Econ 3, Winter 2023

Questions to help you review the material for Midterm #2

Material from before Midterm #1 that you still need to know.
1. What is meant by the standard of living?
The degree to which people have access to goods and services that
make their lives easier healthier and more enjoyable.

2. What is the expenditure equation for GDP?

GDP = C + I + G + NX

Y = C + I + G + NX

3. What is the relationship between real and nominal GDP?

Real GDP is nominal GDP adjusted for inflation

4. What is included in capital income?

Interests, dividends, rent, or royalties

5. How is the inflation rate related to the average price level?

the average price level is an index that tracks the average level of
prices. And indicates inflation.

6. What is the relationship between nominal and real interest rates

and what is the Fisher
effect?

• Real interest rates are nominal interest rates adjusted for inflation

• Fisher effect : Increase in interest rates leads to an increase in

inflation and vice versa.

7. What interest rate (nominal or real) is the interest rate we read in

the Wall Street Journal?
Nominal interest rates
 8. What is the formula for calculating the average annual rate of
growth over T years?

Yt = Y0(1+ %) ^ t

9. If a variable is the product of other variables or the ratio of other

variables, how does its
growth rate relate to the growth rates of the other variables?

When its a rate or percentage they can add or subtract themselves, when
its decimal values they multiply or divide themselves.

Chapter 19 Economic Growth

1. Why do we often talk about real GDP per capita (i.e. divided by
the population) rather than just nominal GDP?
Because real GDP per capita gives you the average amount of
money held by a person while adjusted for inflation and nominal
GDP only gives you the entire GDP not adjusted.

2. Did real GDP per capita grow in a sustained way before the 1800s?
No it didn’t have sustained growth before 1800

3. Following the Hans Rosling video, if you plot life expectancy on

the vertical axis and real
GDP per capita on the horizontal axis, and indicate each country
with a ball, describe the
movement of most of the balls since 1810.

The countries are going to rise in both of the dimensions.

 4. What did Malthus predict and why did his prediction turn out to be
wrong?

He predicted that as population grew, there would be more misery and

he has wrong because he didn’t account for other factors like technology
improvements affecting the ALP which made the economy better not
worse, therefore contradicting Malthus Theory.

5. Use a production function graph (with output on the vertical axis

and # of workers on the
horizontal axis) to show diminishing marginal production of labor
(MPL).

Output

# of Workers

6. Use a production function graph to show average labor product

(ALP) at two points.
 7. Use a production function graph to show the effects of
technological progress.

8. Why do small differences in growth rates matter in the long run?

Because they are exponential

9. What is a simple formula for approximating how many years it

will take for a
geometrically growth variable to double?
Rule of 72:

72 / Growth rate %

10. In which country has real GDP per capita doubled every 10 years
on average since 1980?
South Korea

11. What is the equation that relates output per capita to average labor
productivity?
Y / Pop = (Y/N)(N/POP)
 12. What is an approximate equation that relates growth in output per
capita to the growth in
average labor productivity?

13. What are the key determinants of average labor productivity?

Human Capital

Technology

Entrepreneurship

Physical Capital

Land and Natural Resources

Institutions

14. In the long-run, which countries tend to grow faster, capitalist

countries that use markets
and allow private ownership of businesses or socialist countries in
which the government owns all of the means of production? Give
two examples of countries that were split with one going capitalist
and the other going communist.

Capitalist Countries:

• East / West Germany

• North / South Korea

15. Give examples where the key technological progress was invention
of new goods, not just reducing the cost of existing goods.
Information transmission across U.S ( telephones, telegrams, etc)
 Transportation across US (Airplanes, cars, trains)

16. What government policies help raise the average product of labor?

• Free and subsidized public education

• Good tax incentives
• Stability of govt policies
• Public Capital (Infrastructure)
• Policies that support research and development
• Legal and political framework
•
17. Describe how the growth rate of average labor productivity during
recent decades in the
U.S. compares to the growth rate from 1920 to 1970.
Constant Growth

Chapter 21 Saving and Capital Formation

1. What is the definition of saving at the household level?
Saving = income - spending on current needs

S=Y-C

2. How is a household’s wealth related to the assets and liabilities on

its balance sheet?
Net Worth = Assets - Liabilities

3. If a household pays off some debt, does its net worth rise or fall?
Their Net Worth rises
 4. If I use $500 of my income to pay off my credit card debt, is that
saving or consumption?
Consumption

5. Are capital gains counted as income or saving?

Income

6. What factors can change a household’s wealth?

Change in savings

Change in Capital Gains

Change in Capital Losses

7. What factors determine how much wealth a household can

accumulate for their
retirement?

Income and consumption.

8. Define national saving. How is it related to private and public

saving?

National saving is private saving + public saving.

Private Saving = Y - T - C

Public Saving = T - G

National Saving = Y - C - G

9. What equation shows how the government budget deficit relates to

public saving?
Government Budget Deficit = - Public Saving
Deficit = G - T

10. Currently the government is running a budget deficit. What does

that imply about public
saving?

The public saving is negative

11. How does the primary deficit differ from the overall government
budget deficit?

12. What are the three main motives for household saving?

Life cycle Saving / Precautionary Saving / Bequest Saving

13. What are the main assumptions of the Permanent Income/Life

Cycle Model?

People want to smooth their consumption over time.

People are forward looking

Saving occurs when consumption is less than income

People respond to a change in current income depending if its temporary

or not

14. If a person hears that their income will rise permanently next year,
what will happen to (i)
their consumption and (ii) saving this year?
Their consumption this year will go up because people adjust their
consumption based on changes in the permanent future income

15. Should consumption and saving respond the same to a temporary

increase in income as to
a permanent increase in income?

No people make adjustments in consumption only if the change is

permanent, not temporary.

16. Is it unwise for economics majors to borrow to finance their

education?

It depends on future income and the interest rates on loans

17. If an increase in home prices raises households’ wealth, what is the

predicted effect on
household consumption and saving rates?
Household consumption will increase because the increase in
households wealth will make them feel richer and make them
spend more. Their saving rates will decrease. This is called the
income effect.

18. How do income and substitution effects impact the relationship

between household
saving and real interest rates?
The substitution effect states that when saving returns are greater
people want to save more and consume less. Their saving rate will
go up and their consumption down.

19. Why does the saving supply curve slope up?

Because when saving returns go up the demand for saving will also go
up if we assume the substitution effect.

20. Does the effect of the real interest rate on national saving come
through its effect on
private saving or public saving?

Public Saving

Because if public saving is negative interest rates have to increase.

21. What is the user cost of capital? What factors affect it?

The user cost of capital is the price of capital services. The user cost of
capital describes the amount of money which would have been needed
during the year to cover the use of capital good services

Interest rates, depreciation rate, and the purchase price of the good.

Physical Capital * (real interest rates + Depreciation)

22. What is the benefit side of buying capital?

You can make money as long as the marginal benefit is more than the
marginal cost.

23. List the key factors that affect the benefits to buying capital.

A decrease in the price of new capital goods

A decrease in real interest rates

Technological Improvement (raises marginal product of capital)

Higher prices of the output

More labor to work with the capital

Lower taxes

24. Can government policy, such as corporate tax rates, influence

investment?

Yes lower taxes raises the willingness for people to invest .

25. How does the real interest rate affect investment?

A decrease in the real interest rates raises willingness to invest

26. What is the rule of thumb for deciding whether to represent a

change as a movement along a curve or a shift in the curve?

• If the variable appears on one of the axes the movement is along the
curve

• If the variable doesn’t appear on one of the axes the movement is

represented as a shift in the curve

27. In the model of investment and saving equilibrium, what variable

is on the vertical axis and what variable is on the horizontal axis?
Vertical Axis - interest rates

Horizontal Axis - Saving and Investment

28. Which curve represents the demand for saving?

 Investment

29. What price adjusts to make desired investment equal to desired

saving?

Real Interest Rates

30. What factors shift the investment curve?Technological

Improvements

Tax policies

Price of output

More labor to work with the capital

31. What factors shift the saving supply curve?

Real Interest Rates

32. How do government budget deficits caused by rises in G affect real

interest rates and
investment?

Rises in cause a rise in budget deficit which in turn cause an increase in

interest rates which will cause investment to decrease.

Chapter 22 Money, Prices, and the Federal Reserve

1. What are the three principal uses of money?
• Medium of Exchange

• Unit of Account

• Store of Value

2. What is barter?

Barter is an exchange of goods or services. It requires a double

coincidence of wants.

3. What are some advantages and disadvantages to storing one’s

wealth in currency?

Disadvantages - doesn’t pay interests, risk of theft or destruction

Advantages - Untraceable

4. What was the Indian “demonetization?” Why was it enacted?

The Indian government said it will take out of circulation the 500 and
1000 bills and replace them with new 500 and 2000 denominations with
hopes of reducing illegal activity.

5. What does Kenneth Rogoff mean by “The Curse of Cash?”

Recalibrate the use of cash so people can keep using it, but also diminish
illegal activity like tax evasion, racketeering, etc. By removing high
denomination bills from the market to make money.

6. Define the two leading measures of money in the U.S.

M1- Currency in hands of public, demand deposits, other checkable
deposits, traveler’s checks

M2- M1, savings deposits, small denomination time deposits, money

market mutual funds.

7. What is the reserve-deposit ratio?

Percentage of a commercial banks deposits that it must keep in
cash as a reserve.

8. Explain how fractional reserve accounting leads to a money

multiplier.

9. Considering reserves, deposits, and loans, which are assets and

which are liabilities of
banks?

Assets - loans and reserves

Liabilities - Deposits

10. Is cash in a bank vault considered to be currency or reserves?

Reserve

11. Suppose that the Fed buys $1 million of bonds from the public.
Does the public’s
decision of how much to hold in currency versus in checking
accounts influence the
change in the money supply (M1)?

Yes
 12. What is the relationship between money, currency, reserves, and
the reserve-deposit
ratio?

Money which is equal to M1 is equal to currency held by public +

(reserves / reverse deposit ratio)

13. What is the Federal Reserve? When was it established?

Federal Reserve, Central Bank of the US

Established in 1913 and came into being in 1914

14. What are the main roles of the Federal Reserve (“Fed”)?

Regulates the nations depositary institutions and controls the quantity of

money

15. What is the dual mandate?

Pursuing the economic goals of maximum employment and price
stability

16. Who is the current chair of the Federal Reserve?

Jerome Powell

17. How does the Fed typically raise the money supply? How does it
typically lower the
money supply?

Open Market Operations

Increases the money supply with Open Market purchases (purchases

bonds)
Decreases the money supply with Open Market Sale (sells bonds)

18. What institutional feature makes banking panics more likely? How
does deposit
insurance help prevent banking panics?

When individuals take out money from the banks

Deposit insurance prevents that people always get their money.

19. What is velocity?

The average number of times a dollar is used annually to buy the goods
and services of GDP

V = (P*Y)/M

20. What is the quantity equation?

MV = PY

21. How are money growth and inflation related in the long-run?
According to the quantity Theory the amount of money circulating in an
economy and inflation are closely linked in the long run.

22. What happened to prices when a tornado hit Scrooge McDuck’s

money bin? What
economic theory predicts this?
The prices went up by a lot, this is related to the Quantity Theory
Ch. 23 Financial Markets (International Capital Flows will not be
on the 2nd midterm.)
1. What are financial intermediaries?

institution that acts as a middleman between two parties in order to

facilitate a financial transaction

2. How do banks help allocate saving to productive uses?

Provide information to user about the possible uses of their funds

They share the risks of individual investment projects

3. What are the key terms that describe a bond?

• Principal Amount

• Coupon Rate

• Coupon Payment

• Term to Maturity

• Credit Risk

• Tax Treatment

• Price

4. Why does a fall in market interest rates raise current bond prices?
Because when interest rates fall the old bonds with previous interest
rates pay more than the new bonds being offered with the new interest
rates.

5. What does the financial press call the rate of return on bonds?

Yield

6. How is the yield on bonds different from the coupon rate?

Coupon rate is the interest in which the bonds was emitted and that and
yield is the current interest rate on the bond.

7. What is the equation relating bond prices and interest rates?

Bond Price * (1 + I) = Principal Amount * (1 + Coupon Rate)

8. Why do most bonds have higher interest rates than U.S.

government bonds?

U.S government bonds are considered some of the safest and the interest
rates on bonds is determined by the risk of defaulting so U.S government
bonds have lower interest rates than other bonds because there is less
risk of defaulting.

9. How does a stock differ from a bond?

A bonds is a promise of payment and a stock is a partial ownership of a

firm .
 10. What is the equation relating stock prices to interest rates?

Stock Price Today * ( 1 + Risk Premium + Interest Rate) = Stock Price

Tomorrow + Dividend

11. What is the impact of an increase in expected profits and dividends

on current stock
prices?

An increase in the price of the stock right now.

12. Explain how diversification can lower risk without lowering

expected return.

Diversification spreads out the risk of an investment protecting you

against multiple scenarios.

(You are not responsible for international capital flows for the 2nd
midterm.)
Current events:
1. What was the U.S. unemployment rate in January?

3.4%

2. Is the labor market currently tight or loose?

Tight

3. What was the inflation rate over the past year?

6.4%

4. What is the general situation with government deficits and debt?

Deficit is 1.38 trillion

Debt = 31.46