Memory tricks for macroeconomics

Q: Explain GDP and its limitations as a measure of economic well-being.

A: GDP is the total market value of all final goods and services produced within a country in a given period. The expenditure approach calculates it as C + I + G + (X-M). Limitations as a welfare measure: it ignores income distribution (high GDP is consistent with extreme inequality), excludes non-market activity like household production and volunteer work, fails to account for environmental degradation (pollution that creates medical spending raises GDP), ignores leisure and life satisfaction, and counts all output the same regardless of composition (prisons count the same as schools). Alternatives include the Human Development Index which adds life expectancy and education, and the Genuine Progress Indicator which adjusts for inequality and environmental costs. Nominal GDP uses current prices while Real GDP adjusts for inflation to measure actual changes in output.

Q: Explain the AD-AS model and use it to analyze a recession and appropriate policy responses.

A: Aggregate Demand slopes downward due to the wealth effect, interest rate effect, and exchange rate effect. Short-run Aggregate Supply slopes upward. Long-run AS is vertical at potential GDP determined by resources and technology. A negative demand shock shifts AD left — output falls, unemployment rises, and the price level falls. Classical self-correction: wages and prices eventually fall, SRAS shifts right, economy returns to potential output at a lower price level. Keynesian response: do not wait — fiscal stimulus (increase G or cut T) shifts AD right back to potential. Monetary response: Fed cuts interest rates, investment rises, AD shifts right. A supply shock (SRAS shifts left) causes stagflation — output falls and prices rise simultaneously. Demand policy cannot fix stagflation without making one problem worse, illustrating the limits of demand-side stabilization.

Q: Explain the causes and consequences of inflation and how the Fed responds.

A: Demand-pull inflation: AD rises faster than AS can accommodate, too much money chasing too few goods. Cost-push inflation: SRAS shifts left due to input cost increases like an oil shock, producing stagflation. Built-in inflation: wage-price spiral where workers expect inflation and demand higher wages which raises costs and prices further. Consequences: unanticipated inflation redistributes from lenders to borrowers, creates shoe-leather costs (more trips to bank), menu costs (changing prices), and distorted price signals. Hyperinflation destroys money's functions and can collapse economic activity. Federal Reserve response: raise the federal funds rate target, banks raise lending rates, investment and consumption fall, AD decreases, inflation falls. Taylor Rule: raise rates 1.5 percent for each 1 percent that inflation exceeds the 2 percent target. Trade-off: higher rates slow growth and raise unemployment, creating tension with the dual mandate.

Q: Explain economic growth — its sources and why small differences in growth rates matter enormously.

A: Long-run economic growth is a sustained increase in real GDP per capita — the most important determinant of living standards over decades. Sources: human capital (education and skills that increase worker productivity), physical capital (machinery and infrastructure), technology and Total Factor Productivity (improvements in how inputs are combined — the Solow residual), and institutions (property rights, rule of law, contract enforcement). Solow growth model: capital accumulates until the steady state, and only technology drives long-run per capita growth. Rule of 70: years to double equals 70 divided by the growth rate. At 1 percent growth the economy doubles in 70 years. At 3.5 percent growth it doubles in 20 years. Over a century the difference between 1 and 3 percent growth produces an eightfold difference in living standards — demonstrating the extraordinary power of compounding.

Q: Compare Keynesian and Classical views on recessions and policy.

A: Classical view: prices and wages are flexible so markets clear quickly, recessions are brief self-correcting deviations, Say's Law says supply creates its own demand, and government intervention delays adjustment and creates distortions. Policy prescription: stable money growth and balanced budgets. Keynesian view (Keynes 1936): wages and prices are sticky downward so markets can get stuck below full employment for extended periods, recessions can persist without intervention, and fiscal stimulus has a multiplied impact through the spending multiplier. Policy prescription: increase government spending or cut taxes to close the recessionary gap. Evidence from 2008-09: large multipliers from stimulus in countries that acted, while austerity in Europe produced deeper and longer recessions — supporting the Keynesian view particularly when interest rates are near zero.