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Short Possible Answer Terms Chapter 5 1. Trade Balance: a. In an open economy, the trade balance is represented by Net Exports, which is Savings minus Investment. Or, Output minus Domestic Spending. If NX is positive, we have a trade surplus. In this case we are net lenders in the world financial markets and we are exporting more goods than we are importing. If NX is negative, we have a trade deficit. In this case, we are net borrowers in world financial markets and we are importing more goods than we are exporting. If S I and NX are exactly zero, we are said to have balanced trade. b. Also, if trade surplus, output is greater than domestic spending and if a trade deficit, output is less than domestic spending 2. Net Capital Outflow: a. Represented as saving minus investment which equals net exports. 3. How Policies Influence the Trade balance a. Fiscal Policy at Home i. Increase in Government Spending in small open economy 1. Reduces national saving because S = Y C G 2. Unchanged world real interest rate, investment remains the same 3. Saving falls below investment and now we have a trade deficit ii. Decrease in taxes 1. Lowers T 2. Raises disposable income (Y T) 3. Stimulates consumption 4. Reduces national saving iii. Starting from a balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit b. Fiscal Policy Abroad i. Foreign government increases government spending 1. If small, nothing changes for our country 2. If large, a. Reduces world saving b. World interest rate rises c. Raises cost of borrowing d. Reduces investment in our small open economy e. No change in domestic saving, saving S now exceeds investment I and we have a trade surplus 3. Starting from balanced trade, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus c. Shifts in Investment Demand i. If the demand for investment goods at every interest rate increases (would occur if for example, the government changed the tax laws to encourage investment by providing an investment tax credit) an outward shift in the investment schedule would cause a trade deficit 1. Net capital outflow is negative 4. Nominal Exchange Rate a. The relative price of the currency of two countries i. 1 dollar is 120 yen for example 5. Real Exchange Rate a. The relative price of the goods of two countries b. Tells us the rate at which we can trade the goods of one country for the goods of another c. If the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. If real exchange rate is low, foreign goods are relatively expensive and domestic goods are relatively cheap. 6. How policies influence the real exchange rate a. Fiscal Policy at home i. Government reduces national saving by increasing government purchases or cutting taxes 1. Lowers S I and thus NX 2. Causes trade deficit 3. Raises real exchange rate b. Fiscal policy abroad i. Foreign governments increase government purchases or taxes 1. Reduces world saving 2. Raises world interest rate 3. Reduces domestic investment here 4. Raises S I which raises NX 5. Causes trade surplus c. Shifts in Investment Demand i. Congress passes an investment tax credit 1. Higher value of I 2. Lower value of S I and lower NX 3. Causes trade deficit 7. Purchasing Power Parity a. Law of one price i. The same good cannot sell for different prices in different locations ii. If wheat sold for less in New York than in Chicago, it would be profitable to buy in one and sell in the other. It would become apparent quickly. As arbitrageurs took advantage of this, they would increase the demand in New York and increase the supply in Chicago. It would drive the prices up in New York and down in Chicago, thereby ensuring that prices are equalized in the two markets. b. Purchasing Power Parity i. Stats that if interventional arbitrage is possible, then a dollar must have the same purchasing power in every country ii. 2 important implications 1. Because NX schedule is flat, changes in saving or investment do not influence the real or nominal exchange rate 2. Because the real exchange rate is fixed, all changes in the nominal exchange rate result from changes in price levels iii. Not entirely realistic 1. Many goods are not easily traded a. A haircut for example 2. Even tradable goods are not always perfect substitutes a. Toyota's versus Ford's Chapter 6 8. Frictional Unemployment a. The unemployment caused by the time it takes workers to search for a job b. Solutions i. Job finding programs ii. Unemployment insurance 1. Inadvertently increases the amount of frictional unemployment 9. Structural Unemployment a. Wage Rigidity i. The failure of wages to adjust to a level at which labor supply equals labor demand ii. When the real wage is above the level that equilibrates supply and demand, the quantity of labor supplied exceeds the quantity demanded 1. Can happen from: a. Minimum Wage Laws b. Unions c. Efficiency wages b. Structural Unemployment results from wage rigidity and job rationing i. It arises because firms fail to reduce wages despite an excess supply of labor Chapter 7 10. Steady State a. There is a single capital stock at which the amount of investment equals the amount of depreciation (for chapter 7). If the economy finds itself at this level of the capital stock, the capital stock will not change because the two forces acting on it--investment and depreciation--just balance. Rather than growing or shrinking, they are at a steady state or called the steady-state level of capital. The steady state represents the long-run equilibrium of the economy. 11. How Saving affects Growth a. If the saving rate is high, the economy will have a large capital stock and a high level of output in the steady state. If the saving rate is low, the economy will have a small capital stock and a low level of output in the steady state. b. Higher saving leads to faster growth in the Solow model, but only temporarily. An increase in the rate of saving raises growth only until the economy reaches the new steady state. 12. Golden Rule Level of Capital a. What steady state should the policymaker choose? i. When choosing a steady state, the policymaker's goal is to maximize the wellbeing of the individuals who make up the society. Individuals themselves do not care about the amount of capital in the economy, or even the amount of output. They care about the amount of goods and services they can consume. Thus, a policymaker would want to choose the steady state with the highest level of consumption. The steady state value of capital that maximizes consumption is called the Golden Rule Level of Capital. 13. Starting with too much capital a. The reduction in the saving rate causes an immediate increase in consumption and a decrease in investment. Because investment and depreciation were equal in the initial steady state, investment will now be less than depreciation, which means the economy is no longer in the steady state. Gradually, the capital stock falls, leading to reductions in output, consumption, and investment. These variables continue to fall until the economy reaches a new level of steady state. Because we are assuming that the new steady state is the Golden Rule Steady State, consumption must be higher than it was before the change in the saving even rate, though investment and output are lower. 14. Starting with too little capital a. The increase in the saving rate at time t0 causes an immediate fall in consumption and a rise in investment. Over time, higher investment causes the capital stock to rise. As capital accumulates, output, consumption and investment gradually increase, eventually approaching the new steady state levels. Because the initial steady state was below the Golden Rule, the increase in saving eventually leads to a higher level of consumption than that which prevailed initially. b. The new steady state of consumption eventually is higher, but there is an initial period of reduced consumption c. When the economy begins above the Golden Rule, reaching the Golden Rule produces higher consumption at all points in time. When the economy is below the Golden Rule, reaching the Golden Rule requires initially reducing consumption to increase consumption in the future Chapter 8 15. Efficiency of Labor a. Meant to reflect society's knowledge about production methods: as the available technology improves, the efficiency of labor rises 16. Labor augmenting technological progress a. Measured by g b. Form of technological progress c. Total output grows at rate n+g in ss d. Output per worker grows at rate g in ss 17. Balanced Growth a. Technological progress causes the values of many variables to rise together in the steady state. This property called balanced growth does a good job of describing the long-run data for the U.S. economy. 18. Convergence a. Much research has been devoted to the question of whether economies converge over time to one another. In particular, do economies that start off poor subsequently grow faster than economies that start off rich? If they do, then the world's poor economies will tend to catch up with the world's rich economies. This property of catch up is called convergence. If there is not convergence, then countries that start off behind are likely to remain poor. b. The Solow model makes clear predictions about when convergence should occur. According to the model, whether two economies will converge depends on why they differ in the first place. The two economies would converge is they had different levels of capital, but the same steady state, as determined by the saving rates, population growth rates and the efficiency of labor. If two economies have different steady states, then we should not expect convergence. 19. Policies to Promote Growth a. If MPK < n + g, the economy has more capital than in the Golden Rule steady state and capital accumulation is excessive: reducing the rate of saving would lead to higher consumption both immediately and in the long run b. If MPK > n + g, the economy has less capital than in the Golden Rule steady state and increasing the rate of saving will increase capital accumulation and economic growth and eventually lead to a steady state with higher consumption (although initially consumption will fall) Chapter 9 20. Okun's Law a. What relationship should we expect to find between unemployment and real GDP? i. Because employed workers help to produce goods and services and unemployed workers do not, increases in the unemployment rate should be associated with decreases in real GDP. This negative relationship between unemployment and GDP is called Okun's Law. ii. Percentage Change in real GDP = 3.5% - 2 x Change in Unemployment Rate 1. If the unemployment rate remains the same, real GDP grows by about 3.5% ; this normal growth in the production of goods and services is due to growth in the labor force, capital accumulation and technological progress. 2. In addition, for every percentage point the unemployment rate rises, real GDP growth typically falls by 2% a. Ex: if unemployment rate rises from 5% to8%, then i. Percentage change in GDP = 3.5% - 2 x (8% - 5%) = -2.5% -- indicating recession 21. How the short run and long run differ a. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are "sticky" at some predetermined level. 22. Aggregate Demand a. The relationship between the quantity of output demanded and the aggregate price level b. The AD curve tells us the quantity of goods and services people want to buy at any given level of prices c. Reductions in the money supply shift the AD curve to the left d. Increases in the money supply shift the AD curve to the right 23. Aggregate Supply a. The relationship between the quantity of goods and services supply and the price level b. Depends on time horizon because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run. i. Long Run Aggregate Supply 1. Fixed Y, due to classical model definition that it is fixed in long run so vertical line 2. A fall in AD curve lowers the price level in the long run, but keeps output the same ii. Short Run Aggregate Supply 1. Horizontal line, doesn't adjust to changes in demand 2. A fall in AD curve lowers the level of output but in the short run the prices are sticky and remain the same 24. From the short run to the long run a. Over long periods of time, prices are flexible, the AS curve is vertical, and changes in AD affect the price level but not the output. Over short periods of time, prices are sticky, the AS curve is horizontal and changes in AD affect the level of output but not the price b. A reduction in AD curve lowers output in the short run, but in the long run affects only the price level 25. Stabilization Policy a. Fluctuations in the economy as a whole come from changes in AS or AD. Economists call exogenous events that shift these curves shocks to the economy. A shock that shifts the AD curve is called a demand shock and a shock that shifts the AS curve is called a supply shock. These shocks disrupt the economy by pushing output and employment away from their natural levels. One goal of the model of AS and AD is to show how shock cause economic fluctuations. Another goal of the model is to evaluate how macroeconomic policy can respond to these shocks. Stabilization policy is referred to as this or the policy actions aimed at reducing the severity of short run economic fluctuations. 26. Shocks to AD a. Increase in AD i. Raises output in short run, but in the long run affects only the price level higher as we saw earlier above with other scenarios 27. Shocks to AS a. Adverse supply shock i. They push costs and prices upward ii. The short run AS curve shifts upward iii. If the AD curve is held constant, the economy moves--the price level rises and the amount of output falls below its natural level iv. An experience like this is called stagflation, because it combines stagnation (falling output) and inflation (rising prices) v. Fed has 2 options to control this 1. Leave it be as it will eventually return to steady state in long run, lowering prices and backing down to initial point and level of output, but you are in a painful recession until you get back there 2. Bring the economy toward the natural level of output again but pushing AD curve out, however this permanently holds prices at the new higher level and you have inflation, but you are back at your level of output b. Favorable supply shock i. The breakup of an international oil cartel, which would reduce costs and prices

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