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Circular flow

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A model that shows how households and firms circulate resources, good, and incomes through the economy. This basic model is expanded to include the government and the foreign sector.

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Closed economy

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A model that assumes there is no foreign sector (imports and exports)

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Aggregation

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The process of summing the microeconomic activity of households and firms into a more macroeconomic measure of economic activity

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GDP

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The market value of the final goods and services produced within a nation in a given period of time.

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Final goods

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Goods that are ready for their final use by consumers and firms, e.g., a Ferrari

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Intermediate Goods

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Goods that require further modification before they are ready for final use, e.g., steel used to make the Ferrari

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Double counting

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The mistake of including the value of intermediate stages of production in GDP on top of the value of the final good

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Second-hand sales

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Final goods and services that are resold; final goods can only be counted once so second-hand sales are not counted as part of GDP

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Nonmarket transactions

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Household work or do-it-yourself jobs are missed by GDP accounting

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Aggregate Spending (GDP)

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The sum of all spending from four sectors of the economy; GDP = C + I + G + (X-M)

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Nominal GDP

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The value of current production at the current prices. Valuing 2003 production with 2003 prices creates nominal GDP for 2003

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Aggregate Income (AI)

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The sum of all income earned by suppliers of resources in the economy. With some accounting adjustments, aggregate spending equals aggregate income

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Real GDP

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The vale of current production, but using prices from a fixed point in time. Valuing 2003 production at 2002 prices creates real GDP in 2003 and allows us to compare it back to 2002

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Base year

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The year that serves as a reference point for constructing a price index and comparing real values over time

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Price Index

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A measure of the average level of prices in a market basket for a given year when compared to the prices in a reference year. You can interpret the price index as the current price level as a percentage of the level in the base year.

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Market Basket

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A collection of goods and services used to represent what is consumed in the economy

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GDP Price Deflator

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The price index that measures the average price level of the goods and services that make up GDP

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Real rate of interest

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The percentage increase in purchasing power that a borrower pays a lender

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Expected Inflation

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The inflation expected in a future time period. This expected inflation is added to the real interest rate to compensate for lost purchasing power

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Nominal rate of interest

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The percentage increase in money that the borrower pays the lender and is equal to the real rate plus the expected inflation

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Consumer Price Index (CPI)

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The price index that measures the average price level of items in the base year market basket. This is the main measure of consumer inflation.

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Inflation

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The percentage change in the CPI from one period to the next

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Nominal Income

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Today's income measured in today's dollars. These are dollars unadjusted by inflation

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Real income

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Today's income measured in base year dollars. These inflation-adjusted dollars can be compared from year to year to determine whether purchasing power has increased or decreased.

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Employed

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A person is employed if she has worked for pay at least one hour per week

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Frictional Unemployment

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A type of unemployment that occurs when someone new enters the labor market or switches jobs. This is a relatively harmless form of unemployment and is not expected to last long.

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Seasonal Unemployment

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Unemployment caused by seasonal changes in the demand for certain kinds of labor

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Structural Unemployment

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Unemployment of workers whose skills are not demanded by employers, who lack sufficient skill to obtain employment, or who cannot easily move to locations where jobs are available

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Cyclical Unemployment

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Unemployment caused by a contraction in aggregate demand or total spending in the economy. It rises and falls with the business cycle

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Disposable Income (DI)

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The income a consumer has left over or save once they have paid their taxes. DI = Y - T

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Consumption Function

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The relationship between consumption spending and disposable income.

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Autonomous Consumption

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The part of consumption that is independent of the level of disposable income; changes in autonomous consumption shift the consumption function up/down. It is the y intercept of the consumption graph

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Saving function

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A linear relationship showing how increases in disposable income cause increases in saving

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Dissaving

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Saving < 0, occurring at low levels of DI

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Autonomous Saving

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The amount of saving that occurs no matter the level of DI

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Marginal Propensity to Consume (MPC)

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The change in consumption caused by a change in DI, or the slope of the consumption function. MPC = dC / dDI

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Marginal Propensity to Save (MPS)

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The change in saving caused by a change in DI, or the slope of the consumption function. MPS = dS / dDI

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Determinants of Consumption and Saving

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Factors that shift the consumption and saving functions in the opposite direction are wealth, expectations, and household debt. The factors that change them in the same direction are taxes and transfers

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Expected real rate of return (r)

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The rate of real profit the firm anticipates receiving on investment expenditures. This is the marginal benefit of an investment project.

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Real rate of interest (i)

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The cost of borrowing to fund an investment. This is the marginal cost of an investment project.

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Decision to invest

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A firm invests in projects so long as r ≥ i

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Investment demand

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The inverse relationship between the real interest rate and the cumulative dollars invested. Like any demand curve, this is drawn with a negative slope.

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Autonomous investment

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The level of investment determined by investment demand, and is constant for all GDP

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Market for loanable funds

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The market for dollars that are available to be borrowed for investment projects. Equilibrium in this market is determined at the real interest rate where the dollars saved (supply) is equal to the dollars borrowed (demand)

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Demand for loanable funds

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The negative relationship between the real interest rate and the dollars invested by firms

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Private saving

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Saving conducted by households and the difference between disposable income and consumption

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Public saving

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Saving conducted by government and equal to the difference between tax revenue collected and spending on goods and services

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Supply of loanable funds

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The positive relationship between the dollars saved and the real interest rate

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Multiplier effect

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Describes how a change in any component of aggregate expenditures creates a larger change in GDP

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Spending multiplier

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The magnitude of the spending multiplier effect is calculated as (dGDP / dSpending) = 1/MPS = 1/(1-MPC)

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Tax multiplier

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The magnitude of the effect that a change in taxes has on real GDP. Tm = (dGDP / dTaxes) = MPC*Multiplier = MPC/MPS

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Balanced-budget multiplier

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When a change in government spending is offset by a change in lump sum taxes, real GDP changes by the amount of the change in G; the balanced-budget multiplier is equal to one

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Aggregate Demand (AD)

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The inverse relationship between all spending on domestic output and the average price level of that output. AD measures the sum of consumption spending by households, investment spending by firms, government purchases of goods and services, and the net exports bought by foreign consumers

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Foreign sector substitution effect

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When the average price of U.S. output increases, consumers naturally begin to look for similar items produced elsewhere

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Interest rate effect

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If the average price level rises, consumers and firms might need to borrow more money for spending and capital investment, which increases the interest rate and delays current consumption. This postponement reduces current consumption of domestic production as the price level rises.

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Wealth effect

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As the average price level rises, the purchasing power of wealth and savings begins to fall. Higher prices therefore tend to reduce the quantity of domestic output purchased

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Determinants of AD

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AD is a function of the four components of domestic spending (C, I, G, (X-M)). If any of these components increases/decreases, holding the others constant, AD increases/decreases, or shifts to the right/left.

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Aggregate Supply (AS)

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The positive relationship between the level of domestic output produced and the average price level of that output

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Macroeconomic Short Run

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A period of time during which the prices of goods and services are changing in their respective markets, but the input prices have not yet adjusted to those changes in the product markets. During the short run, the AS curve has three stages - horizontal, upward sloping, and vertical.

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Macroeconomic long run

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A period of time long enough for input prices to have fully adjusted to market forces. In this period, all product and input markets are in a state of equilibrium and the economy is operating at full employment. Once all markets in the economy have adjusted and there exists this long-run equilibrium, the AS curve is vertical at GDPf.

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Determinants of AS

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AS is a function of many factors that impact the production capacity of the nation. If these factors make it easier, or less costly, for a nation to produce, AS shifts to the right, and vice versa.

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Macroeconomic Equilibrium

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Occurs when the real output demanded is equal to the quantity of real output supplied. Graphically this is at the intersection of AD and AS. Equilibrium can exist at, above, or below full employment.

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Recessionary Gap

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The amount by which full-employment GDP exceeds equilibrium GDP

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Inflationary Gap

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The amount by which equilibrium GDP exceeds full-employment GDP.

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Demand-Pull inflation

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This inflation is the result of stronger consumption from all sectors of AD as it continues to increase in the upward sloping range of AS. The price level begins to rise and inflation is felt in the economy

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Deflation

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A sustained falling price level, usually due to weakened aggregate demand and a constant AS

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Recession

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In the AD and AS model, a recession is described as falling AD with a constant AS curve. Real GDP falls far below full employment levels and unemployment rate rises

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Supply-side boom

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When the AS curve shifts outward and the AD curve stays constant, the price level falls, real GDP increases, and the unemployment rate falls

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Stagflation

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A situation in the macroeconomy when inflation and the unemployment rate are both increasing. This is most likely the cause of falling AS while AD stays constant

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Supply shocks

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A supply shock is an economy-wide phenomenon that affects the costs of firms, and the position of the AS curve, either positively or negatively

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Phillips Curve

answer

A curve showing the short-run relationship between the unemployment rate and the inflation rate. In the long run it is vertical at the natural rate of employment

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Fiscal Policy

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Deliberate changes in government spending and net tax collection to affect economic output, unemployment, and the price level. Fiscal policy is typically designed to manipulate AD to "fix" the economy

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Expansionary Fiscal Policy

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Increases in government spending or lower net taxes meant to shift the aggregate expenditure function upward

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Contractionary Fiscal Policy

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A decrease in government purchases, increase in net taxes, or some combination of the two aimed at reducing aggregate demand enough to return the economy to potential output without worsening inflation; fiscal policy used to close an expansionary gap

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Sticky Prices

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Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded, especially with downward changes in AD

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Budget Deficit

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Exists when government spending > tax revenue

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Budget Surplus

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Exists when tax revenue > government spending

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Automatic Stabilizers

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Mechanisms built into the tax system that automatically regulate, or stabilize, the macroeconomy as it moves through the business cycle by changing net taxes collected by the government. These stabilizers increase a deficit during a recessionary period and increase a budget surplus during an inflationary period, without any discretionary change on the part of the government

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Crowding out effect

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When the government borrows funds to cover a deficit, the interest rate increases and households and firms are "crowded out" of the market for loanable funds. The resulting decrease in C and I dampens the effect of expansionary fiscal policy

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Net export effect

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A rising interest rate increases foreign demand for U.S. dollars. The dollar then appreciates in value, causing net exports from the United States to fall. Falling net exports decreases AD, which lessens the impact of the expansionary fiscal policy. This is a variation of crowding out.

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Productivity

answer

The quantity of output that can be produced per worker in a given amount of time

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Human capital

answer

The amount of knowledge and skills that labor can apply to the work that they do and the general level of health that the labor force enjoys

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Non-renewable resources

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Natural resources that cannot replenish themselves. Coal is a good example

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Renewable resources

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Natural resources that can replenish themselves if they are not over-harvested

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Technology

answer

A nation's knowledge of how to produce goods in the best possible way

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Investment tax credit

answer

A reduction in taxes for firms that invest in new capital like a factory or piece of equipment

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Supply-side fiscal policy

answer

Fiscal policy centered on tax reductions targeted to AS so that real GDP increases with very little inflation. The main justification is that lower taxes on individuals and firms increase incentives to work, save, invest, and take risks

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Stock

answer

A certificate that represents a claim to, or share of, the ownership of a firm

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Equity financing

answer

The firm's method of raising funds for investment by issuing shares of stock to the public

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Bond

answer

A certificate of indebtedness from the issuer to the bond holder

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Debt financing

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A firm's way of raising investment funds by issuing bonds to the public

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Fiat money

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Paper and coin money used to make transactions because the government declares it to be legal tender. Because it has no intrinsic value, it is backed by the public's trust that the government maintains its value

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Functions of money

answer

Money serves three functions: a medium of exchange, a unit of account, and a store of value

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Money supply

answer

The quantity of money in circulation as measured by the Fed as M1, M2, and M3. Assumed to be fixed at a given point in time.

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M1

answer

The most liquid of money definitions and the basis for all other more broadly defined measures of money. M1 = cash, coins, checking deposits, and traveler's checks

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M2

answer

Less liquid than M1 because holders would incur a penalty if they wanted to convert their assets into cash. M2 = M1 + saving deposits, small time deposits, money market deposits, and money market mutual funds

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M3

answer

The least liquid of all because the asset holder would have to wait longer to liquidate a CD or pay a large penalty. M3 = M2 + large (over $100,000) time deposits

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Liquidity

answer

A measure of how easily an asset can be converted into cash

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Transaction Demand

answer

The amount of money held in order to make transactions. This is not related to the interest rate, but increases as nominal GDP increases

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Asset Demand

answer

The amount of money demanded as an asset. As nominal interest rates rise, the opportunity cost of holding money begins to rise and you are more likely to lessen your asset demand for money

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Money demand

answer

The demand for money is the sum of money demanded for transactions and money demanded as an asset. It is inversely related to the nominal interest rate

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Theory of Liquidity Preference

answer

Keynes's theory that the interest rate adjusts to bring the money market into equilibrium

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Fractional Reserve Banking

answer

A system in which only a fraction of the total money deposited in banks is held in reserve as currency

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Reserve ratio

answer

The fraction of total deposits that must be kept on reserve. rr = required reserves / total deposits

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Required reserves

answer

The portion of a deposit that must be held at the bank for withdrawals. Requires reserves = reserve ratio * total deposits

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Excess Reserves

answer

The portion of a deposit that may be borrowed by customers. Excess reserves = (1-rr) * total deposits

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Balance sheet (T-Account)

answer

A tabular way to show the assets and liabilities of a bank. Total assets must equal liabilities

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Asset of a bank

answer

Anything owned by the bank or owed to the bank is an asset of the bank. Cash on reserve is an asset and so are loans made to citizens

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Liability of a bank

answer

Anything owned by depositors or lenders is a liability to the bank. Checking deposits of citizens or loans made to the bank are liabilities to the bank.

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Money multiplier

answer

This measures the maximum amount of new checking deposits that can be created by a single dollar of excess reserves. M = 1/rr. The money multiplier is smaller if a) at any stage the banks keep more than the required dollars in reserve, b) at any stage borrowers do not redeposit funds into the bank and keep some as cash, and c) customers are willing to borrow

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Expansionary monetary policy

answer

Designed to fix a recession and increase AD, lower the unemployment rate, and increase real GDP, which may increase the price level

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Contractionary policy

answer

Designed to avoid inflation by decreasing AD, which lowers the price level and decreases real GDP back to full employment

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Open Market Operations (OMOs)

answer

A tool of monetary policy, it involves the Fed's buying (or selling) of securities from (or to) commercial banks and the general public.

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Discount rate

answer

The interest rate commercial banks pay on short-term loans from the Fed

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Federal funds rate

answer

The interest rate paid on short-term loans made from one bank to another. When this rate is a target for an OMO, bonds are bought or sold accordingly until the interest rate target has been met.

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Quantity Theory of Money

answer

A theory that asserts that the quantity of money determines the price level and that the growth rate of money determines the rate of inflation

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Equation of Exchange

answer

The equation says that nominal GDP (P*Q) is equal to the quantity of money (M) multiplied by the number of times each dollar is spent in a year (V). MV = PQ

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Velocity of Money

answer

The average number of times a dollar is spent each year; V = PQ/M

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Domestic Price

answer

The equilibrium price of a good in a nation without trade

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World Price

answer

The global equilibrium price of a good when nations engage in trade

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Balance of Payments Statement

answer

A summary of the payments received by the US from foreign countries and the payments sent by the US to foreign countries

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Current account

answer

This account shows current import and export payments of both goods and services and investment income sent to foreign investors of US and investment income received by US citizens who invest abroad

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Capital (or Financial) Account

answer

This account shows the flow of investment on real or financial assets between a nation and foreigners

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Official reserves account

answer

The Fed's adjustment of a deficit or surplus in the current and capital account by the addition or subtraction of foreign currencies so that the balance of payments is zero

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Exchange rate

answer

The price of one currency in terms of a second currency

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Appreciating (depreciating currency)

answer

When the value of a currency is rising (falling) relative to another currency, it is said to be appreciating (depreciating)

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Determinants of exchange rates

answer

Consumer tastes, relative incomes, relative inflation, and speculation all can shift the exchange rates of currencies

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Revenue tariff

answer

An excise tax levied on goods not produced in the domestic market

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Protective tariff

answer

An excise tax levied on a good that is produced in the domestic market so that it may be protected from foreign competition

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Import quota

answer

A limitation on the amount of a good that can be imported into the domestic market

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