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Explain the forces that determine potential GDP and the distribution of income between labor and other

factors of production. Distinguish between real and nominal variables and explain the importance of the classical dichotomy. Define potential GDP. Define the production function and explain how its shape reflects diminishing returns. Explain the factors that influence the demand and supply of labor. Discuss how equilibrium in the labor market is achieved and describe the labor market's role in determining potential GDP. State how the equilibrium in the labor market determines the functional distribution of income.

Explain what creates unemployment when the economy is at full employment and describe the influences on the natural unemployment rate. Define the natural unemployment rate. Explain what determines job search, with emphasis on the roles played by demographic changes, unemployment benefits, and structural change. Define "job rationing" and explain how job rationing affects the natural unemployment rate. Explain how efficiency wages, the minimum wage, and union wages can lead to job rationing.

Preview the aggregate supply-aggregate demand (AS-AD) model and explain why real GDP fluctuates around potential GDP. Discuss aggregate supply and explain how is it affected by changes in the price level. List factors that change aggregate supply and shift the aggregate supply curve. Discuss aggregate demand and explain how is it affected by changes in the price level. List factors that change aggregate demand and shift the aggregate demand curve. Explain and illustrate macroeconomic equilibrium. Illustrate the three types of macroeconomic equilibrium: full-employment equilibrium, above full-employment equilibrium, and below full-employment equilibrium.

Define and explain the relationships among capital, investment, wealth, and saving. Define physical capital and financial capital, and state how the two are related. Define gross investment and net investment and explain the relationship between net investment and the capital stock. Define wealth and saving and explain how the two are related. Describe financial markets, including the stock market, bond market, short-term securities market, and loan market.

Explain how investment and saving decisions are made and how these decisions interact in financial markets to determine the real interest rate. Explain how the real interest rate affects investment demand. Draw an investment demand curve and discuss what factors change investment and shift the investment demand curve. Explain how the real interest rate affects the supply of saving. Draw a saving supply curve and discuss what factors change saving and shift the saving supply curve. Draw a figure showing equilibrium in the financial market and use the figure to determine how changes in investment and saving affect the real interest rate and the quantity of investment.

Explain how government influences the real interest rate, investment, and saving. Explain the formula I = S + (NT - G). Describe and illustrate the effect a government budget surplus has on the real interest rate and quantity of investment. Describe and illustrate the effect a government budget deficit has on the real interest rate and quantity of investment. Define crowding out and describe why it occurs. Explain how the Ricardo-Barro effect modifies the conclusions from the crowding-out effect.

Define and calculate the economic growth rate, and explain the implications of sustained growth. Tell how the economic growth rate is measured. Define and be able to calculate the growth rate of real GDP. Explain how living standards change as real GDP per person grows. Be able to calculate the growth rate of real GDP per person. Explain and be able to use the Rule of 70.

Identify the main sources of economic growth. Explain why growth in real GDP can be divided into growth in aggregate hours and growth in labor productivity. Tell how labor productivity is measured, and discuss the importance of growth in labor productivity. List and explain the three sources of growth in labor productivity. Illustrate a productivity curve and distinguish between the factors that shift the curve from those that create a movement along the curve. Explain the law of diminishing returns. Use the one third rule to divide labor productivity growth into growth resulting from increases in capital per hour of labor, and growth resulting from technological advancements.

Review the theories of economic growth that explain why growth rates vary over time and across countries. Explain the classical theory of growth and tell why it predicts a return to subsistence living standards. Explain the neoclassical growth theory and describe why it predicts that eventually all countries will have similar living standards and growth rates. Explain the new growth theory and discuss why it predicts growth rates and living standards will vary across countries as long as incentives vary across countries. Discuss the evidence from growth in the global economy.

Describe policies that might speed economic growth. List and explain the preconditions for economic growth, with an emphasis on economic freedom. Describe the five policies the government can take to increase economic growth. Discuss the extent to which government policy can affect economic growth.

Economic growth depends on growth in resources and in technology. Chapter 8 explored elements dealing with the market for one resource, labor, and Chapter 9 dealt with another resource, capital. Chapter 10 concludes the study of economic growth by building on these chapters. Chapter 10 combines their insights to discuss the factors that determine economic growth, study different theories that explain economic growth, and examine possible government polices to speed economic growth. Define and calculate the economic growth rate, and explain the implications of sustained growth. Economic growth is the increase in a nation's production possibilities. The economic growth rate equals the growth rate of real GDP, the annual percentage change in real GDP. Growth in the standard of living is measured by the growth rate of real GDP per person, real GDP divided by the population. Identify the main sources of economic growth. Growth in real GDP occurs when resources grow or when technology advances. Labor productivity equals real GDP divided by total hours worked. Growth in real GDP per person requires growth in labor productivity. Labor productivity grows if workers use more capital, acquire more human capital, or discover better technology. The productivity curve shows how labor productivity changes as the amount of capital per hour of work changes with no change in technology. The one third rule is that a one percent increase in capital per hour of work brings about a one third percent increase in labor productivity. The productivity curve shifts upward when technology or human capital increase. Review the theories of economic growth that explain why growth rates vary over time and across countries. The classical theory asserts that a one-time rise in labor productivity leads to higher living standards. Higher living standards lead to faster population growth, followed by diminishing returns and a return to subsistence living standards. The neoclassical theory assumed growth in technology so that living standards increase, but the higher living standards do not lead to faster population growth. Economic growth lasts as long as technology grows. The new growth theory assumes growth depends on people's decisions. Economic growth will persist indefinitely but only societies with strong profit incentives to innovate, to acquire and education, and to invest will grow rapidly. Describe policies that might speed economic growth. Governments can increase economic growth by creating incentives to save, invest, and innovate; by encouraging savings; by encouraging research and development; by encouraging international trade; and, by improving the quality of education.

Chapter 9 shows how the nation's capital is replaced and increased through investment. Investment requires saving. Saving is disposable income minus consumption and adds to wealth. Saving is converted into investment through financial markets. Define and explain the relationships among capital, investment, wealth, and saving. Physical capital (also called "capital") is the tools, machines, buildings, and so on that have been produced in the past and are now used to produce additional goods and services. Financial capital is the funds firms use to buy and operate physical capital. Gross investment is the total amount spent on new capital goods. Net investment is gross investment minus depreciation. Net investment equals the change in the capital stock from one period to the next. Wealth is the value of all the things a person owns. Saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Financial markets are where lending and borrowing take place. Financial markets determine the price of financial capital, which is expressed as an interest rate. Explain how investment and saving decisions are made and how these decisions interact in financial markets to determine the real interest rate. Firms demand investment gods. Other things remaining the same, the higher (lower) the real interest rate, the smaller (greater) is the quantity of investment demanded. The negatively sloped investment demand curve shows how the quantity of investment demanded depends on the real interest rate. Investment demand changes when expected profit changes. A business cycle expansion, technological change, population growth, and subjective feelings of optimism increase expected profits and thereby increase investment demand. Households supply savings. Other things remaining the same, the higher (lower) the real interest rate, the greater (smaller) is the quantity of saving supplied. The positively sloped saving supply curve shows how the quantity of saving depends on the real interest rate. An increase in disposable income, a decrease in the buying power of net assets, or a fall in expected future disposable income increase saving. The financial market equilibrium occurs at the real interest rate that sets the quantity of investment demanded equal to the quantity of saving supplied. Explain how government influences the real interest rate, investment, and saving. In the global economy, I = S + (NT - G) where I is investment, S is private saving, NT is net taxes, and G is government purchases. NT - G equals government saving. A government budget surplus, NT > G, adds to private saving, resulting in a lower real interest rate and increased investment. A government budget deficit, NT < G, decreases saving, resulting in a higher real interest rate and decreased investment. The government budget deficit crowds out investment. The Ricardo-Barro effect asserts that private saving increases to offset a government budget deficit so that no crowding out occurs.

Chapter 8 examines the determination of potential GDP and a related concept, the natural unemployment rate. It also begins the discussion of movements away from potential GDP, which occur during the business cycle, by introducing the aggregate supply-aggregate demand model. Explain the forces that determine potential GDP and the distribution of income between labor and other factors of production. The classical dichotomy asserts that if the economy is at full employment, the forces that determine real economic variables are independent of those that determine nominal variables. When resources are fully employed the level of output is potential GDP. The production function shows the maximum quantity of real GDP that can be produced for all levels of employment. Its shape reflects diminishing returns, so that as more labor is employed, the additions to real GDP get smaller. Employment is determined in the labor market. The quantity of labor demanded increases (decreases) as the real wage rate falls (rises). The quantity of labor supplied increases (decreases) as the real wage rises (falls). Equilibrium is at the intersection of the labor supply and demand curves. The equilibrium employment is full employment, which is the amount of labor that produces potential GDP. Explain what creates unemployment when the economy is at full employment and describe the influences on the natural unemployment rate. At full employment, the natural unemployment rate consists of frictional and structural unemployment. The natural unemployment rate is the result of job search, which occurs when unemployed workers look for a job, and job rationing, which occurs when the real wage rate exceeds the equilibrium wage rate so that there is a surplus of labor. The amount of job search depends on demographics, unemployment benefits, and structural change. Job rationing is the result of efficiency wages, the minimum wage, and union wages, all of which raise the wage rate above its equilibrium level. Preview the aggregate supply-aggregate demand (AS-AD) model and explain why real GDP fluctuates around potential GDP. The aggregate supply-aggregate demand model is used to analyze business cycle movements. Aggregate supply is the output from all firms. Other things remaining the same, an increase in the price level increases the quantity of real GDP supplied. Aggregate demand is the demand from all buyers. Other things remaining the same, an increase in the price level decreases the quantity of real GDP demanded. Macroeconomic equilibrium occurs at the intersection of the aggregate supply and aggregate demand curves. The macroeconomic equilibrium might be a full-employment equilibrium (real GDP equals potential GDP), an above full-employment equilibrium (real GDP exceeds potential GDP), or a below full-employment equilibrium (real GDP is less than potential GDP).

Explain the forces that determine potential GDP and the distribution of income between labor and other factors of production. The production function describes the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. As the quantity of labor increases, real GDP increases. The quantity of labor demanded increases as the real wage rate falls, other things remaining the same. The quantity of labor supplied increases as the real wage rate rises, other things remaining the same. At full-employment equilibrium, the real wage makes the quantity of labor demanded equal the quantity of labor supplied. Potential GDP is the level of real GDP that the full-employment quantity of labor produces.

Explain what creates unemployment when the economy is at full employment and describe the influences on the natural unemployment rate. The unemployment rate at full employment is the natural unemployment rate. Unemployment is always present because of job search and job rationing. Job search is influenced by demographic change, unemployment compensation, and structural change. Job rationing arises from efficiency wages, the minimum wage, and union wages.

Preview the aggregate supplyaggregate demand (AS-AD) model and explain why real GDP fluctuates around potential GDP. A rise in the price level brings an increase in the quantity of real GDP supplied and a decrease in the quantity of real GDP demanded, other influences on production and expenditure remaining the same. When the quantity of real GDP supplied equals the quantity of real GDP demanded, real GDP might equal, exceed, or be less than potential GDP.

Define and explain the relationships among capital, investment, wealth, and saving. Firms borrow financial capital to buy and operate physical capital. Gross investment is the total amount spent on physical capital in a given period. Net investment equals gross investment minus depreciation. Wealth is the value of what people own; saving is the amount of income that is not spent, and it adds to wealth. A financial market (stock, bond, short-term securities, or loans market) is the collection of households, firms, government, banks, and other financial institutions that lend and borrow to finance the purchase of physical capital.

Explain how investment and saving decisions are made and how these decisions interact in financial markets to determine the real interest rate. Other things remaining the same, the higher the real interest rate, the greater is saving. Saving supply changes when disposable income, the buying power of net assets, or expected future disposable income changes. Other things remaining the same, the lower the real interest rate or the higher the expected profit rate, the greater is the amount of investment. Investment demand changes when the expected profit rate changes. Because capital is free to move internationally to seek the highest possible real rate of return, the real interest rate is determined in a global market. The equilibrium real interest rate makes global saving equal to global investment

Explain how government influences the real interest rate, investment, and saving. National saving equals private saving plus government saving. Government saving equals net taxes minus government purchases. A government budget deficit might increase the real interest rate and crowd out private investment. A government budget deficit might also increase private saving supply because it decreases expected future disposable income.

Define and calculate the economic growth rate, and explain the implications of sustained growth. Economic growth is the sustained expansion of production possibilities. The annual percentage change in real GDP measures the economic growth rate. Real GDP per person must grow if the standard of living is to rise. Sustained economic growth transforms poor nations into rich ones. The Rule of 70 tells us the number of years in which real GDP doubles70 divided by the percentage growth rate of real GDP.

Identify the main sources of economic growth. Real GDP grows when aggregate hours and labor productivity grow. Real GDP per person grows when labor productivity grows. Saving, investment in physical capital and human capital, and technological advance bring labor productivity growth. The productivity curve shows how labor productivity changes when capital per hour of labor changes, other things remaining the same. The productivity curve shifts when human capital expands and technology advances.

Review the theories of economic growth that explain why growth rates vary over time and across countries. Classical theory predicts that economic growth will end because a population explosion will lower real GDP per person to its subsistence level. Neoclassical theory predicts that economic growth will persist at a rate that is determined by the pace of technological change. New growth theory predicts that capital accumulation, human capital growth, and technological change respond to incentives and can bring persistent growth in labor productivity.

Describe policies that might speed economic growth. Economic growth requires an incentive system created by economic freedom, property rights, and markets. It might be possible to achieve faster growth by encouraging saving, subsidizing research and education, and encouraging international trade.

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