Macroeconomics Midterm Study Guide: Core Concepts and Applications

Chapter 1: Getting Started

Definition of Economics and Scarcity

• Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants.

• Scarcity means that resources (land, labor, capital, entrepreneurship) are limited, so choices must be made about their use.

Choices and Opportunity Cost

• Because of scarcity, every choice involves a trade-off.

• Opportunity cost is the value of the next best alternative forgone when a choice is made.

• Benefit refers to the gain or satisfaction received from a choice.

• Marginal cost is the additional cost of one more unit of an activity; marginal benefit is the additional benefit from one more unit.

Microeconomics vs. Macroeconomics

• Microeconomics studies individual markets and decision-makers (households, firms).

• Macroeconomics examines the economy as a whole (GDP, inflation, unemployment).

Positive vs. Normative Economics

• Positive economics describes and explains economic phenomena ("what is").

• Normative economics involves value judgments about what the economy should be like ("what ought to be").

Three Fundamental Economic Questions

• What goods and services will be produced? (Consumption, capital, government, export goods)

• How will they be produced? (Using land, labor, capital, entrepreneurship)

• For whom will they be produced? (Income forms and distribution)

Circular Flow Diagram

• Illustrates the flow of goods, services, and money between households and firms.

• Households provide factors of production; firms provide goods and services.

Chapter 2: The Economic Problem

Production Possibilities Frontier (PPF)

• The PPF shows the maximum combinations of two goods that can be produced with available resources and technology.

• Points on the PPF are efficient; points inside are inefficient; points outside are unattainable.

Opportunity Cost and the PPF

• Moving along the PPF involves shifting resources, which incurs an opportunity cost.

• Constant opportunity cost: PPF is a straight line.

• Increasing opportunity cost: PPF is bowed outward, reflecting that resources are not equally efficient in all uses.

Economic Growth

• Economic growth shifts the PPF outward, allowing more of both goods to be produced.

• Results from increases in resources or technological progress.

• Current vs. future production: Investing in capital goods today can lead to greater production possibilities in the future.

Absolute and Comparative Advantage

• Absolute advantage: Ability to produce more of a good with the same resources.

• Comparative advantage: Ability to produce a good at a lower opportunity cost.

• Trade is based on comparative, not absolute, advantage.

Calculating Opportunity Cost and Trade

• Opportunity cost of Good A = (Units of Good B given up) / (Units of Good A gained)

• Specialization and trade allow both parties to consume beyond their individual PPFs.

• Example: If Farmer can produce 10 food or 5 clothing, opportunity cost of 1 food = 0.5 clothing.

Chapter 3: Supply and Demand

Competitive Market and Law of Demand

• A competitive market has many buyers and sellers, none of whom can influence the price.

• Law of demand: As price falls, quantity demanded rises, ceteris paribus.

• Quantity demanded is the amount buyers are willing to purchase at a specific price; demand is the relationship between price and quantity demanded.

Shifts in Demand

• Income: Normal goods (demand increases with income); Inferior goods (demand decreases with income).

• Price of related goods: Substitutes (increase in price of one increases demand for the other); Complements (increase in price of one decreases demand for the other).

• Tastes/Preferences: Changes can increase or decrease demand.

• Expectations: Future price or income expectations affect current demand.

• Number of buyers: More buyers increase market demand.

Law of Supply and Shifts in Supply

• Law of supply: As price rises, quantity supplied rises, ceteris paribus.

• Quantity supplied is the amount sellers are willing to offer at a specific price; supply is the relationship between price and quantity supplied.

• Input prices: Higher input costs decrease supply.

• Productivity/Technology: Improvements increase supply.

• Substitutes/Complements in production: Changes in profitability of related goods affect supply.

• Expectations: Anticipated future prices can shift supply.

• Number of sellers: More sellers increase market supply.

Market Equilibrium

• Equilibrium occurs where quantity demanded equals quantity supplied.

• Equilibrium price is the price at which the market clears.

• Shifts in demand or supply change equilibrium price and quantity.

• Shortage: Quantity demanded exceeds quantity supplied (price below equilibrium).

• Surplus: Quantity supplied exceeds quantity demanded (price above equilibrium).

Price Controls

• Price ceiling: Legal maximum price (e.g., rent control); can cause shortages.

• Price floor: Legal minimum price (e.g., minimum wage); can cause surpluses.

Chapter 8: GDP

Definition and Measurement of GDP

• Gross Domestic Product (GDP) measures the total market value of all final goods and services produced within a country in a given period.

• GDP can be measured by total income, total expenditure, or total output.

• Included: Final goods/services, new production, within borders.

• Excluded: Intermediate goods, used goods, financial transactions, household production, illegal activities.

Components of GDP

• Consumption (C): Household spending on goods and services.

• Investment (I): Spending on capital goods, inventories, and new housing.

• Government Spending (G): Expenditures by government on goods and services.

• Net Exports (NX): Exports minus imports.

Nominal vs. Real GDP

• Nominal GDP: Value of output using current prices.

• Real GDP: Value of output using constant base-year prices; adjusts for inflation.

• Formulas:

• Nominal GDP: $\text{Nominal GDP} = \sum (P_t \times Q_t)$

• Real GDP: $\text{Real GDP} = \sum (P_{\text{base year}} \times Q_t)$

• Growth rate: $\text{Growth Rate} = \frac{\text{Real GDP}_{t} - \text{Real GDP}_{t-1}}{\text{Real GDP}_{t-1}} \times 100\%$

Business Cycles and GDP

• Business cycle: Fluctuations in economic activity over time.

• Recession: Period of declining GDP.

• Expansion: Period of rising GDP.

GDP and Well-being

• GDP does not account for all aspects of well-being (e.g., environment, leisure, income distribution, happiness).

• Some production is omitted (household, underground economy).

Chapter 9: Inflation and Unemployment

Inflation and the Consumer Price Index (CPI)

• Inflation: Sustained increase in the general price level.

• Consumer Price Index (CPI): Measures the average change in prices paid by consumers for a basket of goods and services.

• Construction of CPI (5 steps):

  1. Fix the basket.

  2. Find the prices.

  3. Compute the basket's cost.

  4. Choose a base year and compute the index.

  5. Compute the inflation rate.

• CPI formula: $\text{CPI} = \frac{\text{Cost of basket in current year}}{\text{Cost of basket in base year}} \times 100$

• Inflation rate formula: $\text{Inflation Rate} = \frac{\text{CPI}_{t} - \text{CPI}_{t-1}}{\text{CPI}_{t-1}} \times 100\%$

Problems with Measuring Cost of Living

• Substitution bias: Consumers substitute toward cheaper goods.

• Introduction of new goods: New products change consumption patterns.

• Unmeasured quality changes: Improvements or deteriorations in quality are hard to measure.

Indexation and Interest Rates

• Indexation: Automatic correction of a dollar amount for inflation by law or contract.

• Nominal interest rate: Stated interest rate, not adjusted for inflation.

• Real interest rate: Adjusted for inflation.

• Formula: $\text{Real Interest Rate} = \text{Nominal Interest Rate} - \text{Inflation Rate}$

• To compare values across time: $\text{Value in Year Y} = \text{Value in Year X} \times \frac{\text{CPI in Year Y}}{\text{CPI in Year X}}$

Unemployment

• Unemployment rate: Percentage of the labor force that is unemployed.

• Labor force: Employed + unemployed (actively seeking work).

• Labor force participation rate: Percentage of working-age population in the labor force.

• Types of unemployment:

  • Frictional: Short-term, due to job search or transitions.

  • Structural: Mismatch between skills and jobs.

  • Cyclical: Due to downturns in the business cycle.

• Natural rate of unemployment: Unemployment rate when the economy is at full employment (frictional + structural).

• Determinants: Job search, demographics, unemployment benefits, structural changes, minimum wage, unions, efficiency wages.

• Discouraged workers: Not counted as unemployed; have stopped looking for work.

Unemployment Rate Calculation

• Formula: $\text{Unemployment Rate} = \frac{\text{Number of Unemployed}}{\text{Labor Force}} \times 100\%$

• Labor Force Participation Rate: $\text{LFPR} = \frac{\text{Labor Force}}{\text{Working Age Population}} \times 100\%$

Issues with Unemployment Measurement

• Does not include discouraged workers or underemployed.

• May understate or overstate true unemployment.