Explain the difference between macroeconomics and microeconomics.
Macroeconomics focuses on the economy as a whole and in particular on the determinants of total national output. Microeconomics by contrast looks at the functioning of individual decision-making units like the household and the firm. Difficulty: E Type: D
Identify three macroeconomic and three microeconomic topics.
Answers may vary but below might be some possibilities: Macro Issues Micro Issues Unemployment Health benefits
Recession Computer sales
Consumption Price movements between Coke and Pepsi
Inflation Changes in the demand for labor
The Money Supply Price floors for wheat farmers Difficulty: E Type: F
Explain what sticky prices are in terms of macroeconomic equilibrium.
Sticky prices are prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Difficulty: E Type: C
Discuss what is meant by the Classical belief that the economy is self-correcting.
Classical theory argued that an excess supply of labor would fairly quickly drive down wages to a new equilibrium level and as a result unemployment would be eliminated. Difficulty: E Type: C
Real GDP in Billions of Dollars
Referring to the above table from the Economic Report of the President what is happening to the economy between 1996 and 1997? What would you assume is happening to the unemployment rate and the inflation rate? What policy action, if any might be appropriate?
The economy is in an economic boom. The unemployment rate is more than likely decreasing and the inflation rate may be increasing. It isn't clear that any policy action be taken unless of course inflation is seen as a serious threat in which case a contractionary fiscal policy might be in order (i.e. a cut in spending or increase in taxes). Difficulty: E Type: C
What are the basic tenets of Keynesian theory that help explain the level of employment?
Keynes' view was that prices and wages do not determine the level of employment as the classical school assumed but rather the level of aggregate demand for goods and services. Hence, Keynes believed that the government could intervene in the economy by directly stimulating aggregate demand and thereby pull the economy out of recession. Difficulty: E Type: C
Assume that the demand for computer programmers drops precipitously. Explain using Keynesian reasoning why this will cause unemployment.
Keynes argued that wages may not adjust right away. Thus the decline in the demand for labor is not met by a commensurate drop in the wage rate. This means that there will be many more programmers actively seeking employment but much fewer being hired in the market. Difficulty: E Type: C
Assume that the demand for construction workers declines because of a slump in the housing market. Explain using Classical reasoning why this will not cause unemployment.
The Classical belief is that markets are resilient and that wages and prices are flexible. Thus the decline in the demand for construction workers should result in lower wages. This will cause some workers to cease looking for work and will serve as an incentive for firms to increase the number of workers demanded. What would otherwise be a surplus (unemployment) in the labor market results in the market clearing. Difficulty: E Type: C
Which school of thought would more likely make the following statements?
a. The economy is in recession but we should leave it alone.
b. Draft a piece of legislation subsidizing the hiring of recent college graduates.
Microeconomists generally do not expect to see excess supplies in most markets. However, macroeconomists will often observe that during recessions the quantity supplied of labor can exceed the quantity demanded of labor. Explain what macroeconomists are referring to and explain why the wage rate may not adjust right away.
The wage rate may stay above the market clearing level if workers have signed multi-year wage contracts or firms may be reluctant to lower wages for fear of adversely affecting morale and productivity. Difficulty: M Type: A
Explain what is meant by deflation. Explain the impact that it might have on the value of assets.
Deflation is a decline in the overall average price level. It can actually cause the real value of assets to rise since the purchasing power of those assets has risen. Difficulty: M Type: A
Keynes argued that it is not prices and wages that determine the level of employment. What then did he argue was the determinant?
Keynes posited that the level of aggregate demand for goods and services determines the level of employment. He believed that the government could intervene in the economy and affect the level of output and employment. That is, the government could augment private demand through public spending. Difficulty: E Type: F
Briefly describe what is meant by the phrase "fine tuning."
This is a term that was coined in the 1960s to refer to the government's discretionary role in regulating inflation and unemployment. Difficulty: E Type: D
Define stagflation and explain why it undermined faith in the simple Keynesian model.
Stagflation refers to the simultaneous occurrence of a rapid rise in the price level and persistent unemployment. This undermined faith in the simple Keynesian model because before the 1970s rising prices were generally observed only when the economy was prospering. Difficulty: E Type: D
What might be some Keynesian prescriptions to get the economy out of an economic slump?
The government could either decrease taxes and/or increase government spending. Difficulty: E Type: C
Under which condition does stagflation occur?
It occurs when the overall price level increases rapidly during periods of recession. Difficulty: E Type: C
What might be some Keynesian prescriptions to bring down the rate of inflation in the economy?
The government could increase taxes and/or decrease government spending. Difficulty: E Type: C
Explain why a cut in spending to bring down inflation during a period of stagflation does not solve all macroeconomic problems.
The reason that the cut in spending does not solve all macroeconomic problems is that it exacerbates the unemployment problem associated with the stagflation. Difficulty: E Type: C
What were the tax cuts in 1981 and 1986 designed to do? What was one of the consequences of this action?
They were designed as supply side policies to improve incentives to work, save and invest. One of the consequences is that it caused the federal deficit to rise sharply. Difficulty: E Type: F
Identify the following topics as either predominantly macroeconomic or microeconomic.
(a) Provision by firms of medical benefits for employees
(b) The demand for coffee
(d) The price of a government bond relative to the price of IBM stock
(j) The money supply
Microeconomics: a, b, d, e, h. Macroeconomics: c, f, g, i, j. Difficulty: E Type: D
How do Classical economists and Keynesian economists differ in their perceptions of how well markets and prices function?
In general, Classical economists conclude that markets work well and that prices are flexible. Excess demand or supply is competed away. In contrast, Keynesians observe that prices do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Examining the labor market, for example, Keynesians find sticky prices and persistent mismatches between the quantity of labor demanded and supplied. Difficulty: D Type: A
What event provided the impetus for the development of modern macroeconomics? Why did this event require a fundamental rethinking of how the macroeconomy operated?
The impetus for the development of macroeconomics was the Great Depression. The Classical model could not explain the Great Depression. According to the Classical model, the economy is self-correcting and unemployment should not persist. During the Great Depression, very high levels of unemployment persisted for about 10 years. Because the classical model could not explain the Great Depression, the approach to macroeconomics had to be rethought. Difficulty: M Type: F
Classical economists believed that recessions were self correcting. In their view, how did the economy self correct?
According to Classical economists, the economy adjusts because wages and prices are flexible. If there is unemployment, wages would fall and unemployment would be reduced. Difficulty: M Type: A
Discuss three of the major concerns of macroeconomics.
Three major concerns of macroeconomics are inflation, output growth, and unemployment. Difficulty: E Type: C
List the three major concerns of macroeconomics.
The three major concerns of macroeconomics are inflation, output growth and unemployment. Difficulty: E Type: F
What is inflation?
Inflation is an increase in the overall price level. Difficulty: E Type: D
Explain the costs and consequences of hyperinflation.
When inflation increases at a very rapid rate, that is several hundred percent per year or more it can cause the whole organization of a country to break down. Workers may go on strike to demand higher wages to compensate for the high inflation rate, firms may find it difficult to obtain credit and as a consequence output and employment may decline sharply. Difficulty: E Type: D
Define the terms recession and depression.
Technically speaking a recession is defined as a period of time in which aggregate output has declined for two quarters in a row. A depression is simply a very severe recession. However, economists are not in agreement about when a recession becomes a depression. Difficulty: E Type: D
Describe what a business cycle is.
The business cycle is represented by the short-term ups and downs in the economy's aggregate output. Difficulty: E Type: D
Lay people often define unemployment as when there are people out of work. How do economists define unemployment?
Identify the following as either fiscal or monetary policy.
a. The government increases spending on roads and bridges.
b. The Federal Reserve lowers interest rates.
c. The government increases the income tax rate.
d. The government buys bonds in the open market.
a. Fiscal policy
b. Monetary policy
c. Fiscal policy
d. Monetary policy Difficulty: E Type: F
Explain why we should not expect to see zero percent unemployment.
At any point in time, some firms may go bankrupt due to competition from rival firms, bad management or simply misfortune. Typically, employees are not able to find work immediately and while they are actively seeking work are unemployed. In addition, there may be workers that are entering the labor market for the very first time that may require many weeks or months to find a job. Difficulty: E Type: C
When there is unemployment there is an excess supply of workers. Describe how microeconomic theory explains the response to this phenomenon.
The response to excess supply is a decrease in the price of the commodity in question (that means a decrease in the wage rate) and therefore an increase in the quantity demanded. This will in turn result in a reduction in the quantity supplied (some workers may choose to exit the labor market), and the restoration of equilibrium. With the quantity supplied equal to the quantity demanded, the market clears. There is now no more unemployment. However, because markets may not immediately clear it is possible that unemployment can exist when there is not an excess supply of workers (i.e. it exists when wages are in equilibrium in the form of frictional and structural unemployment). Difficulty: M Type: C
List and explain the three governmental policies for influencing the economy.
The three governmental policies for influencing the economy are fiscal policy, monetary policy and growth policies. Difficulty: E Type: F
In 1981, President Reagan cut tax rates for individuals and for businesses. Explain why this was an example of a supply-side policy.
This could have been classified as a fiscal policy, but fiscal policies, in fact, focus on adjusting aggregate demand. The tax rate changes, as noted in the text, were designed to stimulate aggregate supply by increasing incentives to work, save and invest. Difficulty: M Type: A
Explain the three different types of government policies that can be used to influence the macroeconomy.
The three different government policies are fiscal policy, monetary policy, and growth or supply-side policies. Fiscal policy involves changing the level of government spending and taxes to either stimulate or contract the economy. Monetary policy involves changing the money supply. Growth or supply-side policies are policies that focus on the aggregate supply and increasing production. Difficulty: E Type: D
Explain the three market arenas in which households, firms, the government, and the rest of the world interact.
The three market arenas are: the goods-and-services market, the labor market, and the money market. In the goods and services market goods and services are traded. In the labor market human services are traded. In the money market savers are linked to borrowers. Diff: E Type: D
The Components of the Macroeconomy
Which are the four components of the macroeconomy?
Macroeconomics focuses on four groups: households and firms (the private sector), the government (the public sector), and the rest of the world (the international sector). Difficulty: E Type: F
What do supply-side economists argue is the best way to increase production?
They believe that government must enact policy to stimulate the supply of labor and capital and increase investment. Difficulty: E Type: F
What are some of the major features of growth policies?
Growth policies are those that focus on aggregate supply rather than on aggregate demand. They may, among other things, include tax cuts. The argument is that lower tax rates increase the incentive to work, save, and invest which can enhance productivity. Difficulty: E Type: C
What is the main point that we are supposed to glean from the circular flow diagram?
We are suppose to recognize that one person's expenditure is someone else's income. Difficulty: E Type: C
Explain why labor markets are different from goods markets. Make sure to include in your answer who is doing the demanding and who is doing the supplying.
In the goods market the firm is supplying and the household is demanding the product. In the labor market just the reverse is true. Households supply labor services to firms and firms demand labor services from households. Difficulty: E Type: C
Briefly explain what the circular flow diagram illustrates for a macroeconomy.
The circular flow diagram shows the payments made and income received in the three sectors of the economy. The three sectors are private (households and firms), public (government), and international (trade of goods and services). The model can also be used to highlight the role of the goods and services market, the labor market, and the money/financial market. Difficulty: M Type: C
List and briefly explain the three market arenas.
The three market arenas are the goods-and-services market, the labor market and the money market. The first includes purchases of goods and services by households from firms or firms buying goods and services from each other. The labor market is where both firms and government purchase labor from households. Households supply the labor and government and firms demand labor. In the money market households purchase stocks and bonds from firms. Households buy these instruments with the expectation that they will earn income in the form of dividends or capital gains from stocks and interest on bonds. Difficulty: E Type: D
Explain what the money market is. Make sure to discuss the three players in the money market.
The money market is where households purchase stocks and bonds from firms. Households supply funds to firms with the expectation of earning payment in the future in the form of interest or dividends. In addition, households borrow money in the money market to finance things like cars or homes. Firms borrow in the money market to build new factories or purchase equipment. In addition, the government borrows money in the money market to finance its obligations. Difficulty: E Type: F
Define what is meant by the term stock.
A stock is a financial instrument that gives the holder a share in the ownership of a firm and, therefore, the right to share in the profits of the firm. Difficulty: E Type: D
Explain what a capital gain is and give an example.
A capital gain occurs whenever the value of an asset increases. An example might be a purchase of a home for $80,000 and the subsequent sale of this home two years later for $85,000. Difficulty: E Type: D
What is a dividend?
A dividend is the portion of a corporation's profit that the firm pays out each period (month or year) to its shareholders (the owners of the corporation). Difficulty: E Type: D
List the three debt instruments that the federal government issues and explain how they work.
The three debt instruments issued by the federal government are Treasury bonds, notes and bills. They are issued to finance government spending whereby the government has an obligation to pay the loan back at some specified time in the future including interest for the use of the funds. Difficulty: E Type: F
How is issuing stock different from issuing a corporate bond? Explain.
A share of stock is a financial instrument that gives the holder a share in the firm's ownership and therefore the right to share in the firm's profits. If the firm prospers, the stock price may rise and the stockholder will enjoy a capital gain. In addition, the firm may pay dividends directly to stockholders. Bonds are debt instruments. The bond holder is not an owner of the firm and therefore does not earn dividends. However, the bond holder is paid interest for the service of lending the money to the firm. It should be noted that stock owners (and lenders) can lose money, in addition to receiving capital gains, dividends and interest payments. Difficulty: E Type: C
In which of the three basic markets (goods-and-services, labor, financial) is each of the following items traded?
What is the differences between a corporate bond and a share of stock?
The bond is a debt the corporation owes to the holder or lender while a share of stock is part ownership in the corporation. Difficulty: E Type: D
The government releases GDP data on a quarterly basis. Explain why this would make it difficult for policy makers to determine what point in the business cycle the economy is at currently.
You cannot tell where we are in the business cycle until after the fact. You cannot tell if the economy has moved out of a recession until the data indicates that the level of economic activity has increased. Difficulty: M Type: C
They are promissory notes issued by the federal government when it borrows money. Difficulty: E Type: D
What are corporate bonds?
They are promissory notes issued by corporations when they borrow money. Difficulty: E Type: D
The Methodology of Macroeconomics
Define aggregate demand and aggregate supply and draw a graph of each on the same diagram.
Aggregate demand is the total demand for all goods and services in the economy. Aggregate supply is the total supply of goods and services in the economy.
Difficulty: E Type: A
Explain why the availability of substitutes is irrelevant when analyzing the behavior of aggregate demand.
In microeconomics, when the price of one good increases the relative price of all other goods in the economy decreases meaning that the opportunity cost of purchasing the good in question is higher. The sacrifice in terms of other goods forgone increases. But when the overall price level changes, there may be no changes at all in relative prices. Therefore the availability of substitutes has no bearing on the analysis of the aggregate demand curve. Difficulty: M Type: C
L abel the graph below assuming that one of them represents aggregate demand and the other aggregate supply. Make sure to label each axis.
Difficulty: E Type: D
What is the primary assumption that is made in microeconomics concerning the supply curve and how is that assumption different when looking at the aggregate supply curve?
The supply curve for a firm in microeconomics is derived under the assumption that all its input prices are fixed. That is, as the firm's output changes this has no affect on the price of its inputs. In macroeconomics we are looking at changes in the overall price level, however, all prices are changing (including input prices), so the aggregate supply curve cannot be based on the assumption of fixed input prices. Difficulty: M Type: C
What is aggregate behavior?
The behavior of all households and firms together. Difficulty: E Type: D
Why do economists look to microeconomics to explain macroeconomic events?
Macroeconomic behavior is the sum of all the microeconomic decisions made by households and firms. The movement of macroeconomic aggregates reflects decisions being made by individual firms and households. To understand the aggregate measures, it is necessary to understand the underlying individual decisions. Difficulty: M Type: A
The U.S. Economy Since 1900
Define an expansion or boom.
An expansion is the period in the business cycle from a trough (the bottom part of the cycle) up to a peak during which output and employment increase. Difficulty: E Type: D
Define contraction (recession or slump).
A contraction is a period in the business cycle from a peak down to a trough during which output (and usually employment) falls. Difficulty: E Type: D
Draw a graph of a business cycle. Label and explain the phases of a business cycle.
During an expansion the level of economic activity is increasing. The peak is the highest level of economic activity. A contraction means that the level of economic activity is falling. A trough is the lowest level of economic activity.
Difficulty: E Type: C
Refer to Table 5.2. In terms of the business cycle, describe what is happening to this economy from year 1 to year 2 to year 3. Using the table above, predict what is likely to be happening to the unemployment rate and the inflation rate from year 1 to year 3. If the government wished to restore the economy's production level to 100 using fiscal policy, should it use an expansionary fiscal policy or a contractionary fiscal policy? Explain.
From year 1 through year 2, there is a recession. The unemployment rate will be increasing and the inflation rate may be decreasing. An expansionary policy would be called for to restore the economy's production level to 100. During year 3 an expansion begins. The unemployment rate may be decreasing whereas the inflation rate may be increasing. A further expansionary fiscal policy would be needed restore the economy's production level to 100 Difficulty:M Type: A