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ECON 1102 - Review Part 2, Study notes of Economics

This is the second set of 4 chapters of ECON 1102, that I studied and created into a review. It has all material required for Midterm 2 and a few sample questions for each chapter.

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2021/2022

Available from 05/12/2023

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Principles of Macroeconomics 2
Chapter 7- Adding Government and Trade to the Simple Macro Model
What is Fiscal Policy?
- The use of the government’s tax and spending policies to achieve government objectives.
- Desired government purchases (G) are part of an aggregate desired expenditure (AE).
- Government purchases are autonomous meaning they are not affected by GDP, they enter the AE
function directly.
What is Net Tax Revenue?
- Net tax revenue (T) is total tax revenue minus transfer payments.
- Taxes enter the AE function indirectly, by affecting disposable income (YD) and consumption (C).
- C = Autonomous Consumption (Č) + MPC x Disposable Income (YD = Y-T).
- The net tax revenue function is T = tY (T = 0.3Y, meaning 30% of income is for taxes).
What is the Budget Balance?
- The budget balance is the difference between total government revenue, and total government
expenditures, which equals net tax revenue minus government purchases (T-G).
- The government has a budget surplus if net tax revenue exceeds purchases (T>G).
The government has a budget deficit if purchases exceed net tax revenue (G>T).
- The government has a balanced budget when the two amounts are equal (T=G).
How is Foreign Trade Introduced?
- Exports (X) will not change due to changes in Canadian national income, so they are treated like
autonomous expenditures.
- Imports (IM) do change due to changes in Canadian national income. The marginal propensity to
import (m) is the increase in import expenditure induced by a one-dollar increase in national income.
- Import function: IM = mY (IM = 0.2Y). Net Exports function: NX = X mY
- Trade is balanced when NX = 0 or X = IM
What are the factors that shift Foreign Trade?
1. Foreign Income
- As foreign income increases, people will import more Canadian goods, making exports shift up (rise)
- As foreign income decreases, people won’t import Canadian goods, making exports shift down (fall)
2. Canadian Prices
- If CAD appreciates (prices increase), exports will go down because Canadian goods are relatively more
expensive, causing people to import fewer Canadian goods, however, Canada will start importing more
goods (m goes up) from other countries, making the net exports slope steeper and lower.
- If CAD depreciates (prices decrease) exports will go up because Canadian goods are relatively less
expensive, causing Canada to import fewer goods from other countries (m goes down), making the net
exports slope higher and flatter.
- Foreigners pay less money to buy CAD, and Canadians pay more money to buy foreign currency.
When do we reach Equilibrium National Income?
- Equilibrium National income is the level of income at which desired aggregate expenditure equals
actual national income (AE = Y).
- The marginal propensity to consume out of national income (after taxes) is less than the marginal
propensity to consume out of disposable income (before taxes).
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Principles of Macroeconomics 2 Chapter 7 - Adding Government and Trade to the Simple Macro Model What is Fiscal Policy?

  • The use of the government’s tax and spending policies to achieve government objectives.
  • Desired government purchases (G) are part of an aggregate desired expenditure (AE).
  • Government purchases are autonomous meaning they are not affected by GDP, they enter the AE function directly. What is Net Tax Revenue?
  • Net tax revenue (T) is total tax revenue minus transfer payments.
  • Taxes enter the AE function indirectly, by affecting disposable income (YD) and consumption (C).
  • C = Autonomous Consumption (Č) + MPC x Disposable Income (YD = Y-T).
  • The net tax revenue function is T = tY (T = 0.3Y, meaning 30% of income is for taxes). What is the Budget Balance?
  • The budget balance is the difference between total government revenue, and total government expenditures, which equals net tax revenue minus government purchases (T-G).
  • The government has a budget surplus if net tax revenue exceeds purchases (T>G). The government has a budget deficit if purchases exceed net tax revenue (G>T).
  • The government has a balanced budget when the two amounts are equal (T=G). How is Foreign Trade Introduced?
  • Exports (X) will not change due to changes in Canadian national income, so they are treated like autonomous expenditures.
  • Imports (IM) do change due to changes in Canadian national income. The marginal propensity to import (m) is the increase in import expenditure induced by a one-dollar increase in national income.
  • Import function: IM = mY (IM = 0.2Y). Net Exports function: NX = X – mY
  • Trade is balanced when NX = 0 or X = IM What are the factors that shift Foreign Trade?
  1. Foreign Income
  • As foreign income increases, people will import more Canadian goods, making exports shift up (rise)
  • As foreign income decreases, people won’t import Canadian goods, making exports shift down (fall)
  1. Canadian Prices
  • If CAD appreciates (prices increase), exports will go down because Canadian goods are relatively more expensive, causing people to import fewer Canadian goods, however, Canada will start importing more goods (m goes up) from other countries, making the net exports slope steeper and lower.
  • If CAD depreciates (prices decrease) exports will go up because Canadian goods are relatively less expensive, causing Canada to import fewer goods from other countries (m goes down), making the net exports slope higher and flatter.
  • Foreigners pay less money to buy CAD, and Canadians pay more money to buy foreign currency. When do we reach Equilibrium National Income?
  • Equilibrium National income is the level of income at which desired aggregate expenditure equals actual national income (AE = Y).
  • The marginal propensity to consume out of national income (after taxes) is less than the marginal propensity to consume out of disposable income (before taxes).
  • The slope of the AE function is the marginal propensity to spend out of national income (z).
  • AE Function: AE = C + I + G + X – IM and z = MPC (1-t) – m.
  • To solve for equilibrium: 1. Simplify consumption 2. Add AE components 3. Use AE condition Example: C = 200 + 0.8YD I = 100 G = 300 T = 0.3Y X = 200 IM = 0.2Y
  1. C = 200 + 0.8(0.7Y) = C = 200 + 0.56Y
  2. AE = 200 + 0.56Y + 100 + 300 + (200 – 0.2Y) = AE = 800 + 0.36Y
  3. Y = AE | Y = 800 + 0.36Y | 1Y- 0.36Y = 800 | 0.64Y/0.64 = 800/0.64 = 1250 Z = MPC (1-t) – m = 0.8 (1-0.3) – 0.2 | 0.8(0.7) – 0.2 = 0.56 – 0.2 = 0.36 = z What changes Equilibrium National Income?
  • Investment increases output, which increases income, which increases consumption.
  • The three withdrawals that come out of income are taxes, saving, and exports.
  • The presence of imports and taxes reduces the marginal propensity to spend out of national income and reduces the value of the simple multiplier (z).
  • A high marginal propensity to consume would increase the multiplier (steeper AE), while a high marginal propensity to import or a higher net tax rate would reduce the multiplier (flatter AE).
  • Governments use stabilization policy (fiscal) to bring national income closer to potential GDP, Y*. The policy is designed to reduce the economy, and cyclical fluctuations, thereby stabilizing national income with smaller peaks and troughs.
  • If there is a reduction in the net tax rate or an increase in government purchases the AE curve would shift upward, causing the multiplier to increase the equilibrium national income.
  • G: Change in Y over Change in G = 1 / (1-z) | Change in Y = Change in G x 1/(1-z)
  • T: An increase in ‘t’ flattens the AE curve while a decrease in ‘t’ steepens it. (Y1 – Y0 = Change in y)

Chapter 8- Output and Prices in the Short Run How do changes in Price Levels affect the Demand Side of the Economy?

  • An exogenous change in the price level has two effects on aggregate expenditure:
  • A change in consumption and the change in net exports.
  • A change in the price level affects consumption by changing the real value of wealth
  • The real (adjusted) value of money depends on the level of prices.
  • A rise in the price level lowers real wealth, causing a decrease in C and AE, C = 175
  • A fall in the price level raises real wealth, causing an increase in C and AE, C =
  • A change in the price level affects net exports by changing the relative attractiveness of Canadian goods.
  • If CAD prices levels rise, exports will go down because Canadian goods are more expensive, causing people to import fewer Canadian goods, however, Canada will start importing more goods from other countries, shifting net exports and AE downwards.
  • If CAD price levels fall, exports will go up because Canadian goods are less expensive, causing Canada to import fewer goods from other countries, shifting net exports and AE upwards.
  • An increase in the price level, therefore causes the AE curve to shift downward so the equilibrium GDP falls, a decrease causes the AE curve to shift upward so the equilibrium GDP rises. What is the Aggregate Demand Curve?
  • The AD curve shows the combinations of real GDP and the price level that make desired aggregate expenditure (AE) equal national income. Changes in Price cause movements along AD.
  • A rise in the price level causes AE to shift downward, and AD to move upward and to the left, reflecting a fall in the equilibrium level of GDP. Real Wealth, Consumption, and Net exports go down.
  • A fall in the price level causes AE to shift upward, and AD to move downward and to the right, reflecting a rise in the equilibrium level of GDP. Real Wealth, Consumption, NX, AE, and Y go up.
  • Changes in anything other than price level will shift the AD Curve, causing an Aggregate Demand shock.
  • An increase in autonomous aggregate expenditure shifts AE curve upward and the AD curve rightward
  • A decrease in autonomous aggregate expenditure shift AE curve downward and the AD curve leftward. What is the Aggregate Supply Curve?
  • The AS curve shows the relation between the price level and the quantity of aggregate output supplied
  • If firms want to increase their output, less efficient factories may be used and less efficient workers may get hired, and existing workers may have to work overtime.
  • Therefore, unit cost increases and firms will only be willing to produce and sell more of the can charge a higher price. Y goes up only if P goes up.
  • The curve is flat at low levels of GDP but is steep at higher levels of GDP because firms have excess capacity when GDP is low, they do not need a big increase in prices to encourage them to produce more.
  • Although, if the output is at or above capacity, unit costs rise rapidly and firms need larger price increases to induce increases in output. Y goes up only if P goes UP by a LOT.
  • The aggregate supply curve shifts when firms’ production costs change, specifically input prices. A rise in input prices reduces the profitability of production, causing AS to shift leftward. A fall in the input prices increases profitability and shifts AS to the right.
  • Another source of changing production costs is technology. An improvement in technology reduces unit cost for any given level of outfit and causes AS to shift to the right. A deterioration in technology increases unit cost and causes AS to shift to the left. Shifts are called Aggregate Supply shocks.

What is Macroeconomic Equilibrium?

  • Macroeconomic equilibrium is the intersection of aggregate demand and aggregate supply that determines the equilibrium GDP and equilibrium price level.
  • A rightward shift in an AD or AS curve is called a positive shock and results in higher GDP.
  • I leftward shift in an AD or AS curve is called a negative shock and results in lower GDP.
  • Aggregate demand shocks cause the price level and real GDP to change in the same direction, both rise with an increase in aggregate demand, and both fall with a decrease in aggregate demand.
  • When AD shifts to the right, the horizontal distance of the shift represents the simple multiplier. However, when we add aggregate supply to it, the price rises, so GDP does not rise as much as the shift and aggregate demand would indicate. As P goes up, consumption and net exports fall.
  • The amount by which GDP changes with an AD shift, depends on how steep the AS curve is.
  • If the output is low and the AS curve is flat, then a shift right in AD leads to a large increase in GDP and a small increase in the price level, and a bigger multiplier.
  • If the output is high, and the AS curve is steep, a shift right In AD will lead to a small increase in GDP and a large increase in the price level and a smaller multiplier
  • AS shocks cause the price level in real GDP to change in opposite directions. Negative supply shock shifts the AS curve leftward, leading to a rise in the price level and a fall and equilibrium GDP.
  • A fall in GDP and an increase in the price level lead to more unemployment and more inflation, causing stagflation and a stagnant economy. Sample Questions-
  1. Everything else remains the same, an increase in foreign income
  • Shifts Canada's aggregate demand curve to the right
  1. Consider the nature of macroeconomic equilibrium. If, at a particular price level, the total output demanded is greater than that supplied by producers, then
  • The price level will rise toward its equilibrium value.
  1. Consider the AD/AS model. Suppose there is a decrease in aggregate demand and, simultaneously, an increase in aggregate supply. The result will be a
  • An indeterminate change in real GDP and a fall in the price level.
  1. Consider the basic AD/AS model. If their unit costs rise as output increases, price-taking firms will be prepared to produce ________ only if ________.
  • More; prices increase

What is the Discretionary Fiscal Stabilization Policy?

  • The government uses policies on taxes and government spending in an attempt to push real GDP back toward the potential output (change in the laws).
  • A recessionary gap may be closed by the downward (right) shift of the aggregate supply curve, which happens over time, so governments may increase government spending or reduce taxes which shifts the aggregate demand curve to the right, and eliminate the recessionary gap. AS RIGHT - > AD RIGHT
  • Output returns to potential GDP quickly but at the cost of a higher price level.
  • An inflationary gap may be removed by an upward (left) shift of the aggregate supply curve, overtime, or by contractionary fiscal policy, such as a reduction in government spending or a rise in taxes, causing a leftward shift of the aggregate demand curve. AS LEFT - > AD LEFT
  • One limitation is that changing fiscal policy requires making changes in taxes and government expenditures. The period of time between reaching a problem, and deciding on what to do is called the decision lag. The time that it takes to put policies in place, is called an execution lag.
  • Another limitation is the difficulty of fine-tuning the economy, which is attempting to maintain output at its potential level by means of frequent changes in fiscal or monetary policy. Policymakers focus on gross tuning, which is the use of macroeconomic policy to stabilize the economy. What is the Automatic Stabilizer?
  • The government's tax and transfer system works automatically to stabilize the economy.
  • Suppose a shock shifts the aggregate demand curve to the right, and increases the short-run level of real GDP, as real GDP increases government tax revenues also increase, and with fewer low-income, households, and unemployed persons requiring assistance, governments make fewer transfer payments to individuals. T UP = tY (Y UP)
  • The rise in the tax revenues dampens the overall increase in real GDP, caused by the initial shock which stabilizes the economy. Net Taxes = Taxes – Transfers
  • The tax and transfer system reduces the multiplier because the higher the net tax rate, the smaller the simple multiplier is and the more stable real GDP is in response to shocks to autonomous spending.
  • The marginal propensity to spend on national income is z = MPC(1-t)-m. Simple Multiplier = 1/(1-z)
  • Low t = high z and bigger multiplier, and a big AD shift.
  • High t = low z and smaller multiplier, and a small AD shift. Sample Questions-
  1. Potential output is a vertical line because
  • potential GDP is independent of the price level.
  1. An important automatic fiscal stabilizer in Canada is
  • the income-tax system.
  1. In the basic AD/AS model, which of the following is a defining assumption of the adjustment process that takes the economy from the short run to the long run?
  • factor prices respond to output gaps
  1. Refer to Figure 24-6. The government could close the existing output gap by
  • decreasing the net tax rate.

Chapter 10- Long-Run Economic Growth What is the Nature of Economic Growth?

  • Economic growth occurs when there is an increase in GDP, in the standard of living, which is the GDP per person is the improvement in economic growth.
  • If a country has a negative average annual growth (shrinkage) rate, then that means that the average person was worse off than their grandparent.
  • If a country has a positive average annual growth rate, then that means that the average person has triple and more than their grandparents.
  • Small differences in annual growth rates have large effects over time due to compound growth, so if a country grows at a fast rate, the high GDP will be compounded into an even higher GDP in the future.
  • Y 0 X (1 + Growth)n^ = 100 X (1.05)^100
  • The rule of 72 is a trick that helps to find the number of years. It takes a magnitude to double when it is growing at a constant rate by dividing 72 by the growth rate. Is GDP growing at 5%? 72/5 = 14.4 years. What are the effects?
  • If the majority of income growth accrues to the top earners in the income distribution then there will be a rise in income inequality, and the stagnation of incomes for those in the middle of the income, distribution, causing poverty and income inequality policy issues to be addressed.
  • One cost of increased growth is reduced consumption today, because attaining a higher rate of investment in new capital, increases future productivity and output, but at the expense of consumer goods that could have been produced instead.
  • Another cost is reduced leisure time caused by increased working hours.
  • Also, involving existing firms being overtaken (creative destruction), and made obsolete by new firms. How can a higher GDP be achieved?
  1. Growth in the labor force through population growth or through a rise in the fraction of the population that participates in the labor force.
  2. Growth in human capital refers to the set of skills workers acquire for formal education and on-the-job training, which is acquired through the investment of time and money.
  3. Growth in physical capital because investment creates changes in physical capital.
  4. Growth from technological improvement, new and better ways of producing goods.
  • Real GDP per person is the average output of those employed multiplied by the percentage of those employed in the population.
  • If (Y) denotes total real output, and (N) signifies the number of employees workers, and (H) represents the number of hours worked, and (POP) means the total population, then GDP per person = Y/POP = Y/H X H/N X N/POP What are the Saving Measures?
  • Income minus consumption is saving, Y = C+I, Y-C =I, then S = I because S = Y-C.
  • At the equilibrium level of real GDP desired saving equals desired investment real GDP is equal to Y* and the interest rate adjusts to determine equilibrium in the market for financial capital.
  • If the government is added through government purchases (G), and collecting taxes net of transfers (T), in the long run, desired private saving is equal to (Y* - T– C) and public saving is equal to (T-G). What is National Saving?
  • National saving is equal to private saving plus public saving = NS = (Y* - T– C) + (T-G) = Y*-C-G
  • The supply curve (savers)for national saving and the investment demand curve (borrowers) make up the economy’s market for financial capital.
  • The first implication is that there is learning by doing. The second is that the diffusion of new technology through knowledge transfer is a costly and time-consuming process. The third is the idea that rivalry between firms leads to greater innovation. Lastly, even adverse shocks, such as a rise in input prices, may have positive results if they lead to technological advances.
  • Some research suggests the possibility of increasing returns that remain for considerable periods of time with the sources of these increasing returns being market development costs, which allow for higher returns to later investment than earlier investment and the importance of ideas. Sample Questions-
  1. Consider the market for financial capital for a closed economy in the long run. Other things being equal, a country with a high national saving rate will tend to have
  • a high growth rate because sustained high investment is possible with high saving.
  1. Because of diminishing marginal returns, an economy can continue to increase real GDP per hour worked only if
  • there is technological change.
  1. Growth eventually stops in neoclassical growth theory when
  • technology stops advancing.
  1. The costs of economic growth include
  • the effects on workers whose skills are made obsolete by technical change.
  1. If GDP is currently $1.7 trillion and is growing at a rate of 2.3% per year, how long will it take GDP to reach $3.4 trillion?
  • about 31.3 years
  1. The key factors in raising standards of living in low-income countries have been increases in
  • technology and resources.
  1. According to the "Rule of 72," how many years will it take for real GDP per capita to double when the growth rate of real GDP per capita is 5%?
  • 14.4 years