Study Guide for Midterm 2*

Econ 2630 STUDY GUIDE FOR MIDTERM 2* * The study guide is not necessarily exhaustive. It is intended to give you direction as to what you should focus on understanding given your limited study time.

Inflation and the Price Level -The Consumer Price Index -How it’s measured, interpreted, and using it to calculate inflation and real prices -Using CPI to calculate to real prices and real income -True Costs of Inflation -How it redistributes wealth between borrowers and lenders, workers and employers -Real and Nominal Interest Rates -Deflation and its impact to the economy

-The current economic situation -The Great Recession and it’s comparison with the Great Depression and previous recessions -The strength of the recovery and projections for the near future -Total Factor Productivity

-Aggregate Expenditures (Keynesian) Model -The multiplier effect and its relationship with the marginal propensity to consume -John Maynard Keynes, his book, and why it was important -“Meeting the demand” -Aggregate Expenditures -Initial expenditures and the marginal propensity to consume -Calculating the short-run equilibrium given an AE function -Calculating and graphing changes in output when AE changes -Changes to unemployment (Okun’s Law) when output changes

Aggregate Supply and Demand -Why the Aggregate Demand curve is downward sloping -Interest rate and real balances effects -What can cause AD to shift -Effects of appreciation or depreciation of U.S. dollar on net exports -Why the Aggregate Supply curve is upward sloping and what can cause it to shift -Long Run Aggregate Supply (Potential Output) -Expansionary and Recessionary Gaps on AD/AS diagram -What happens to output and inflation in the short run and long run when AD/AS change -Understanding historical economic situations (by decade) and it’s relationship with AD/AS

-Fiscal policy -Expansionary and contractionary policies -Political biases -Automatic stabilizers -Progressive tax system -Tax brackets and average tax rates -Deficits and the national debt -Net and gross debt

1 -Current situation and comparisons with other countries -History and Future Projections -Social Security and Medicare -Supply side economics -The Laffer Curve -What could be done to reduce the deficit or debt -Basics of Democrats and Republicans deficit reduction plans

Practice Problems:

1. How is the CPI calculated?

2. Here are values of the CPI for each year from 1990 to 1994. Year CPI Inflation Rate (%)

1990 1.307 x

1991 1.362

1992 1.403

1993 1.445

1994 1.482

a. For each year beginning with 1991, calculate the rate of inflation from the previous year.

b. If the nominal interest rate was 6.4% in 1992, what was the real interest rate?

c. Suppose you learn your grandfather earned $3,000 in 1933 when the CPI was 0.130. Your father earned $50,000 in 1993. Who earned more in real terms?

3. Suppose the CPI equaled 1.00 in 1995 and 1.65 in 2005 and a typical household's income equaled $35,000 in 1995 and $40,000 in 2005. What happened to real household income between 1995 and 2005?

4. Who does higher than expected inflation help and who does it hurt?

7. Suppose workers expect inflation to be 3% next year and create a contract to increase real wages by 4%. Actual inflation turns out to be 5%. What happens to the real wages of workers?

2 8. If a bank wants to earn a 4% real interest rate and inflation is 6%, what nominal interest rate would the bank have to charge?

9. Why is deflation generally considered to be worse as far as its impact to the economy than inflation?

10. What is the current economic situation in the U.S.? How bad was the Great Recession compared to the Great Depression and previous recessions? What economic indicators have rebounded since the Great Recession ended? What are projections for GDP, unemployment, and inflation in the next few years?

11. What is total factor productivity? What does it tell us? Why is it important?

12. The larger the mpc, the ____ the multiplier and the ____ the effect of a change in initial spending on short-run equilibrium output.

13. Suppose the marginal propensity to consume is 0.67, and the change in initial spending is $50 million. What is the estimated change to GDP?

14. If aggregate expenditure in an economy equals 1,000 + .9Y, initial spending equals _____, the MPC equals ___, and the multiplier equals ____.

15. If aggregate expenditure in an economy equals 1,000 + .9Y and potential output (Y*) equals 9,000, then this economy has a(n) ______output gap equal to ______.

16. If short-run equilibrium output equals 9,000, the MPC equals .8, and potential output (Y*) equals 10,000, then spending must be ______by ______to eliminate any output gap.

17. Suppose the potential output in an economy is $8 trillion, actual output is $7 trillion, and the multiplier is 4. To remove this output gap, what must the change in initial expenditures equal?

18. Refer to the figure above. Based on the figure and starting from an initial short-run equilibrium where output equals 20,000, if initial spending decreases by 1,000, then the new short-run equilibrium is at an output equal to:

3 19. Based on the figure, if the economy is in short-run equilibrium with output equal to 16,000, then there is a(n) _____ gap and a _____ in government spending would return the economy to potential output (Y*).

20. Based on the figure, suppose output is currently at 16,000. According to Okun’s Law, what is the level of cyclical unemployment?

21. Based on the figure above, if the economy is in short-run equilibrium with output equal to 24,000, then there is a(n) _____ gap and a _____ in government spending would return the economy to potential output (Y*).

22. Based on the figure above, the multiplier in the economy equals ____.

23. Suppose there is an expansionary output gap. What steps could the government take to eliminate the gap?

24. An increase in inflation causes a(n) ______in aggregate quantity demanded and a(n) ______in aggregate quantity supplied, other things constant.

25. Suppose there is a boom in the stock market that increases wealth in the economy. How would this affect the AD and/or AS curve? How would this affect inflation in the short-run

26. Consider a situation where the economy is initially in a long-run equilibrium and a decrease in housing prices induces a large decrease in consumer spending. How would this affect inflation and output in the short-run?

Consider the following graph:

27. At point A there is a ______gap equal to ______.

28. Suppose the economy starts at point A in the diagram above. What is the appropriate fiscal policy to bring the economy back to potential?

29. As the U.S. dollar appreciates in value compared to foreign currencies, what will happen to the prices of U.S. exports and foreign imports, as well as net exports?

30. Suppose the invention of a new computer system permanently increases worker productivity. What will happen to output and inflation in the long-run?

31. What is stagflation and what is it associated with in the AD/AS model?

32. Fill in the first two blanks with high or low. Then explain what was true of AD or AS to explain that situation (AD was higher, AD was lower, AS was higher, AS was lower). a. For most of the 1960s there was ______inflation and ______unemployment. This is because ______than normal. b. For most of the 1970s there was ______inflation and ______unemployment. This is because ______than normal.

4 c. For most of the 1990s there was ______inflation and ______unemployment. This is because ______than normal. d. Today there is ______inflation and ______unemployment. This is because ______than normal.

33. What are automatic stabilizers?

34. The U.S. income tax system is (progressive or regressive), which means that as GDP rises, average tax rates (fall or rise).

The following table shows U.S. income tax brackets in the U.S. in 2011 Tax Bracket Taxable Income 10% $0–$8,350 15% $8,351– $33,950 25% $33,951–$82,250 28% $82,251–$171,550 33% $171,551–$372,950 35% $372,951 and above

35. a. What’s the average tax rate for someone who earns $25,000? b. What’s the average tax rate for someone who earns $50,000?

36. Someone who earns $50,000 falls into a tax bracket of 25% in the U.S. The percent of their income paid in federal taxes will be (greater than, less than, equal to) 25%.

37. The U.S. deficit currently equals approximately ______, and the national debt currently equals approximately ____.

38. What is the difference between gross and net public debt?

39. What are the major problems associated with a large amount of government debt?

40. What are the future projections regarding the U.S. debt situation?

41. Currently, approximately ______% of the federal U.S. budget is ‘discretionary’. If fiscal policy is not changed, it is projected that ______% of the federal U.S. budget will be discretionary by 2030.

42. What could be done to address the growing burden of Social Security and Medicare?

43. Since 2000, what has happened to average tax rates in the U.S. and the top marginal income tax rate?

44. Laffer curve shows the relationship between ______and ______.

45. Empirical studies suggest that the peak of the Laffer curve is equal to approximately ___.