Economics Final Review

Chapter 1
1. It is the social science concerned with the efficient use of scarce resources to achieve the
maximum satisfaction of economic wants
2. Inductive reasoning starts by observing specific examples then moving to broad generalizations.
For example, if all the swans you have seen are white, then you would conclude that all swans are
white (even though black swans exist).
Deductive reasoning starts with generalizations then moves to specific examples. For example, if all
people are mortal, and Socrates is a person, then Socrates is mortal.
3. Positive statements are statements of fact and contain no indication of approval or disapproval
(what should be). Ex: the employment rate in several European nations is higher than that in the
United States.
Normative statements involve value judgment and expresses what ought to be. Ex: European nations
ought to undertake policies to reduce their unemployment rates
4. Ceteris paribus or the other-things-equal assumption assumes that all other variables except those
under immediate consideration are held constant for a particular analysis. For example, when
considering the relationship between the price of Pepsi and the amount of it purchased, it helps to
assume that all other factors that might influence the amount of Pepsi purchased (ex: price of Coca-
Cola) stay constant while only the price of Pepsi varies.
Fallacy of composition is the assumption that what is true for one individual or part of a whole is
necessarily true for a group of individuals or the whole. Ex: As an individual, standing up at a football
game improves your view, but if everyone stands up, then there will be no improvement.
Post hoc fallacy is also known as the “after this, therefore because of this” fallacy; because event A
precedes event B, A is the cause of B. Ex: a football team hires a new coach and the team’s record
improves, so the new coach is the cause.
5. Scarcity limits options and requires that we make choices. Because we can’t have it all, we must
decide what we will have, and what we must forgo. Scarce resources are the limited quantities of
land, capital, labor, and entrepreneurial ability that are never sufficient to satisfy people’s virtually
unlimited economic wants.

Chapter 2
1. The economizing problem is that the economic wants of its citizens and institutions are virtually
unlimited and insatiable, but the means of producing goods and services are limited or scarce.
2. Land includes all natural resources that are used in the production process. Ex: arable land,
forests, mineral and oil deposits, and water resources.
Capital includes all manufactured aids used in producing consumer goods and services. Ex: all
tools, machinery, equipment, factory, storage, transportation, and distribution facilities. Capital
does not refer to money.
Labor is a broad term for all the physical and mental talents of individuals available and usable in
producing goods and services. Ex: logger, retail clerk, machinist, teacher, professional football
player, nuclear physicist
Entrepreneurial ability refers to the special human resources distinct from labor. Ex: The
entrepreneur takes the initiative in combining the resources of land, capital and labor to produce a
good/service. The entrepreneur makes basic business-policy decisions. The entrepreneur
commercializes new products, new production techniques, or even new forms of business
organization. The entrepreneur risks not only his or her invested funds but those of associates and
stockholders as well.
3. Consumer goods are products and services that satisfy wants directly.
Capital goods are the human-made resources used to produce consumer goods/services and do
not satisfy wants directly.
4. Causes of shifts in the curve: increase in the supply of resources, improvements in technology,
and an allocation of goods that has capital accumulation (some consumption must be given up
today so that more capital goods can be produced)
 5. Points inside the curve are attainable, but they reflect inefficiency and therefore are not as
desirable as points on the curve; these points imply that the economy could have more of both
books and pizzas if it achieved full employment and productive efficiency. Points outside the
curve would represent a greater output than the output at any point on the curve. Such points,
however, are unattainable with the current supplies of resources and technology.
6. The law of increasing opportunity costs states that the more of a product that is produced, the
greater is its opportunity cost. This law is reflected in the shape of the production possibilities
curve: The curve is bowed out from the origin of the graph. As the economy moves from point A
to point E, it must give up successively larger amounts of books (1, 2, 3, and 4) to acquire equal
increments of pizza (1, 1, 1, and 1)
7. Capitalism refers to the market system, which is characterized by the private ownership of
resources and the use of markets and prices to coordinate and direct economic activity. Goods
and services are produced and resources are supplied by whoever is willing and able to do so.
Prices are determined by market prices.
In command economy, the government owns most property resources and economic decision
making occurs through a central economic plan. (also known as socialism or communism). The
use of resources, the composition and distribution of output, and the organization of production
are all decided on by the govt. Prices are determined by govt.
Traditional economies are very underdeveloped economies that often depend on agriculture as its
main base. The economy works through bartering and trading, and there is very little of that
because so little surplus is produced. There may be no prices whatsoever.
8.

Chapter 3
1. Law of demand states all things equal, as price falls, the quantity demanded rises, and as price
rises, the quantity demand falls (inverse relationship).
Law of diminishing marginal utility states that each buyer of a product will derive less
satisfaction (or benefit, or utility) from each successive unit of the product consumed. (Ex: the
second Big Mac will yield less satisfaction to the consumer than the first, and the third still less
than the second)
Income effect indicates that a lower price increases the purchasing power of a buyer’s money
income, enabling the buyer to purchase more of the product than he/she could buy before.
Substitution effect suggests that at a lower price, buyers have the incentive to substitute what is
now a less expensive product for similar products that are now relatively more expensive. (ex: if
the price of chicken is low, people will buy chicken instead of beef)
2.

3. Taste – a change in consumer preferences for a product that makes the product more desirable
means that more of it will be demanded at each price
Income – a rise in income causes an increase in demand
Market size – an increase in the number of buyers in a market increases demand
Expectations – a newly formed expectation of higher future prices may cause consumers to buy
now in order to beat the anticipated price rises, thus increasing demand
Related goods (substitutes and complements) - when two products are substitutes, the price of one
and the demand for the other move in the same direction; when two products are complements,
the price of one good and the demand for the other good move in opposite directions
4. Change in demand is a shift of the entire demand curve to the right or to the left and occurs
because the consumer’s state of mind about purchasing the product has been altered in response
to a change in one or more of the determinants of demand.
Change in quantity demanded is a movement from one point to another point on a demand curve
and occurs as a result of a change in increase or decrease in the price of a product
5. A substitute good is one that can be used in place of another good – when the price of beef rises,
consumers buy less beef, increasing the demand for chicken.
A complement good is one that is used together with another good - when the price of movie
tickets rises, the demand for it falls, as well as the demand for popcorn.
6.

7. Subsidies/taxes – an increase in taxes reduces supply; an increase in subsidies increases supply

Technology – increase in technology increases supply
Prices of Other goods – an increase in price of soccer ball will shift production to other goods that
are cheaper and decrease supply of soccer ball
Number of Sellers – the larger the number of suppliers, the greater the supply
Price Expectations – if a farmer anticipates high corn prices in the future, he will sell his corn
later and decrease the supply of corn
Raw materials/Resources – decrease in the prices of seed/fertilizer increases the supply of corn
8. Change in supply means a change in the entire schedule and shift of the entire curve and is caused
by a change in one or more of the determinants of supply.
Change in quantity supplied is a movement from one point to another point on the supply curve
and is the result of a change in the price of the product. If prices move from $5 to $4, then the
quantity of corn moves from 12,000 to 10,000
 9.

10. Price ceilings are legally established maximum price for a good or service (prices cannot go
above the ceiling). This causes a shortage, because the decrease in prices will result in too many
people buying.
Price floors are legally determined prices above the equilibrium price (prices cannot go below the
floor). This causes a surplus, because the increase in prices will result in not enough people
buying

Chapter 4
1. Private property - in a market system, private individuals and firms, not the government, own
most of the property resources (land and capital).
Freedom of enterprise – entrepreneurs/businesses are free to obtain and use economic resources
to produce their choice of goods and services and to sell them in their chosen markets; freedom of
choice – enables owners to employ/dispose of their property and money as they see fit
Self-interest – each economic unit tries to do what is best for itself
Competition – basic regulatory force; the presence in a market of independent buyers and sellers
competing with one another and the freedom of buyers and sellers to enter and leave the market
Markets and prices – give the system its ability to coordinate economic decisions; a market
system is necessary to convey the decisions made by buyers and sellers of products and resources
Reliance on technology and capital goods
Specialization – division of labor
Use of money – money is used as a medium of exchange that is generally acceptable to sellers in
exchange for goods and services
Active, but limited, government
2. Specialization is the use of the resources of an individual, a firm, a region, or a nation to
concentrate production on one or a small number of goods and services.
Division of labor is the separation of the work required to produce a product into a number of
different tasks that are performed by different workers (specialization of workers).
Comparative advantage refers to whoever has the lowest opportunity cost. A nation has a
comparative advantage when it can produce a product at a lower domestic opportunity cost than
can a potential trading partner.
Absolute advantage refers to whoever makes the most.
3. Firms and resources suppliers, seeking to further their own self-interest and operating within the
framework of a highly competitive markets system, will simultaneously, as though guided by an
invisible hand, promote the public or social interest. Ex: businesses use the least-costly
combination of resources to produce a specific output because it is in their self interest to do so

CHAPTER 5
1. Business types in the US
Sole Proprietorship
Strengths: easy to organize, owner has freedom & power
Weaknesses: limited capital, lack of managerial expertise, unlimited liability
Partnership
Strengths: easy to organize, can raise greater amounts of capital, 2 heads are better than 1
Weaknesses: conflict between partners, unlimited liability
Corporation
Strengths: can raise huge amounts of capital through sale of stocks, limited liability, unlimited
life
Weaknesses: hard to establish, owners give up ownership, double taxation
2.

3. To provide legal structure, maintain competition, redistribute income, reallocate resources, promote
stability
4. To provide a legal framework and to maintain competition
5. Spillover costs: cost imposed without compensation on third parties by production or consumption of
sellers or buyers
Spillover benefits: benefit obtained without compensation on third parties by production or
consumption of sellers or buyers

6. To stabilize economy by adjusting spending, tax revenues, & interest rates

7. Public goods- good or service that IS indivisible and to which the exclusion principle does not apply
Free rider principle- inability of potential providers of an economically desirable but indivisible good
or service to obtain payment from those who benefit, because the exclusion principle IS not
applicable
8. Government purchase- exhaustive; the products purchased directly absorb resources and are part of
the domestic output
Transfer payment- non exhaustive; they do not directly absorb resources or create output; social
security benefits, welfare payments
9. Progressive- more earned, higher % paid in taxes
Regressive- less earned, higher % paid
Proportional (flat tax)- everyone pays same % regardless of income
10. Tax revenues- personal income tax, payroll taxes, corporate income tax, excise taxes
Expenditures- pensions & income security, health, national defense, interest on public debt
11. Tax revenues- sales & excise taxes, personal income tax, corporate income tax, licenses, property
taxes
Expenditures- education, public welfare, heath & hospitals, highways, public safety
12. Tax revenues- property taxes, sales & excise taxes, personal & corporate income taxes
Expenditure- education, welfare, health, hospitals, public safety, housing & sewage, highways
Chapter 6
1. Market in which various national currencies are exchanged for one another
2. protective tariffs
import quotas
nontariff barriers
export subsidies
3. It was legislation passed in 1930 that established very high tariffs to reduce imports & stimulate the
domestic economy, but resulted in retaliatory tariffs by other nations
4. GATT: international agreement reached in 1947 in which 23 nations agreed to give equal and
nondiscriminatory treatment to one another, to reduce tariff rates by multinational negotiations and to
eliminate import quotas
WTO: organization established in 1994 to replace GATT to oversee the provisions of the Uruguay
Round & resolve any disputed stemming from it
EU: an association of 15 European nations that has eliminated tariffs & import quotas among them,
established common tariffs for goods imported from outside the member nations, allowed the free
movement of labor and capital among them, & created other common economic policies
NAFTA: 1993 agreement established, over a 15 year period, a free trade zone composed of Canada,
Mexico & US

Chapter 7
1. GDP: total market value of all final goods & services produced in a given year
GNP: total market value of all final goods & services produced during a particular time period by US
residents
2. Inflation and double counting.
3. Expenditures Approach: add up all money spent in a year
Income Approach: add up all money earned in a year
4. GDP = C + Ig + G + Xn
-C: consumer spending, largest part of GDP
-Ig: gross investment/business spending; includes construction spending & purchasing of capital
goods
-G: government spending; all purchases & activities of government
-Xn: net exports; exports - imports
5. All final purchases of machinery, equipment, & tools
All construction
Changes in inventories
6. Gross Investment: expenditures for newly produced capital goods & for additions to inventories
Net Investment: gross private domestic investment less consumption of fixed capital
7. All the income that flows to American -supplied resources, whether here or abroad
8. All income received whether earned or unearned
9. Personal income less personal taxes
10. Price index in given year = (price of market basket in specific year) / (price of same market basket in
base year) x 100

11. It measures the prices of a fixed market basket of some 300 goods & services bought by a typical
consumer
12. Nominal/Unadjusted GDP: based on prices that prevailed when output was produced
Real/Adjusted GDP: deflated/inflated to reflect changes in the price level

Chapter 8
1. Peak: temporary period of full employment & near capacity output
Trough: bottom of a recessionary period
Recession: decline from peak to trough
Recovery: expansion from trough to peak
2. Frictional unemployment: short term, less than 6 weeks, people in between jobs, somewhat desirable
b/c indicates mobility in economy
Cyclical unemployment: caused by recession phase of business cycle, people who are laid off as we
enter recession
Structural unemployment: caused by changes in structure of demand for labor, occurs when jobs
become obsolete or when the geographic need for jobs changes
3. It is the use of all variable resources to produce want-satisfying goods & services.
The situation in which the unemployment rate is equal to the full- employment unemployment rate &
there is frictional & structural but no cyclical unemployment (& the real GDP of the economy equals
potential output)
4. For every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a GDP
gap of about 2 percent occurs
5. Cost push inflation: increases in the price level (inflation) resulting from an increase in resource costs
& hence in per-unit production costs; inflation caused by reductions in aggregate supply
Demand pull inflation: increases in the price level (inflation) resulting from an excess of demand over
output at the existing price level, caused by an increase in aggregate demand
6. Lenders: hurt by inflation
Borrowers: helped by inflation
Persons on fixed income: hurt by inflation
Savers: hurt by inflation
7. Cost-of-living adjustment (COLA) - an automatic increase in the income of workers when
inflation occurs; guaranteed by a collective bargaining contract between firms & workers.

Rule of 70- a method of determining the number of years it will take for some measure to double,
given its annual percentage increase. (70/x)

Chapter 11

1. Real Balances Effect, Interest-Rate Effect, Foreign Purchases Effect

2. Change in consumer spending
Change in investment spending
Change in government spending
Change in net export spending
(C+Ig+G+Xn)
3.
 4. Horizontal Range- price level is constant as real domestic output changes

Intermediate (Up-sloping) Range- an expansion of real output is accompanied by a rising price level

Vertical Range- economy is at full capacity

5. Change in input prices, productivity, and legal-institutional environment

6.

7.

Notes on Keynes

1. Act of producing creates enough income to purchase everything that was made. “Supply creates
its own demand”

2. Keep the size of the puddle equal to the size of the syringe.

3. Full employment is the natural state. If under spending did occur, prices and wages would come
down to return the economy to equilibrium.

4. Interest rates, and profit expectations

5. Because Keynes believes in the Ratchet Effect, in which prices only move in one direction, up.

6. MPC- Change in Consumption/Change in Disposable Income ( C/ DI)

MPS- Change in Savings/Change in Disposable Income ( S/ DI)

APC- Consumption/Income (C/DI)

APS- Savings/Income (S/DI)

 7. Unintended investment is the growth of inventory. Not a good thing.

8. The multiplier effect is the effect on equilibrium GDP of a change in aggregate expenditures or
aggregate demand (caused by a change in the consumption schedule, investment, government
expenditures, or net exports)

Multiplier= 1/MPS or 1/(1-MPC)

Chapter12

1. Balanced budget multiplier holds that if government revenues and expenditure increase or
decrease simultaneously and equally, then national income will also change in the same amount -
which means that the balanced budget multiplier equals to 1.

2. The government officially commits to positive monetary & fiscal policy to maintain economic
stability.

3. Deliberate changes in taxes (tax rates), and government spending by Congress to promote full
employment, price stability, & economic growth.

4. Speed up: Expansionary Fiscal Policy (easy money) - raise government spending and lower taxes.

Slow down: Contractionary Fiscal Policy (tight money) - lower government spending and raise taxes

5. In a progressive tax system, the average tax rate rises with GDP. The more progressive the tax
system, the greater the economy’s built-in stability.

6. Recognition lag- it takes Congress time to realize that there’s a problem w/ the economy.

Administrative lag- it takes Congress time to pass legislation.

Operational lag- it takes time for the legislation to have effect on the economy.

7. Deficit spending causes government to borrow money, driving up interest rates & crowding out
investors out of the market.

8. If the Federal Budget is balanced at the outset, expansionary fiscal policy will create a budget
deficit-government spending in excess of tax revenues.

Chapter 13

1. Medium of Exchange, unit of account, Store of Value.

2. M1= coins & currency + checkable deposits.

M2= M1 + saving deposits + small certificates of deposits.

M3= M2 + large certificates of deposits

3. Transaction demand- the amount of money people want to hold for use as a medium of
exchange (to make payments); varies directly w/ nominal GDP.
Asset demand- the amount of money people want to hold as a store of value; varies inversely w/
interest rate.

Total demand- sum of transaction & asset demand.

 4. Member’s terms are staggered every two years; terms last 14 years.

5. 12 Federal Banks, the most important is the Federal Reserve Bank of New York

Chapter 14

1. Fractional reserve system- only a fraction of the total money supply is held in reserve as currency
2. Banks create money through lending. When someone asks for a loan, the bank creates the money
for the loan in that person’s checking account.
3. Reserve ratio - the ratio of the required reserves the commercial bank must keep to the bank’s
own outstanding checkable-deposit liabilities; a percent value
4. Actual reserves- cash reserves
Required reserves - funds equal to a specified percentage of checkable-deposit liabilities that banks
and thrifts must deposit with the Federal Reserve Bank (or hold as vault cash) to meet the legal
reserve requirement
Excess reserves- actual reserves – required reserves
5. Reciprocal of the MPS. Exists because the reserves and deposits lost by one bank are received by
another bank.
Chapter 15

1. Lower/Raise reserve ratio, Lower/Raise discount rate – interest rate on banks, and buy/ sell
bonds.

2. Easy Money- used to solve recession; lower reserve ratio, lower discount rate, and buy bonds;
money supply is increased; lower interest rate; gross investment increases; aggregate demand
increases

Tight Money- used to solve inflation; raise reserve ratio, raise discount rate, sell bonds; money supply
is decreased; higher interest rate; gross investment decreases; aggregate demand decreases

3. Should the Fed control interest rates or money supply?

Chapter 16

1. Keynesians= spending is the key to economy.

Monetarists= key to economy is money supply

2. MV = PQ

M- money supply

V- velocity of money – average number of times per year a dollar is spent on final goods and
services

P-price level;

Q- quantity of all goods and services sold

Monetarists believe that V is stable, so only changes in money supply affect GDP: PQ = GDP

3. Monetary Rule- Fed should increase money supply by a stable 3-5% each year to keep the
economy growing at a reasonable pace

4. Rational Expectations Theory- idea that businesses, consumers, and workers expect changes in
policies or circumstances to have certain effects on the economy and, in pursuing their own self-
interest, take actions to make sure those changes do not affect them; beliefs: all markets clear, prices
and wages are flexible, people have access to all available sources of information and use it to act
rationally, only policies that work are surprises, economic models don’t work

5. Phillips Curve- shows the inverse relationship between unemployment and inflation, as inflation
decreases, unemployment increases

6. Supply shocks can shift the entire curve.

7. Stagflation- simultaneous rise in inflation and unemployment

8. Supply shocks-sudden, large changes in resource costs that shift an economy’s aggregate supply
curve

9. People expect there to be inflation in the future so they spend their money while it worth more,
thereby causing inflation in doing so. Self-fulfilling prophecy.

10. Laffer Curve - depicts relationship between tax rates and tax revenues, as tax rates increase from
0% to 100%, tax revenues increase from 0 to some maximum level, m, and then fall to 0; higher tax
rates discourage economic activity
 11. Supply-siders focus their attention on marginal tax rates, the rates on extra dollars of income,
because those rates affect the benefits from working, saving, or investing more.

Misc.

1. Deficit- amount by which government expenditures exceed government revenues in a given year

Debt -total accumulation of deficits the Federal government has incurred through time; total amount
of money owed by the Federal government to the holders of U.S. securities

2. Wars, recessions, and tax-rate cuts

3. U.S. individuals
Foreign ownership
U.S. banks and other financial institutions,
State and local governments,
Federal Reserve
U.S. government agencies
4. Public debt does not have to paid off, and the gov’t can print money to pay off the debt.

5. Functional finance - the use of fiscal policy to achieve a noninflationary full-employment gross
domestic product without regard to the effect on public debt; economic balance is the main goal, not
budget balancing

6. A stronger currency makes imports cheaper and exports more expensive. A weaker currency
makes imports more expensive and exports cheaper.

7. Trade deficit- imports exceed exports

Philosophies

Adam Smith- came up with the Invisible Hand in capitalism. If the government does not do anything,
there's a controlling factor of people themselves who can guide markets. If you sell books for 1 dollar
each and some a competitor sells them for 50 cents, they will get all the business. So, you'll lower prices
to compete. The Invisible Hand that guides us all.

Thomas Malthus- contributed the notion that man's economic growth is self-limiting because such growth
induces population growth which consumes all of what increment is produced.

David Ricardo- theory on international trade focused on comparative costs and looked at how a country
could gain from trade when it had relatively lower costs (i.e. a comparative advantage). Extra land that
was brought into cultivation would become more and more marginal in terms of profitability, and
eventually returns would not be enough to attract any further capital. At this point the maximum level of
economic rent would have been earned.

John Maynard Keynes- believed that an active government intervention in the marketplace and monetary
policy is the best method of ensuring economic growth and stability.
Milton Friedman- Started Monetarism. In general, he argued that government discretionary "fine-tuning"
of the economy, as had been proposed by Keynesians, ought to be replaced with iron "rules" of policy -
notably his famous "money supply growth" rule.