STUDY Guide Quiz #2
This test consists of 24 multiple choice questions. You will have two hours to complete the quiz.
What is a trade deficit? (imports versus exports) exports are less than imports
Trade deficits are situations in which the imports of goods and services exceed the products exported by a specific country. While is it not unusual for nations with a very stable economy to experience a small amount of trade deficit from time to time, prolonged periods with a significant imbalance between exports and imports can create significant economic issues within the country. At the same time, a trade deficit may also weaken the currency of the country on the Forex market.
What division in the U.S. makes the decision to increase interest rates?
Central Bank, IE The FED, Federal Reserve
What division in the U. S. makes the decision to increase taxes?
U.S Congress
What is monetary policy? p478, p516 - Monetary policy affects the exchange rate primarily through its effect on the real interest rate.
* Monetary policy refers to the decisions that determine the nation’s money supply and interest rates
* Monetary policy is set and implemented by a nation’s central bank
* In the U.S. the central bank is called the Federal Reserve System or simply the Fed Founded in 1913
* Primary mission of fostering economic growth, keeping inflation low, and maintaining stability in financial markets
What is fiscal policy? p478 - refers to discussions to decisions that determine the governments budget, including the amount and composition of government expenditures and government revenues.
When the government officials spend more than they collect in taxes, the government runs a deficit, and when they spend less, the governments budget is in surplus.
What is a recession? p488 A period in which the economy is growing at a rate significantly below normal
What are characteristics of a recession?
Real GDP falls for at least two consecutive quarters
-worker layoffs
-lower prices
-less consumer spending therefore,
-less profit for businesses
-slow economy
-less demand for products
What occurs with inflation preceding a recession? p493 Recessions tend to be followed by a decline in inflation and preceded by an increase in inflation.
Today, most mainstream economists favor a low, steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
After a recession? p493 Recessions tend to be followed by a decline in inflation and preceded by an increase in inflation.
What does an open market purchase do to interest rates and the money supply?
Any of the purchases and sales of government securities and commercial paper by a central bank in an effort to regulate the money supply and credit conditions. Open market operations can also be used to stabilize the prices of government securities. When the central bank buys securities on the open market, it increases the reserves of commercial banks, making it possible for them to expand their loans and investments. It also increases the price of government securities, equivalent to reducing their interest rates, and decreases interest rates generally, thus encouraging investment. If the central bank sells securities, the effects are reversed. Open market operations are usually performed with short-term government securities such as treasury bills.

What is the nominal exchange rate? Be able to calculate this based on different currencies. p508 - The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. A rise in the value of a currency relative to other currencies is called an appreciation; a decline in the value of a currency is called a depreciation.
Exchange rates can be flexible or fixed. The value of a flexible exchange rate is determined by the supply and demand for the currency in the foreign exchange market, the market on which currencies of various nations are traded for one another. The government sets the value of a fixed exchange rate.
**Look in chapWorkProblems.xls for calculation
When the interest rate in the US increases, what happens to US assets in relation to foreign investors? p516 - The tightening of monetary policy raises the domestic U.S. real interest rate r, making U,S, assets, such as bonds, more attractive to both foreign and American financial investors. The increased willingness of foreign investors to buy U.S. assets increases the demand for dollars, shifting the demand curve rightward from D to D'. The willingness of American investors to buy more U.S. assets (and presumably fewer foreign assets) decreases the supply of dollars and shifts the supply curve leftward from S to S'. The equilibrium moves from point E to point F, and the market equilibrium value of the dollar rises from e'" to e"•'.
In short, a tightening of monetary policy b~ the Fed raises the demand for dollars and reduces the supply of dollars, causing the dollar to appreciate.
What are international reserves? p521 To be able to purchase its own currency and maintain an overvalued exchange rate, the government (usually the central bank) must hold foreign currency assets, called international reserves, or simply reserves. For example the Latinian central bank may hold dollar deposits in U.S. banks or U.S. government debt, which it can trade for pesos in the foreign exchange market as needed.
What is a speculative attack? p523 - A government's attempt to maintain an overvalued exchange rate can be ended quickly and unexpectedly by the onset of a speculative attack. A speculative attack involves massive selling of domestic currency assets by both domestic and foreign financial investors. For example, in a speculative attack on the Latinian peso, financial investors would attempt to get rid of any financial assets-stocks, bonds, deposits in banks-denominated in pesos. A speculative attack is most likely to occur when financial investors fear that an overvalued currency will soon be devalued, since in a devaluation, financial assets denominated in the domestic currency suddenly become worth much less in terms of other currencies. Ironically, speculative attacks, which are usually prompted by fear of devaluation, may turn out to be the cause of devaluation. Thus, a speculative attack actually may be a self-fulfilling prophecy.
You will have problems like this: Suppose the government of South Island has fixed the value of its currency, the Islandia, at $0.80 per Islandia, but the market equilibrium value of the Islandia is $0.90 per New Peso. In order to maintain the official value of the Islandia the Central Bank of South Island must either _decrease_____ domestic interest rates or supply Islandia, which causes the supply of international reserves to _increase___. (increase or decrease) p520 -
Key point - If monetary policy is used to set the fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy.

What is the purchasing power parity theory? p535 - The most basic theory of how nominal rates are determined in the long run is called purchasing power parity, or PPP. To understand this theory, we must first discuss a market equilibrium economic concept, called the law of one price.
What is economic profit? p360 - is the difference between total revenue and total economic cost
Economic profit = Total revenue – Total economic cost = Total revenue – Explicit costs – Implicit costs
What is a price-taking firm? p371 - Price-taking firm
* Cannot set price of its product
* Price is determined strictly by market forces of demand & supply
Price-setting firm
* Can set price of its product
* Has a degree of market power, which is ability to raise price without losing all sales
What are features characterizing market structures? p373 - Market characteristics that determine the economic environment in which a firm operates
- Number & size of firms in market
- Degree of product differentiation
- Likelihood of new firms entering market

What is a competitive market? p372
- Large number of relatively small firms
- Differentiated products
- No barriers to entry

What are characteristics of a monopoly market structure? p373 - Single firm
- Produces product with no close substitutes
- Protected by a barrier to entry
What is an oligopoly?
In oligopoly markets, there are only a few firms whose profits are interdependent—each firm’s decisions about pricing, output, advertising, and so forth affects all other firms’ profits—with varying degrees of product differentiation.
Why is economic profit the best measure of a firm’s performance?
* economic profit takes into consideration all cost both implicit and explicit.
* In general when managers maximize economic profit, they are also maximizing the value of the firm, which is the price someone will pay for the firm.
What are examples of an implicit cost to a firm?
* Examples include the value of an entrepreneur’s labor and the interest that could be earned were the owners’ assets (including the values of stock in corporations) not tied up in the business. In entering the software business and creating Windows, and subsequently Microsoft, Bill Gates dropped out of college and made a conscious decision to surrender what wages he could have made as a college graduate if his endeavor failed. Though it paid off for him, similar decisions are made on a daily basis by people all over the world and it doesn’t always end favorably for everyone. Firms must all bear both implicit and explicit costs into consideration to make rational business decisions.
* A cost that is represented by lost opportunity in the use of a company's own resources, excluding cash.
* p357 - In contrast to explicit costs of using market-supplied resources, there are no out of pocket monetary or cash payments made for using owner-supplied resources. The opportunity cost of using an owner-supplied resource is the best return the owners of the firm could have received had they taken their own resource to market instead of using it themselves. These nonmonetary opportunity costs of using a firm's own resources are called implicit costs because the firm makes no monetary payment to use its own resources. Even though firms do not make explicit monetary payments for using Owner-supplied inputs, the opportunity costs of using such inputs are not zero, The opportunity cost is only equal to zero if the market value of the resource is zero, that is, if no other firm would be willing to pay anything for the use of the resource.
When does the market demand curve shift for a given good shift? p393 - Increase in demand A change in the demand function that causes an increase in quantity demanded at every price and is reflected by a rightward shift in the demand curve
What would lead to a decrease in the given demand for a good?
Price goes up for compliment goods or Income goes up cause a demand decrease in inferior goods
If input prices increase, what happens to supply?
Supply goes down. Cost of production goes up and the motivation to produce more goes down.
When a company reduces the price of the product what occurs with demand?
A reduction in price results in an increase in demand.
Price goes up , than the demand on substitutes go up p391 - Law of demand = Quantity demanded increases when price falls, and quantity demanded decreases when price rises, other things held constant
What is the relationship between the actual market price and the equilibrium market price?" p404 - usually the same . A situation in which, at the prevailing price, consumers can buy all of a good they wish and producers can sell all of the good they wish.
You may have questions like this: If the current price of a good is $30, market demand is Qd = 800 – 20P, and market supply is Qs = -80 + 10P, - is there a demand or shortage??
See chapWorkProblems.xls
Be able to calculate the equilibrium price and output given information: If the demand function is Qd = 100 - 4P and the supply function is QS = 20 + 2P.
See chapWorkProblems.xls
Know the relationship of a firm maximizing profits and the level of output.
In economics, profit maximization is the (short run) process by which a firm determines the price and output level that returns the greatest profit.
What is an objective function?
Function to be either maximized or minimized.
Minimize Cost
Choice variables determine the value of the objective function
What is a choice variable?
The determinants of the values of objective functions
Labor and Capitol types Continuus(ie things that change) or discrete (ie # of planes, # of pilots)
Constraints include Budget, Production, Technology and Government regulations
Know the relationship between marginal cost and marginal benefit. p439 - Marginal benefit (MB)
*Change in total benefit (TB) caused by an incremental change in the level of the activity
Net Benefit , diff between Tot Ben and Tot cost for an activity. Optimal level is the level the max benefit.
Marginal cost (MC)
*Change in total cost (TC) caused by an incremental change in the level of the activity slopes of total benefit and tot cost curves , measuring the rate of change.
Find Optimal activity level. MB > MC activity should be increased until we reach the highest net benefit. When MB = MC that is optimal. This is known as the cost benefit principle.
Irrelevant Cost are
- Sunk Cost = cost that have been previous paid.
IE example paying bonus money to a player and make sure they play because you paid them.
- Previous paid and cannot be recovered. IE Rent. going to have to pay anyway.
- Average (or unit) cost, computed by dividing total cost by the number or units of the activity.
The above to not affect Marginal Cost.