Equilibrium: Y = C + I
Y>C+I
aggregate output > planned aggregate expenditure
C+I>Y
planned aggregate expenditure > aggregate output
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Let us find the equilibrium level of output (income) algebraically.
There is only one value of Y for which this statement is true, and we can find it
by rearranging terms:
The equilibrium level of output is 500, as shown in Table 8.1 and Figure 8.6.
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The Saving/Investment Approach to Equilibrium
Because aggregate income must be saved or spent, by definition, Y ≡ C + S,
which is an identity. The equilibrium condition is Y = C + I, but this is not an
identity because it does not hold when we are out of equilibrium. By substituting
C + S for Y in the equilibrium condition, we can write:
C+S=C+I
Because we can subtract C from both sides of this equation, we are left with:
S=I
Thus, only when planned investment equals saving will there be equilibrium.
 FIGURE 8.7 The S = I
Approach to Equilibrium
Aggregate output is equal
to planned aggregate
expenditure only when
saving equals planned
investment (S = I).
Saving and planned
investment are equal at Y =
500.
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Adjustment to Equilibrium
The adjustment process will continue as long as output (income) is not equal to
planned aggregate expenditure.
If an economy with planned spending greater than output (where unplanned
inventory reductions occur) will adjust to equilibrium by increasing output, with
Y going higher than before.
If planned spending is less than output, there will be unplanned increases in
inventories. In this case, firms will respond by reducing output. As output falls,
income falls, consumption falls, and so on, until equilibrium is restored, with Y
lower than before.
As Figure 8.6 shows, at any level of output above Y = 500, such as Y = 800,
output will fall until it reaches equilibrium at Y = 500, and at any level of output
below Y = 500, such as Y = 200, output will rise until it reaches equilibrium at Y
= 500.
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The Investment Multiplier
Investment multiplier The ratio of the change in the equilibrium level of
output to a change in investment.
1
multiplier 
MPS
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, or
1
multiplier 
1  MPC
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Government in the Economy
discretionary fiscal policy Changes in taxes or spending that are the result
of deliberate changes in government policy.
(1) Government Purchases (G),
(2) Net Taxes (T), and therefore Disposable Income (Yd)
net taxes (T) Taxes paid by firms and households to the government minus
transfer payments made to households by the government.
disposable, or after-tax, income (Yd) Total income minus net taxes: Y − T.
disposable income ≡ total income − net taxes
Yd ≡ Y − T
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budget balance The difference between what a government collects in taxes
and what it spends in a given period: T − G.
budget balance ≡ T − G
budget surplus if T − G > 0
budget deficit if T − G < 0
balanced budget if T − G = 0
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Adding Taxes to the Consumption Function
To modify our aggregate consumption function to incorporate disposable
income instead of before-tax income, instead of C = a + bY, we write
C = a + bYd
or
C = a + b(Y − T)
Our consumption function now has consumption depending on disposable
income instead of before-tax income.
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The Determination of Equilibrium Output (Income)
Y=C+I+G
TABLE 9.1 Finding Equilibrium for I = 100, G = 100, and T = 100
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Planned
Planned
Unplanned
Output
Net Disposable Consumption Saving Investment Government Aggregate
Inventory Adjustment
(Income) Taxes
Income
Spending
S
Spending Purchases Expenditure
Change
to DisequiY
T
Yd ≡Y −T C = 100 + .75 Yd Yd – C
I
G
C + I + G Y − (C + I + G)
librium
300
100
200
250
− 50
100
100
450
− 150
Output ↑
500
100
400
400
0
100
100
600
− 100
Output ↑
700
100
600
550
50
100
100
750
− 50
Output ↑
900
100
800
700
100
100
100
900
0
Equilibrium
1,100
100
1,000
850
150
100
100
1,050
+ 50
Output ↓
1,300
100
1,200
1,000
200
100
100
1,200
+ 100
Output ↓
1,500
100
1,400
1,150
250
100
100
1,350
+ 150
Output ↓
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The Saving/Investment Approach to Equilibrium
saving/investment approach to equilibrium:
S+T=I+G
To derive this, we know that in equilibrium, aggregate output (income) (Y)
equals planned aggregate expenditure (AE).
By definition, AE equals C + I + G, and by definition, Y equals C + S + T.
Therefore, at equilibrium:
C+S+T=C+I+G
Subtracting C from both sides leaves:
S+T=I+G
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Fiscal Policy at Work: Multiplier Effects
At this point, we are assuming that the government controls G and T. In this
section, we will review three multipliers:
Government spending multiplier
Tax multiplier
Balanced-budget multiplier
The Government Spending Multiplier
government spending multiplier 
1
1

MPS 1  MPC
government spending multiplier The ratio of the change in the equilibrium
level of output to a change in government spending.
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The Tax Multiplier
tax multiplier The ratio of change in the equilibrium level of output to a
change in taxes.
 1 
 Y  (initial increase in aggregate expenditure)  

 MPS 
Because the initial change in aggregate expenditure caused by a tax change of
∆T is (−∆T × MPC), we can solve for the tax multiplier by substitution:
1 
MPC 


Y  (  T  MPC )  
  T  

 MPS 
 MPS 
Because a tax cut will cause an increase in consumption expenditures and
output and a tax increase will cause a reduction in consumption expenditures
and output, the tax multiplier is a negative multiplier:
tax multiplier  
 
MPC
MPS
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